building successful cloud provider service

8/11/2019 Building Successful Cloud Provider Service

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Building a SuccessfulCloud Provider

ServiceAccounting and Tax

Considerations

kpmg.com


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CONTENTS

1 Introduction

2 Accounting implications

14 Tax issues

22 Conclusion

24 How KPMG can help

24 KPMG cloud publications

26 Contact us


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Cloud has become one of the biggest revenue growth drivers fortechnology companies. As cloud continues to enable new business

models and creates incremental disruptions in enterprise and consumer

markets, cloud service providers need to consider a variety of business,

financial reporting, and tax implications to enhance the efficiency and value

of their cloud offerings

Gary Matuszak, Global and U.S. Chair,

Technology, Media & Telecommunications

ACCOUNTING IMPLICATIONS

Revenue recognition. . . . . . . . . . . . . . . . 4

Are cloud arrangements subject

to software guidance? . . . . . . . . . . . . . . . . 4

Separation criteria . . . . . . . . . . . . . . . . . . . . . 6

Allocating revenue to

separate units of accounting. . . . . . . . . . . . . . 6

Limitations on allocating the consideration . . . . 7Timing of revenue recognition . . . . . . . . . . . . . . . 8

Accounting for costs incurred to develop,

maintain, and deliver a cloud offering . . . . . . . . . . . 9

Costs to develop internal-use software

and Web site development. . . . . . . . . . . . . . . . . . . . 9

Direct costs associated with setup or

implementation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Costs incurred subsequent to implementation. . . . . . . 10

Customer perspective up-front costs incurred

for cloud implementation. . . . . . . . . . . . . . . . . . . . . . . . . 11

What lies ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

TAX CONSIDERATIONS

General considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

U.S. federal tax considerations . . . . . . . . . . . . . . . . . . . . . . . . . 16

Classifying cloud computing transactions . . . . . . . . . . . . . . . . . 16

Sourcing income from cloud computing transactions. . . . . . . . 18

Outbound and inbound taxation considerations. . . . . . . . . . . . 18

State and local tax considerations . . . . . . . . . . . . . . . . . . . . . . . 19

Nexus considerations for cloud computing companies . . . . . . 19

Characterization of cloud computing transactions for

state and local sales and transaction tax purposes . . . . . . . . . . 20

Characterization and sourcing of receipts for

state net income tax purposes . . . . . . . . . . . . . . . . . . . . . . . . . 20

Transfer pricing considerations . . . . . . . . . . . . . . . . . . . . . . . . . 21

Non U.S. tax considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

KPMG LLP (KPMG) has been providing guidance that specifically addresses the businessissues cloud service providers (CSPs) need to address to deliver their services successfully.

This publication is focused on the key accounting and tax areas including:

Cloud business models are constantly creating new business opportunities and risks. CSPs that proactively manage and plan for

the accounting and tax issues associated with operating in the cloud may unlock incremental value for their business models.


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1The following discussion addresses only general accounting issues; hence, it is not intended to provide in-depth accounting advice for all possible offerings, business models, or contract structures.

Accounting implicationsassociated with cloud1


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A typical cloud offering will have

multiple elements that may be delivered

at different points over the relationship,

and the accounting model is influenced

by the service providers ability to separate

those elements into units of accounting.

This ability to separate elements will

affect, for instance, the timing of revenue

recognition.

CSPs may face accounting challenges and

opportunities in delivering services throughthe cloud. In particular, the very nature of cloud

computing and the related pricing mechanisms

often results in a ratable recognition of revenue over

the relevant service period. Thus, a cloud computing

model presents a service provider with an opportunity

for a more predictable, recurring revenue stream. For

example, in a more traditional software licensing model

involving the sale of on-premise perpetual licenses,

more revenue may be recognized upon the delivery of

the software if the vendor has vendor-specific objective

evidence (VSOE) of selling price for its other deliverables

included in the arrangement.

We have noticed many vendors with hybrid offerings in which

certain elements are licensed on-premise, perhaps with a

future hosting option, while other elements are offered only in

a cloud environment. This type of model can result in a different

accounting model for different elements, sometimes even within

the same arrangement. In some cases, certain elements of a

cloud arrangement may qualify for up-front revenue recognition,

while in others, fees are required to be aggregated and

recognized over a longer service period, regardless of when

the respective elements are delivered.

For a vendor with a cloud offering, this may require carefulforecasting of future revenues and managing stakeholders

expectations for growth. In particular, vendors should be mindful

of any features that may allow the customer not to pay for

delivered services until the vendor provides other goods or

services, or features that entitle the customer to a refund

equal to the pro rata amount of any undelivered services.

A cloud computing model may also result in the need to

measure and provide different financial metrics such as billings,

bookings, levels of recurring contract value, or similar key

performance indicators. Further, the recognition of revenue over

time continues to present challenges in managing and delivering

consistent or stable profit margins, especially when the effortrelated to professional services occurs before the associated

revenue.

