Gone are the days when brick-and-mortar businesses dominated the market. Recent trends show that many businesses are now shifting to online platforms. These may range from home-based start-ups tapping the online market, to a small to medium-sized enterprise expanding its reach, or even to a multinational enterprise (MNE) that has gone global. To ensure success and continuity, businesses are rapidly moving forward on the digital track.
For many MNEs, technology is an inevitable medium to help them penetrate the international market. Due to the growing complexity of evolving business models, more and more MNEs are adopting cloud computing into their operations.
Cloud computing is generally defined as the practice of using a network of remote servers hosted on the internet to store, manage and process data, rather than on a local server or a personal computer. Web-based e-mails are commonly in the cloud. An e-mail user creates a local e-mail account (e.g. firstname.lastname@example.org). This e-mail account can be accessed by the user from any device as long as there is access to the internet. The e-mail service provider, which has local presence, neither owns the hardware nor software to deliver the online e-mail service. The local e-mail service provider engages the services of its related party operating on a global scale to capitalize on its reputation for on-demand network access to a shared pool of applications and servers located offshore.
The nature of cloud computing for MNEs, with related party transactions, is potentially relevant from a tax perspective, specifically, in transfer pricing. Transfer price is the price charged by one entity to a related party for property or services. Transfer pricing rules apply an arm’s length standard wherein transactions between related parties must be that which unrelated parties would have realized in a comparable transaction under comparable circumstances.
To achieve economies of scale, MNEs often procure their information technology infrastructure on a regional or global level. Capital and maintenance costs encompass several jurisdictions but overall costs are reduced as data storage and software applications are managed from one location accessible through the cloud. This is where transfer pricing kicks in.
For example, a cloud computing service provider with servers located offshore allows its related party in the Philippines access to its applications and remote facilities in the cloud. Though the related Philippine entity derives profits directly from its customers, how then do we determine if the price charged by the cloud computing service provider to its affiliate company in the Philippines is at arm’s length?
Some MNEs may shift profits to low-tax jurisdictions to reduce their overall tax burden. By doing so, these MNEs can minimize their overall tax liability by artificially shifting profits towards jurisdictions with favorable tax regimes. Thus, it is important to have adequate transfer pricing rules to address profit shifting and for the concerned jurisdictions to have a fair share of taxes that should be due to them.
In most jurisdictions, transfer pricing is governed by regulations mostly based from the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines. The OECD, under the Base Erosion and Profit Shifting (BEPS) project termed as Action Plans initiated by G20 countries, has addressed issues on old tax frameworks that no longer match the current practice of doing business across borders.
While the Philippines is not a member of the OECD, the local tax authorities adhere to the guidelines set by the OECD. As such, it may be prudent to anticipate that the local tax authorities may eventually adopt the BEPS Actions Plans.
The OECD’s BEPS Action Plan on Addressing the Tax Challenges of the Digital Economy complemented by its Action Plan on Aligning Transfer Pricing Outcomes with Value Creation has caught up with the rapid growth and sophistication of information technology. However despite the OECD’s robust Actions Plans, there still exist challenges on each jurisdiction’s right to tax its portion of the profits under its local laws.
Though the BEPS Action Plan serves as guidance on the tax challenges of the digital economy, at present, there is no concrete set of guidelines on the application of transfer pricing rules to cloud computing transactions between related parties. Thus, MNEs may be able to maneuver around current transfer pricing rules to structure their cloud operations with minimal overall tax liability.
There is still uncertainty on how cloud computing should be characterized from a transfer pricing perspective. Is there a provision of service or a transfer of intangible assets or rights? While an analysis of the value chain would be a good foundation in a transfer pricing analysis, how then should the most appropriate transfer pricing method in benchmarking the pricing of related party cloud computing transactions be identified? It is also a challenge to identify value drivers in related party cloud computing transactions as to which entity performs relevant functions, incurs economically significant risks and employs or contributes assets to arrive at an appropriate return reflecting the value of their contributions. This in turn leads to further challenges in searching for comparable independent transactions to benchmark cloud computing transactions between related parties. An equally important challenge is to determine the location of cloud-based services being virtual in nature.
Cloud computing at non-arm’s length pricing could possibly occur. With rapid changes in business models brought about by the digital economy, it is imperative to specifically address the issue on the appropriateness of the return or charge of member entities of MNEs providing cloud computing services. Ultimately, MNEs as well as tax authorities should carefully consider and address the transfer pricing challenges in these transactions.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Ana Katrina C. Celis-De Jesus is a Tax Senior Director of SGV & Co.