Transfer Pricing Issues in Cloud Computing
Organizations around the world are gaining valuable insight into not only the potential benefits of the Cloud, but also the practical challenges of adopting these highly disruptive technologies. One of the key considerations when deploying Cloud computing in a multinational enterprise (MNE) is whether or not operating in the Cloud changes the nature of the transaction from a transfer pricing perspective.
This will impact the transfer pricing methodology used to test the transaction. Further, the selection of a Cloud computing solution will affect the transfer pricing implications of the information technology charges, which flow within a MNE group.
The US transfer pricing regulations do not specifically address the treatment of transactions in which computing resources, such as software, are transferred or otherwise made available by one controlled entity to another of the same organization. Guidance, however, can be derived from the Treas. Reg. § 1.861-18 regulations (henceforth, “the software regulations”) disseminated in the year 1998 under the source of income rules that are specifically applicable to Treas. Reg. § 1.482-1. See Treas. Reg. § 1.861-18(a)(1):
“This section provides rules for classifying transactions relating to computer program for purposes of subchapter N of Chapter 1 of the Internal Revenue Code, sections 367, 404A, 482.”
The software regulations apply to computer programs, which the regulations define as “a set of instructions to be used directly or indirectly in a computer in order to bring about a certain result.” The software regulations quantify four types of transactions:
- Transfer of a copyright;
- Transfer of a copyrighted article;
- Provision of services for the development or modification of a computer program; and
- Provision of know-how relating to computer programming techniques.
The determination of whether a transfer of a computer program involves the transfer of a copyright right or a copyrighted article is based on whether the transferee acquires one of the four enumerated rights in the computer program, including the right to make copies for distribution to the public, the right to make derivative works, the right to make a public performance and the right to publicly display. If any of these four rights are transferred, the transaction is treated as a transfer of a copyright and is characterized as either a sale or a license generating royalty income. If none of these rights are transferred as part of a software transaction, the transaction is treated as a transfer of a copyrighted article and is characterized as either sale or a lease generating rental income.
A Cloud computing scenario does not involve actual transfer of software (either downloaded or copied).
The characterization of a transaction is a very important step in any transfer pricing analysis, as the selection of the most appropriate transfer pricing method (or the “best method”) for determining the arm’s length nature of the transaction is dependent on it; or in other words, this characterization will significantly impact the benchmarking analysis required to support the intra-group transaction as arm’s length. See Treas. Reg. § 1.482-1(c).
“In general, the arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result. Thus, there is no strict priority of methods, and no method will invariably be considered to be more reliable than others. An arm’s length result may be determined under any method without establishing the inapplicability of another method, but if another method subsequently is shown to produce a more reliable measure of an arm’s length result, such other method must be used. Similarly, if two or more applications of a single method provide inconsistent results, the arm’s length result must be determined under the application that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.”
Considering the above, for instance, the transfer of copyright rights would be analyzed under one of the four transfer pricing methods for intangible property, i.e. comparable uncontrolled transaction (CUT), profit split method (PSM), comparable profits method (CPM, also called TNMM in the OECD Transfer Pricing Guidelines) or an unspecified method.
On the other hand, in the instance of a copyright article transfer, the transaction would more appropriately be evaluated under one of the six transfer pricing methods for tangible property, i.e. comparable uncontrolled price (CUP) method, resale price method (RPM), cost-plus method, CPM, PSM, or unspecified method. The use of Cloud computing, however, eliminates the actual transfer of rights or ownership and creates the possibility that the transaction will be characterized as a service rather than a sale, license, or lease. Thus, an argument can be made, that in a Cloud computing scenario, the transactions can be evaluated under the transfer pricing rules for services, i.e. the services cost method would come into play and if the relevant criteria are met, the transaction can also be charged out at cost or at a very low margin, subject to the documentation of relevant benefit.