For cloud service providers (CSPs), common accounting issues relate to the timing and amount

of revenue that can be recognized in an ongoing customer relationship, as well as how

companies account for the costs associated with providing services in the cloud. Since changes

to accounting guidance were issued about two years ago, we have noted certain implementation

challenges, as well as evolving policies and practices among various cloud providers.


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The following discussion seeks to address some of the more common considerations for CSPswhen structuring customer contracts. Please note that, generally, the customer arrangementswill be subject to the accounting provisions of Accounting Standards Codification Topic 605-25(including the ASU 2009-13, Multiple-Deliverable Revenue Arrangements, as codified in ASC Topic605-25), SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, and ASC Topic 985-605,Software Revenue Recognition.

A typical cloud offering will have multiple elements that may be delivered at different points duringa relationship period. Therefore, the accounting model will be affected by the CSPs ability toseparate these elements into discrete units of accounting, and the ability (or inability) to separatethe various elements will drive the timing of when revenue can be recognized for each element.

Are cloud arrangements subject to software guidance?

CSPs often include a license to use the intellectual property, and

in some cases CSPs may install software at the customer site

that acts as an interface between the customer and the CSPs

server. The inclusion of a license that allows the customer to use

software hosted by the cloud computing vendor is not in-and-of

itself a sufficient basis to conclude that the arrangement is in the

scope of ASC 985-605. Rather, CSPs would need to evaluate the

substance of the arrangement to determine whether software is

considered a deliverable in the arrangement.

A cloud arrangement contains software that is within the

scope of ASC 985-605 if both of the following conditionsare met:

>The customer has the contractual right to take possession

of the software at any time during the hosting period without

incurring a significant penalty, and

>It is feasible for the customer to run the software either on

its own hardware or on a third partys hardware.

A significant penalty embodies two distinct concepts: (1)

the ability to take delivery of the software without incurring

significant costs (i.e., a financial penalty), and (2) the ability to

use the software separately without a significant reduction in its

utility or value (i.e., a functional penalty). Generally, in a typical

cloud arrangement, the customers do not have the contractual

right to take possession of software and run the software in-

house or through an unrelated vendor; therefore, cloud service

arrangements generally are not in the scope of ASC 985-605.

Questions have been raised whether a software element exists

in arrangements where the customer is able to take possessionor ownership over partial software elements, but not the entire

software, because current guidance is silent about those fact

patterns. In those cases, CSPs should evaluate whether a

service based on software is being provided to the customer,

or whether the software itself is being delivered. Some may

conclude that if the customer does not have the right to take

possession of significant features and functionalities of the

software, a service based on the software is being delivered.

2Unless otherwise noted, all technical references in this section are to the current FASB Accounting Standards Codification (ASC) Topic 605-25, Multiple ElementArrangements. The more familiar, precodification reference is EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables.

Revenue recognition2

The following is a general overview of the accounting guidance and frameworks relevant to providers

of cloud computing services. Cloud service providers (CSPs) will likely encounter implementation

challenges when applying the relevant guidance to their specific facts and circumstances. While we have

identified the general factors to consider in accounting for a cloud offering, the guidance that follows

will not address every potential scenario a CSP will face. We note that while this particular guidance

has been applied by cloud vendors for approximately two years, the FASB and IASB (the boards) are

working toward a converged revenue standard, expected to be issued in 2013, that would replace most

transaction- and industry-specific revenue recognition accounting guidance in U.S. generally accepted

accounting principles (GAAP) with broad-based principles applicable to all customer contracts. See the

What Lies Ahead section for a preview of the potential impact from the proposed revenue standard.



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Allocating revenue to separate units of accounting

Assuming a CSP can separate the elements of an arrangement

into multiple units of accounting, revenue would be allocated

to each unit at the inception of the arrangement based on their

relative selling price and recognized when the relevant criteria

are satisfied for each element.

Multiple-element arrangement guidance includes a hierarchy of

evidence to determine the stand-alone selling price of a unit of

accounting based on the CSPs own specific objective evidence,

third-party evidence (TPE) and estimated selling price. If VSOE

is available, it is used to determine the selling price of a unit of

accounting. If not, a vendor would determine whether TPE is

available and can be used to determine the selling price.

If TPE is not available, an estimated selling price is used.

>VSOE is generally the price that a vendor charges when it

sells a product or service separately (i.e., on a stand-alone

basis). For an item not yet sold separately, VSOE is the price

established by management having the relevant authority

to establish such a price. It must also be probable that the

established price will not change before the product or service

is introduced into the marketplace. In some cases, it may be

difficult for a CSP to establish VSOE due to the significant

variability in services pricing, competitive pressures, and

introduction of new service offerings.

>TPE is generally the price at which a competitor or third

party sells the same, or a similar and largely interchangeable,

deliverable on a stand-alone basis. TPE may also include

the CSPs stand-alone selling price for a similar and largely

interchangeable product or service, but not the same product

or service.

