April 29, 2016 - Phil Hodgen

Cloud Computing Taxation for Minimultinationals

Hi, Phil here again. Welcome to the Friday Edition. Every other week you get international tax stuff. When I am on a plane, you get a Jell-O Shot. (No plane rides for me, at least for a while. Too much year-end school stuff with the kids).

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Cloud Computing and International Tax

This episode is for people who own and run software companies – specifically, cloud-based companies: Platform-as-a-Service, Software-as-a-Service, etc. Mailchimp, the company that delivers the Friday Edition to you, is a perfect example of this kind of business. Fastmail is another. Website hosting companies are a third type of example. Big companies provide these services: iCloud, Google Apps, AWS.

I am going to assume this is a non-U.S. cloud-based business, with U.S. customers. The frequent calls that we receive are from U.S. citizen entrepreneurs, who are thinking of setting up foreign corporations to do business “in the cloud” and, of course, not pay tax. But we could easily be thinking of non-U.S. persons who have a business outside the United States, delivering cloud-based digital services to customers in the United States.

The Dream

Tax saving strategies for the “smaller than Google” crowd come to mind immediately:

I will write some software that people can use to send their email newsletters. Then I will set up a company in a nice tax-free location, and put my software on a server there. I will sell monthly subscriptions to my service.

A company in a tax-free location is providing the service and earning the profit. No tax is payable in the USA or anywhere else!

What could possibly go wrong – for the tax collector or the entrepreneur?

  • This idea might work. Bad for the IRS: the application of tax law is correct, and no tax is collected.
  • This idea might not work. Bad for the entrepreneur: this application of tax law might be wrong, and a life-altering tax bill comes due.

The Land of Fog

At the moment we live in a world of “might”. U.S. international tax laws were written decades ago, when telex machines and steam ships were quite the fashion. The last significant effort from the IRS at writing rules for taxing software? It happened in 1998, when buying a box full of disks was the way things worked.1

Anyone looking at the antique concepts of Subchapter N2 – and even the quaintly late-90s vintage rules of T. Regs. §1.861-18 – will quickly get confused. Applying those laws to digital business is sometimes an exercise of parsing the meaning of fog.

You, however, run a business and need to deal with business risk – tax. You live and work in Country A. Your servers are in five other countries. Your marketing team is in Country B, and your sysadmins are in Country C. Your customers are spread across the globe.

Where do you pay tax? And how much? (Worse yet – and the topic for another day – what kind of tax? Income tax? VAT? Sales tax?)

This Has Not Escaped the Government’s Attention

This situation has not escaped the attention of the IRS, and you will be pleased to know that they have started to work on the problem. They are working on the problem incrementally: one big question at a time.

How to Navigate in the Fog

When there is uncertainty, revert to First Principles. I will walk you through the basic principles of U.S. tax law, and show you, the owner or executive of a cross-border digital business, how to think your way through tax planning – in the absence of clear guidelines.3

When looking at cloud computing transactions, the analytical steps look like this:

  • What type of activity is generating the income? Tax jargon for this is “what is the character of the income?”
  • The type of activity will help you decide on where the income was earned. Tax jargon for this is “source of income”.
  • Countries typically like to tax income that is pulled from sources within their borders. So knowing the “source of income” tells you whether a particular country will want to tax the income. Or not.
  • Once you know that the income will be taxable, it is then a matter of figuring out the tax rate.

Character of Income

For better or worse, taxing cloud computing transactions seems to be an exercise in analogy. Back to Mailchimp. When I pull up a browser, navigate to Mailchimp, and log in, what is Mailchimp doing for me? The tax system has a limited number of ancient analogies to draw from:

  • Mailchimp is renting a slice of their server to me, so I am paying them rental income. Or, if you read the tax literature, I am making a rent payment to Mailchimp.
  • Mailchimp is providing me a completely automated service. I use (but do not rent) their servers and their software to send out the Friday Edition.
  • Mailchimp lets me use their software (intellectual property) in exchange for money. I pay them a royalty.
  • Mailchimp sells me a metaphysical “thing” (I’m not sure what, frankly), so it is like I purchased a pencil. It’s a purchase and sale.

None of these are really satisfactory analogies to explain what is happening, but the consensus is that “service” is the least bad answer. The reason? Internal Revenue Code Section 7701(e), which tries to distinguish between leases of property, and providing a service using property.

This, incidentally, is the problem of building incrementally on an existing set of laws to accommodate a new way of doing business. How do you explain a mammal when all you know is fish? Often, the easiest way is to deny that the mammal is intrinsically different from the fish. 🙂

It is not an easy problem. What if my transaction is mixed? I pay for a bundle of a rented bare metal server, some server-side software, and a significant downloaded piece of client-side software? I could conceivably have a lease payment, a service, and a royalty all in a single payment.