Transfer Pricing Example
Suppose there are three entities – X, Y and Z. X is based in the US, Y in Europe and Z in Asia. They are collectively the “XYZ group.” XYZ group implemented an enterprise resource planning (ERP) package which handles the groups accounting function. X has developed (funded) a proprietary customer relationship management (CRM) and supply chain management (SCM) application. Both the ERP and CRM/SCM applications are also used by Y and Z (copies of applications have been provided by X). XYZ group also uses commercially available email program and office applications.
All the applications are hosted on servers and networks located in each region. All the three entities, X, Y and Z, maintain separate license with a vendor in each area. X has granted Y and Z licenses to use the CRM and SCM applications. For the CRM applications, Y and Z have the right to use, modify and create modified software applications, while for the SCM applications, Y and Z only have the right to use.
Analyzing the above from the software regulations perspective, the transaction transferring the CRM applications would be treated as transfer of a copyright right, while the transfer of the SCM applications would be treated as transfer of a copyright article. Thus, the transfer of the CRM application would most likely be analyzed under the rules of transfer of intangible property (i.e. use of methods such as CUT, PSM, CPM or unspecified method). The transfer of the SCM applications on the other hand would most likely be analyzed under the rules of transfer of tangible property (i.e. CUP, RPM, cost-plus method, CPM, PSM or unspecified method).
The Table below depicts the transfer pricing approach which is most likely to be adopted for the inter-company transactions between X, Y and Z.
|Rights Conferred to Entities Y & Z||Characterization: Software Regulations||Characterization:
|Applicable Transfer Pricing Methods|
|To use and modify the CRM application, including ownership of derivatives.||Transfer of a copyright right.||Transfer of intangible property.||CUT, PSM, TNMM or unspecified method.|
|To use the SCM application.||Transfer of a copyright article.||Transfer of tangible Property.||CUP, RPM, Cost-Plus Method, TNMM, PSM or unspecified method.|
Suppose XYZ group decides to shift to a Cloud computing environment. The ERP applications are shifted to the vendor’s public Cloud. Under this arrangement, the vendor will charge X. Further, the CRM and SCM applications are moved to a private Cloud, which would be maintained and operated by X. Practically, what it means is that X has moved its proprietary CRM and SCM applications to a private Cloud. Under this arrangement, both Y and Z will access the applications via the internet. Neither Y nor Z will host the applications on their networks (prior to the move to the Cloud, they would have to host the applications on their respective networks!), nor will they receive copies of the proprietary applications. Thus, one can argue that the transactions would fall outside the scope of the software regulations and the transactions may be characterized as a service. This would attract the rules covering controlled service transactions. (Detailed discussion on the controlled service regulations (Service Regulations) and their application is beyond the scope of this article. Analysis and positions can differ from a case-to-case basis.)
The OECD’s Transfer Pricing Guidelines specify that a functional analysis may be required to establish comparability, but with Cloud computing it may be difficult to know who is doing what, thus impacting the contributions of each transacting entity. Further, a shift to a Cloud-based environment also requires a detailed analysis of the existing and future intangibles developed subsequent to the shift. The deeper integration may also bring the advantages of anticipated synergy gains over and above the directly measured contributions of the participating entities. This raises the most important question in transfer pricing, i.e. how such benefit should be allocated between related enterprises. Clearly, transfer pricing will increase in complexity.
Here, it would be worthwhile to mention that the changes in the current business models due to the adoption of Cloud computing may also test the current arm’s length standard, and it is highly likely that there will be a rise in the usage of profit-based transfer pricing methods, in particular, the PSM. A more than remote possibility – not by choice, but by limitation – might be the use of Global formulary apportionment as an alternative.
Furthermore, for a Cloud service provider, Cloud computing transfer pricing issues will be influenced by how the value of the cloud computing business is distributed among the intellectual property, cloud computing infrastructure and personnel that support the business. It is very likely that Cloud computing transactions may witness not only home territory transfer pricing rules, but also the rules and guidelines employed by foreign jurisdictions and entities (including but not limited to the OECD).