>Estimated selling price is defined as the price at which a

vendor would transact if the deliverable were sold by the

vendor regularly on a stand-alone basis. A vendor would

consider market conditions as well as entity-specific factors

when estimating a stand-alone selling price. A vendors

best estimate of selling price should be consistent with the

objective of determining VSOE.

Separation criteriaGuidance in ASC 605-25 requires a CSP to separate the elements

of an arrangement when the following criteria are met:

>The delivered item or items have value to the customer on a

stand-alone basis

>If the arrangement includes a general right of return relative to

the delivered item, delivery or performance of the undelivered

item or items is considered probable and substantially in the

control of the CSP.

For an item to have stand-alone value to the customer, the

element (product or service) must either be sold separately

by any CSP or the customer could resell the delivered item oritems on a stand-alone basis. Considering that most, if not all,

elements being provided by a CSP will consist of services, CSPs

generally satisfy this requirement by demonstrating that different

services are sold separately, either by the CSP or another service

provider, rather than by demonstrating a customers ability to

resell the element. For example, many cloud offerings involve

consulting or other implementation services that enhance the

value received by the customer by tailoring the service offerings

to the customers needs and operating environment. The

CSP may provide implementation services separately through

follow-on arrangements, or other service providers may offer

implementation services on a stand-alone basis, either of which

could satisfy this stand-alone value criterion.

However, if the professional services are unique and are not

capable of being provided by another vendor due to unique

features, knowledge requirements, or complexity, and the CSP

does not sell the professional services separately, this may

indicate the services would not satisfy the stand-alone value

criterion.

Additionally, in some arrangements the CSP may charge

fees incremental to the hosting services at inception of an

arrangement for various activities such as service activation,

access, or other required setup activities (i.e., up-front services).

Those up-front services in a hosting arrangement would not

represent a separate deliverable if the up-front services have

little or no value to the customer on a stand-alone basis.

In these situations, up-front fees would be deferred and

recognized systematically over the period in which the hosting

services are performed, which may extend beyond the initial

contractual period if the relationship with the customer is

expected to extend beyond the initial term and the customer

continues to benefit from the up-front services (e.g., if

subsequent renewals are priced at a bargain to the initial

up-front fee).



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Limitations on allocating the considerationThe guidance on multiple-element arrangements includes a

limitation to prevent revenue from being recognized as units

of accounting are delivered when the arrangement permits

delayed payments, or requires refunds of amounts recognized

as revenue if all or some of the remaining deliverables are not

delivered, even when delivery or performance is substantially

within the vendors control.

A common feature in CSP arrangements is a contractual

provision entitling the customer to a refund equal to the pro rata

amount of any undelivered services that are not provided (i.e.,

the CSPs right to receive or retain a portion of the arrangement

consideration is linked to its successful delivery of the

undelivered items to the customer). In those cases, the amount

allocated to the delivered item or services is the lesser of the

amount that would otherwise be allocated on a relative selling

price basis and the amount that is not contingent on delivery of

the undelivered items.


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Timing of revenue recognitionOnce the revenue has been allocated to the unit or units of

accounting, SAB 104 is the relevant guidance for determining

the timing of recognition for each unit of accounting for items

not specifically addressed by other authoritative literature.

SAB 104 provides four criteria that a CSP must satisfy to

recognize revenue:

>Persuasive evidence of an arrangement exists

>Delivery has occurred or services have been rendered

>The sellers price to the buyer is fixed or determinable, and

>Collectability is reasonably assured.

SAB 104 indicates service fees should be recognized on a

straight-line basis, unless evidence suggests the revenue is

earned or obligations are fulfilled in a different pattern over the

contractual term of the arrangement or the expected period

during which the specified services will be performed, whichever

is longer. Determining whether a pattern of performance

other than straight-line is evident requires the application of

judgment. Many cloud services are provided consistently from

period to period so a pattern of performance other than straight-

line generally will not be evident. However, other elements

in an arrangement that are accounted for separately, such as

consulting or other professional services, may have a pattern of

performance associated more directly with the proportion of the

services provided over the total effort expected.

Determining when service revenue commences in a cloud

arrangement may require judgment and careful consideration of

all relevant facts and circumstances. Often, CSPs must perform

setup activities such as services to configure the CPSs services

to the customers needs, data, or environment. The customers

ability to use or view data, process transactions, or otherwise

use the functionality in the cloud may not be possible until

certain setup services are completed by the CSP. Generally, only

the activities of the service provider that offer substantive value

to the customer would trigger the commencement of revenue.

Administrative or setup activities related to preparing the

customers environment, particularly if the customer does not

yet have the ability to use the ongoing service offering, generally

will not trigger the commencement of revenue.



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Accounting for the costs incurred to develop, maintain, and deliver a cloud offering

Costs to develop internal-use software and Web site development

Generally, since the technology developed to support cloud

services and the related customer interface will be used by

the CSP to provide that service, the costs associated with

this development will be accounted for under ASC Subtopic

350-40, Internal Use Software. The nature of many Web site

development costs are considered to be software development

and therefore subject to the same accounting guidance as

software development costs.