The IRS is focusing on the question of character of income first, as they work their way through the kit of questions that surround cloud computing transactions. My guess is that they will try to finesse the “mixed transaction” problem I described – just for simplicity and ease of administration. My further guess is that cloud computing will be treated as a service. I do not envy the government folk who are working on this job. This is brain-hurt territory.

Guidance for the Perplexed

Your starting assumption is that you have income generated from providing a service, until proven otherwise or until the government writes a rule that gives you a blindingly obvious answer. This conclusion is the raw material for business decisions you will make.

Source of Income

Now that we think the income earned is from rendering a service to the customers, we have to ask where that income came from. The default answer for services is easy: income is earned where the service is rendered. Your first assumption is that you render the service from the location of the server. Well, maybe. This idea gives the appearance of certainty but can be manipulated. And what if the software is actually executing in the customer’s browser or on a locally installed piece of software?

What if your servers are in France, your marketing team is in Hong Kong, and your sysadmins are in India? You live in the United States and manage the business. Now what? If you are selling a service to customers, where was the service rendered?

This topic will be analyzed and laws will be written – sooner or later. My guess is that the IRS will write some rules that are less than entirely clear to attempt to define “where the services were rendered” in the context of cloud computing transactions. As a fallback, they will impose a rule that says “If you cannot figure out the answer, allocate the income 50% to U.S. source and 50% to foreign source.” This idea is used for inventory and for telecommunications income; recycling of ideas is to be encouraged, right?

Guidance for the Perplexed

Until the IRS says otherwise, aim for foreign source income unless you have machines or people in the United States, doing things. This takes a bit of effort. There are angels dancing on the heads of pins here. What if you run your business on rented servers in the U.S.? Your own servers in a U.S. data center?“ A VPS instance? Your objective will be to be able to have a U.S. customer but, as a non-U.S. business, pay no tax on the revenue you receive from that U.S. customer.

The analogy you are aiming for is the analogy of providing personal services (as a consultant, for instance) while working entirely outside the United States for a U.S. customer. That is “foreign source income.” Can you set up the equivalent to that concept for all of the elements of your cloud-based business? People and machines?

Not Doing Business in the USA

Next, you will want to avoid “doing business” in the USA. The United States will tax income from services (even if services are performed outside the United States) if it can somehow link the income from those services to a home base in the United States. Jargon to look for: tax is imposed on income that is effectively connected with the conduct of a U.S. trade or business.

Guidance for the Perplexed

Do not have offices (a “fixed place of business”) in the United States. This includes more than you think it includes.

People. Do not have employees in the United States. Be very, very careful with contractors in the United States. Sometimes the actions of agents are treated as the actions of the principal. You think you have an independent contractor, but from a tax point of view that independent contractor is your Man in Miami (or whatever) and you have a tax-gravity creating point of presence in the United States that causes revenue to be taxed in the United States.


The tax rules for online businesses are a bit of a mess now. The IRS will be writing rules intended to clarify exactly what will and will not be taxed for cloud transactions. Until those rules are written, work towards a non-U.S. cloud service provider being able to receive revenue from U.S. customers without U.S. income tax.

Don’t get terribly excited by this conclusion. It won’t necessarily make you rich by eliminating U.S. income tax. There is an armada of collateral tax problems that you will need to deal with, ranging from “How do I get ownership of this software into a foreign corporation without triggering a massive tax problem?” to “OMG I thought I was so clever but I wasn’t really” (aka Subpart F or PFIC problems).

And the work to be done is not commodity work based on clearly defined rules. You will spend a lot of money on lawyers and accountants to set up your systems and do the tax paperwork every year. You (the founder or executive) will divert a fair amount of your brainpower away from your business in order to make the system work as planned.

Still, I don’t want to discourage you. For U.S. entrepreneurs, remember that international tax planning is mostly about tax deferral–paying the income tax many years from now, instead of now. Do some cost/benefit modeling. You may decide the work and brain damage is worth it.


Yes, I know there are a zillion companies out there right now making money in the cloud and not paying tax. There are two possible answers for this: (1) they’re really, really smart; or (2) they are really, really lucky.

More than most of the things that I write about, this whole cloud-based business taxation stuff is murky. So don’t rely on this newsletter to make strategic business decisions. Get someone to help you out, and do a lot of research.

See you in a couple of weeks with more minimultinational tax stuff.

  1. T. Regs. §1.861-18. 
  2. Subchapter N is the part of the Internal Revenue Code that contains most of the international tax rules. 
  3. Clear rules are coming, unfortunately. They are coming from the Internal Revenue Service. They are coming from the OECD and the European Union, as well as from every self-respecting tax bureaucracy in every country larger than a breadbox. Goose, prepare to be plucked. 
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