Typically, all costs incurred in the preliminary design and

development stages will be expensed as incurred. Once a

technology project or Web site has reached the application

development stage, certain internal, external, direct, and indirect

costs may be subject to capitalization after development

milestones are met. Generally, costs are capitalized until

the technology is available for its intended use. Subsequent

costs incurred for the development of future upgrades and

enhancements, which the CSP expects will result in additional

functionality, would follow the same protocol for capitalization.

In addition to the research and development of products and

services offered in the cloud, some examples of the types of

costs a CSP can expect to incur include:

>Costs to develop Web sites and software used in providing

the service

>Costs to maintain the portal, delivery engine, or other

customer interface

>Acquisition of servers and security solutions to maintain

accounts and protect customer data

>Costs to set up and deliver the services

>Sales and field service personnel commissions

>Professional services associated with delivering the service

>Other related costs.

For certain costs, there are some alternatives available to CSPs

related to recognizing costs, depending on the nature of these costs.


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Costs incurred subsequent to implementation

The costs of fulfilling the service requirements of an

arrangement after revenue recognition commences, or

go-live, would be expensed as incurred. Costs incurred

to acquire equipment or other infrastructure (e.g., security

software, storage) would be subject to standard accounting

principles for capital-type expenditures.

Direct costs and costs associated with setup or implementationDirect costs and costs associated with setup activities include:

>Internal contract/customer relationship origination costs

>Salaries for personnel activating the service

>Sales commissions of internal sales personnel

>Solicitation costs, such as referral fees paid to internal

employees.

SAB 104 allows a CSP to select from two alternative

accounting policies related to setup costs to either:

>Expense costs in the period incurred, or

>Defer certain costs that are recognized systematically over

the period in which the related revenue is being recognized.

Expensing costs as incurred and recognizing the associated

revenue over time may result in an uneven profit margin over

the term of an arrangement. Therefore, many CSPs elect to

defer and amortize costs.

The types of costs eligible for deferral are based on an analogy

to either ASC 605-20-25-4 (formerly FASB Technical Bulletin

(FTB) 90-1, Accounting for Separately Priced Extended Warranty

and Product Maintenance Contracts, or ASC 310-20 (formerly

SFAS No. 91, Accounting for Nonrefundable Fees and Costs

Associated with Originating or Acquiring Loans and Initial Direct

Costs of Leases.

Under the first alternative (the FTB 90-1 model), the costs

eligible for deferral need to be directly related both to the

arrangement and the service providers incremental costs as a

result of the arrangement. For example, while internal contract

processing and setup costs are considered to be direct costs,

neither are incremental to the CSP since those costs would be

incurred regardless of the arrangement with the customer and

would not qualify for capitalization under the FTB 90-1 model.

However, if a third party had been hired specifically to performthese services for the arrangement, these costs would have

been eligible for deferral under this model. Sales commissions

paid to an employee as a result of an arrangement also would

be eligible for deferral.

The second alternative (the SFAS No. 91 model) permits the

deferral of both direct internal and external origination costs, but

not solicitation costs. Sales commissions and salaries paid to

internal employees may qualify for capitalization to the extent the

salesperson performs origination (as opposed to just solicitation)

activities, and then only on the amount of time the salesperson

spends on successful origination activities.



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Customer perspective up-front costs incurred for cloud implementationRather than purchasing enterprise software for internal use,

more companies are outsourcing software from third parties.

When the vendor hosts software as a service and the purchaser

does not have the right to take physical possession of the

software, the arrangement is typically viewed by the customer

as the purchase of services rather than of software.

Prepayments by the customer for future services generally

are capitalized as prepaid expenses and charged to expense

as the CSP performs the services. However, no authoritative

accounting standard directly addresses how the customer

should account for the up-front costs of setup activities in a

cloud arrangement that represents the purchase of services.

Some relevant guidance that may be helpful to analyze these

payments include FASB ASC Subtopics 350-40, Intangibles

Goodwill and OtherInternal-Use Software, and 720-45, Other

ExpensesBusiness and Technology Reengineering, and the

definition of an asset in FASB Concepts Statement No. 6,

Elements of Financial Statements.

Based on that guidance, the up-front payment to the cloud

vendor may be viewed as a prepayment that provides probable

future benefits in the form of a contractually enforceable right

to use cloud services over time. A customer typically would

amortize the capitalized amount over the period during which

the CSP provides services. However, other standards, such as

FASB ASC Subtopic 720-15, Other ExpensesStart-Up Costs, by

analogy, may support an alternative approach of expensing the

costs of the setup activities as the costs are incurred.

If the customer pays the cloud vendor to provide other related

services that the entity ordinarily would recognize as an expense

as incurred, e.g., training for employees or business process

reengineering activities, the customer should expense the costs

associated with those activities when the services are provided.

The implementation guidance in ASC Section 720-45-55,

Other ExpensesBusiness and Technology Reengineering

Implementation Guidance and Illustrations, may provide a

good starting point for determining whether costs represent

a prepayment for cloud services or period expenses.

If the customer pays other third-party vendors (not the CSP)

or incurs internal personnel costs, those costs generally would

be expensed as incurred. However, in certain circumstances

certain costs may be capitalizable under ASC Subtopic 350-40,

IntangiblesGoodwill and OtherInternal-Use Software, where

the result of the activities is the development of internal-use

software owned by the customer. Where the customer does not

have rights to the intellectual property or code, ASC Subtopic

350-40 would not apply. We encourage CSPs and customers to

consult their accounting advisors in analyzing these transactions

before selecting an accounting policy.


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asset relates. In some cases, the asset may be amortized over

more than one contract when the asset relates to goods or

services that will be provided under an anticipated contract that

the CSP can identify specifically (e.g., renewal options). The

requirement to capitalize costs would not be new to CSPs that

currently capitalize such costs. However, many CSPs currently

amortize costs over the noncancellable contract term, whereas

the proposed requirement to amortize such costs, under certain

circumstances, over a period beyond the initial contract period

may result in an accounting change for CSPs whose historical

experience indicates that contracts are expected to be renewed.

In response to the boards November 2011 revised joint

exposure draft on revenue recognition (2011 ED), some CSP

respondents requested that the boards limit the amortization

period to the initial contract period.

At the time of this publication, in response to various comments

received on the 2011 ED, the boards plan to deliberate various

aspects of the ED again, and expect to issue a final standard in

2013. CSPs should stay tuned as adopting the proposed revenue

standard may be a significant task for some organizations

because of the pervasive effect revenue can have on various

financial metrics, reporting, and communication.

In closing, there are many variables a CSP should consider

when establishing accounting policies related to cloud services.

In many cases, these policies will be a factor in how customer

arrangements are structured and priced. We recommend

consulting with your professional advisors when developing

these policies and accounting methods.


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Tax issues associatedwith cloud


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Most tax laws governing sales transactions were developed at a time in which

the physical transfer of goods was the predominant paradigm. The advent of

software licensing has already put these concepts under strainnow that the delivery of

technology is moving into the cloud, CSPs desiring a specific tax treatment must rely on

careful planning to achieve the desired results. On the plus side, however, addressing theissues posed by a cloud computing operation may offer opportunities for a CSP to develop

a more tax-efficient structure.

For some CSPs, determining the tax

consequences of a cloud computing

transaction will be a relatively straightforward

exercisethe tax treatment will flow neatly

from the natural design of the transaction.

For other CSPs, especially those that may

desire a specific type of tax treatment thatmay not flow intuitively from the natural design

of the transaction, the determination may be

more complex. A couple of factors contribute to

the potential complexity. First, many of the rules

and concepts that will govern cloud computing

transactions were born out of a need to deal with

so-called old economy transactions, and were not

designed to address highly automated businesses.

Second, determining the consequences of a cloud

computing transaction can be highly fact-intensive. Generally,

no one-size-fits-all conclusions can or should be drawn about a

CSPs operations. For CSPs desiring a specific tax treatment,

careful planning will likely be necessary to achieve the desired

results.

Generally speaking, CSPs transitioning from a more traditionalbusiness model to a cloud computing model will have more to

do to adapt their structures to the new issues they face. For

new CSPs, the issues may be easier to address, though planning

is necessary to avoid unwanted consequences. Whether a CSP

is migrating to a new business model or beginning a new one

from scratch, however, dealing with the issues posed by a cloud

computing operation may offer opportunities for the CSP to

develop a more tax-efficient structure. Diligence and planning

are key.

General considerations


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Classifying cloud computing transactions

The proper classification of a transaction depends to a large extent on whether, as part of thetransaction, the transaction involves a transfer of a property (including a property right) to thecustomer. In many, if not most, cloud computing transactions, there will be no such transferand the rules governing the taxation of services income should apply. However, there may becircumstances where property is transferred to a customer, in which case the CSP will have toconsider whether the income earned is treated as sales, rental, or royalty income (all of whichinvolve the transfer of either a copyrighted article or an intangible property right). Where thetransaction involves a transfer of property, classification will depend upon the nature of the rightsthe customer has in the property transferred. Consider the following examples:

Example one

A customer hires a CSP to provide extra computing capacity

to meet seasonal needs. The customer sends data to the

CSP to be processed using the service providers computing

infrastructure and software. Through algorithmic load-balancing,

the customers research project is processed on multiple,

nonspecific servers. Once the project is finished, the CSP sends

the customer a detailed electronic report constructed according

to the customers specifications. This transaction is likely to be

characterized as a services transaction since no property

or property right is transferred to the customer.

The general approach that should be used to evaluate a cloud

computing business from a tax perspective is as follows. First,

classify the nature of the transactions conducted by the CSP,

e.g., determine whether the transaction is a service, sale,

license, or lease transaction. Classification is the first step

because the Internal Revenue Code (Code) generally treats

the income derived from each of these types of transactions

differently, with specific tax provisions applying to each type.

Some of the other determinations impacted by transaction

classification include:

>The source of the income for purposes of computing

creditable foreign taxes

>Whether the income will be subject to the antideferral rules

of the subpart F regime

>Whether, or to what extent, the income is subject to U.S.

or foreign withholding tax.

Second, once the transaction is properly classified, apply the

sourcing provisions applicable to the type of income earned bythe CSP from such transactions.4

4For lack of a more comprehensive set of rules, this two-step approach mirrors provisions in the Treasury regulations that are used to determine the tax treatment of computer program transactions.See Treas. Reg. 1.861-18. The approach is also similar to OECD pronouncements regarding the treatment of software transactions. See Commentary on Article 12 of the OECD Model TaxConvention.

U.S. federal tax considerations

TAX CONSIDERATIONS


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Example two

On the other hand, consider a customer with very specific

research needs that contacts the CSP for access to the service

providers computing infrastructure. The CSP makes a specific,

physical portion of its computing apparatus available on a

dedicated, but temporary, basis, and the customer is given

the right and means to control the apparatus and the activities

conducted with it. Through a Web interface, the customer

uploads custom software and data onto the CSPs computing

infrastructure to accomplish the customers research tasks.

The customer monitors the process remotely through theWeb interface, making adjustments as needed to achieve

good performance. Income earned from this transaction may

constitute rental income since the CSP transfers temporary,

exclusive use of a specific portion of its property to the

customer.

As mentioned above, cloud computing transactions can give

rise to different types of income. Any of the three prevailing

cloud computing modelsusage-based, subscription, and ad-

supportedcould give rise to services income. The usage-based

and subscription models offer the most potential to generate

rental income, which is likely to result where the customer has

substantial but temporary control over a specific physical portion

the CSPs property, e.g., a specific server within the CSPs cloud

computing infrastructure.

None of the three prevailing models would, prima facie, appear

to give rise to a sales transaction. For CSPs desiring sales

treatment, careful planning will almost certainly have to be

undertaken to achieve the desired treatment. In the cloud

computing context, royalty treatment will constitute the least

likely transaction classification.


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Outbound and inbound taxation considerations

The Codes subpart F provisions accelerate the inclusion of income on a U.S. CSPs tax returnswhere the service providers controlled foreign subsidiary (i.e., a controlled foreign corporationearns foreign base company income. The transaction classifications described previouslycan potentially give rise to one or more types of foreign base company income. With planning,CSPs can typically lessen the impact of the subpart F provisions. However, the international taxlandscape is not static, and CSPs should keep a vigilant eye on new legal developments and planor amend their structures accordingly.

For foreign CSPs, or U.S. CSPs running cloud operations

offshore through foreign subsidiaries, a key component of

factual development and planning will be inquiring about the

existence of a U.S. office of the foreign provider, or an agent

acting on behalf of the foreign provider within the United States.

The existence of either suggests a possibility that the foreign

provider has effectively connected income taxable in the United

States. Finally, CSPs should keep in mind applicable income

tax treaties, which may alter the source rules discussed above,

lower withholding taxes, and mitigate the application of the

effectively connected income rules.

Sourcing income from cloud computing transactions

Determining the source of income is important because other tax determinations key off whetherincome is U.S.-source or foreign-source. For example, a U.S. CSP may claim foreign tax credits on aU.S. tax return only to the extent the U.S. taxes against which the credits are being applied relateto foreign source income. A foreign CSP will be interested in the source determination, since thesource may affect whether U.S. withholding taxes are imposed on payments it receives from itscloud computing transactions.

Generally, income derived from the provision of services is

sourced to where the services are performed. The source rule

for services income raises certain complexities in the cloud

computing context. Rarely will all of the inputs that make up the

service offering be conducted in a single jurisdiction, yet underthe case law one looks to the location of the activities giving rise

to the services income to determine its source. In cases where

activities are performed both within and outside the United

States, the income must be allocated between U.S. and foreign

sources based upon the relative contribution of the activities

performed within and outside the United States.

If a transaction is classified as rental income, income from the

transaction is generally sourced to the place where the property

is used (e.g., generally where the servers and other components

of the cloud apparatus are located). If a classification analysis

leads to a conclusion that a transaction gives rise to sales income

(e.g., the transaction is a sale of an item of property), income

from the sale of property the CSP has developed generally mustbe split between the country where the property is produced

and the country where the sale takes place (e.g., where title

and benefits and burdens of ownership pass to the buyer). As

with the location of services inputs, ascertaining the location of

production activities in the cloud computing context may not

be a straightforward exercise. Careful consideration of the facts

will be necessary. Royalties are sourced to where the intangible

property is used (exploited) by the CSPs customer.

TAX CONSIDERATIONS


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State and local tax considerations

Nexus considerations for cloud computing companies

Traditional notions of physical presence nexus, in which jurisdiction to tax generally is created by thepresence of people or property in a state, can be distorted in the electronic and digital services world.While ownership, and likely rental, of a server creates nexus with a state, nexus-creating activitiesmay also include renting space on shared servers and collocating servers in third-party data centers.Additionally, some states may consider software to be tangible personal property, raising the question ofwhether software maintained in electronic format within a given state will be sufficient to create nexus.

In addition to the federal tax issues described above, numerous state and local tax issues arise inconnection with cloud computing transactions.

In the income tax context, it is important to note that Public

Law 86-272, the federal law that limits the applicability of a

state net income tax where the taxpayer sells tangible personal

property, performs only solicitation in the state, and meets certain

other conditions, will not be applicable to the extent the cloud

computing transaction is treated as the sale of services or the

licensing of an intangible. Even if the transaction is deemed to

consist of tangible personal property, the safe harbor of Public

Law 86-272 does not apply to a lease or license.

In addition, concepts of attributional nexus are also becoming

more important. The presence of in-state agents, including in-

state affiliates participating in a network referral program, may

create nexus and, in the sales tax context, a sales tax collection

obligation. Approximately nine states have enacted click-through

nexus. Further, with regard to income taxes, economic nexus,

based on the notion that the use of intangibles in a state can

create nexus within that state, continues to be an area in which

states have become increasingly aggressive.


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KPMG Cloud Tax Technical Literature

Characterization of cloud computing transactions for state and local salesand transaction tax purposes

Sales and transaction-based taxes can present significant challenges for cloud computing serviceproviders. Because these taxes are measured by a companys gross receipts or gross sales pricewithout a deduction for expenses or cost of goods sold, they are likely to be applicable evenwhen the company generates losses for net income tax purposes. In addition, these taxes createa large monthly compliance burden as well as a significant audit risk as a result of the generallack of interpretive guidance related to cloud computing transactions. Specifically, audit issuesmay involve whether cloud computing transactions should be treated as a taxable sale of tangiblepersonal property or the sale of services that can be treated as nontaxable. Some states, however,do provide for taxable services that can include cloud computing transactions.

Characterization and sourcing of receipts for state net income tax purposesAs with state sales and transaction-based taxes and the federal income tax, in the state income taxcontext the critical issue centers around the characterization of the cloud computing transaction aseither a sale of tangible personal property or a sale, lease, or license of services or intangibles. Howa transaction is characterized determines whether Public Law 86-272 is applicable, as well as howreceipts will be sourced for apportionment purposes.

TAX CONSIDERATIONS


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Transfer pricing considerations

Establishing and maintaining a cloud computing business will raise issues involving transferpricing, i.e., the pricing of transactions conducted among controlled companies.

Transfer pricing issues raised by cloud computing will involve

how the value of the cloud computing business is distributed

among the intellectual property, cloud computing infrastructure,

and personnel that support the business. Thus, where multiple

corporate entities combine efforts to provide a cloud offering to

customers, CSPs will need to evaluate each entitys economic

contribution to the effort and compensate each entity according

to arms-length principles. Intercompany transactions will need to

be documented contemporaneously and supported by economic

analyses. CSPs operating multinationally will have to consider

both the Codes transfer pricing provisions (i.e., section 482 and

its attendant regulations) and also rules employed by foreign

jurisdictions, including Organization for Economic Cooperation

and Development (OECD) principles.

Non-U.S. tax considerations

One of the main issues CSPs will need to contend with is whether their operations create a taxablepresence in a foreign jurisdiction.

Taxation can be governed by a foreign countrys domestic

law or, if applicable, by the provisions of an income tax treaty.

Establishing cloud operations (either data centers or personnel)

in foreign jurisdictions will impact a CSPs offshore tax model.

The clearest path to managing such risk is to create dedicated

offshore operations with minimal assistance from shared

employees from the U.S. or other jurisdictions.

Some of the other considerations CSPs should keep in mind in

establishing offshore operations include appropriate ownership

and funding of the cloud business (debt/equity mix, repatriation

strategies), ability to credit foreign taxes paid against U.S. taxes,

and whether any cross-border payments are subject to withholding

tax. CSPs should seek assistance in achieving advance rulings

from local tax authorities about the tax treatment of the foreign

operations. This will be crucial as many of the issues will be inuncharted waters where clear guidance rarely exists.


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Conclusion


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It is becoming increasingly important for CSPs and cloud users not to undertake cloud

activities in isolation but weigh any business opportunities with the potential accounting,

tax, and other operations implications.

From a CSP perspective, many variables should be addressed when establishing accounting

policies related to cloud services. In many cases, these policies will be a factor in how

customer arrangements are structured and priced. We recommend consulting with your

professional advisors when developing these policies and accounting methods.

CSPs should monitor developments in the issuance of new accounting guidelines to enhance

their ability to adopt any proposed revenue standard and to understand the pervasive effect

revenue recognition can have on various financial metrics, reporting, and communication.

Given the lack of clarity over cloud tax treatment, users and providers of cloud services need to plan

their operations and activities carefully to manage their exposure while gaining the desired benefits

from cloud. Since cloud transactions raise numerous tax issues, be thorough in evaluating all risks.

Importantly, organizations that proactively manage and plan for the accounting and tax issues associatedwith operating in the cloud may unlock significant value for their organization.


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Clarity in the CloudThe survey examines three different perspectives with

regard to the adoption of cloud and provides insight into

the forces shaping the cloud market

Embracing the CloudThis report looks at the findings of our Clarity in the

Cloud survey from a CSPs perspective

Tax in the CloudOur new report addresses a number of direct and

indirect tax issues, challenges, and opportunities that

can arise when adopting cloud services

Exploring the CloudThis KPMG survey examines the perceptions of the key

trends of cloud on governments, its leaders, and

IT professionals

Country perspectives on taxing the cloud

KPMG member firms take a look at how tax authorities are

approaching the challenge of cloud computing, by examining the

potential taxes applied

To view these publications or for more information,

visit kpmg.com/cloud

KPMG can help in the development and management of

a comprehensive cloud strategy, including the following

areas:

>Revenue recognition, accounting for costs of development,

service setup and delivery, and commissions

>Tax implications, including tax structures and transfer

pricing

>Customer management and operations, including

contracting, pricing, planning, and forecasting margins

>IT controls, risk, and compliance

KPMGs professionals combine industry knowledge with

technical experience to provide insights that help you take

advantage of existing and emerging technology opportunities

and proactively manage business challenges.

Our professionals have extensive experience working with

global technology companies ranging from FORTUNE 500

to pre-IPO start-ups. We go beyond todays challenges to

anticipate the potential long- and short-term consequences

of shifting business and technology strategies.

In an evolving business environment, where

cloud is seen as a transformative technology that

can enable innovation, business agility, and cost

savings, CSPs will need to continue to address

a host of significant accounting, tax customer

management, and operational considerations.

Across KPMGs global technology industry network,

we have extensive experience in CSP business

models and as a firm we have the commitmentto continue our leadership in this space.

Gary Matuszak, Global and U.S. Chair,


How KPMG can help

KPMG CLOUD PUBLICATIONS


27/28

About the authors

Gary Matuszakis the global chair of KPMGs Technology, Media

& Telecommunications industries, and is the chair of KPMGs

Global Technology Innovation Center. Gary works with global

technology companies ranging from FORTUNE 500 to pre-IPO

start-ups, and represents KPMG in a number of organizations

affecting the industry.

Gary has influenced the development of key industry positions

on several issues that impact the technology sector. He is

a frequent speaker on technology industry trends, including

technology innovation, Chinas emerging role, cloud provider

and user perspectives, and industry outlooks. He has devoted

virtually his entire career to serving the technology industry.

Jana Barstenis an Audit partner in KPMGs Silicon Valley

office. She is a member of KPMGs Global Technology Steering

Committee and currently serves as the Global Audit Sector

leader for KPMGs Technology sector. Jana has 26 years of

experience in public accounting, with a focus primarily on the

software, services, and Internet industries. She has served

numerous FORTUNE 500 technology companies, advising such

companies on complex accounting matters. In addition to serving

public companies, Jana has extensive experience working with

venture-backed growth companies, assisting them through their

development and establishment of policies and practices, as well

as their IPO readiness.

Lynn DeVaughnis an Audit partner in the Technology sector,

based in the Silicon Valley office. She specializes in software and

cloud services, and has experience in serving clients across the

development cyclefrom start-ups, to emerging growth/recently

public companies, to larger, well-established software and cloud

companies. She has been a speaker at various cloud computing

events and seminars.

Rusty Thomasis a Tax partner in KPMGs Silicon Valley office.

Rusty is the Global Tax leader for the Technology sector. He has

extensive experience in serving high-technology clients in Silicon

Valley with KPMG, and 30 years of total of high-technology andtaxation experience. Rusty served as vice president of Taxes

for a FORTUNE 500 company and CFO of two technology

companies.

Contributors

We acknowledge the contribution of the following individuals who assisted in

the development of this publication:

Prasadh Cadambi, Audit partner

Jason Hoerner, Tax Principal

Omar Munoz, Tax Senior manager

Patricia Rios, Marketing director, Technology, Media & Telecommunications


28/28

Contact us

For more information about this

publication, or about how KPMG

can help your business, please contact:

Gary Matuszak

Partner, Global and U.S. Chair


408-367-4757

[email protected]

Jana Barsten

Global Audit Sector Leader, Technology

408-367-4913

[email protected]

Rusty Thomas

Global Tax Sector Leader, Technology

408-666-4067

[email protected]

2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independentmember firms affiliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved. Printed inthe U.S.A. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individualor entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is

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