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Building a Successful

Cloud Provider
Service
Accounting and Tax
Considerations
kpmg.com
CONTENTS
1 Introduction
2 Accounting implications
14 Tax issues
22 Conclusion
24 How KPMG can help
24 KPMG cloud publications
26 Contact us
2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member rm of the KPMG network of independent member rms afliated with KPMG
International Cooperative (KPMG International), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and cutting through complexity
are registered trademarks or trademarks of KPMG International. 76067NYO
Cloud has become one of the biggest revenue growth drivers for
technology 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,
nancial reporting, and tax implications to enhance the efciency 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 . . . . 7
Timing 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 specically addresses the business
issues 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.
1
The 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 implications
associated with cloud
1
2 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
A typical cloud offering will have
multiple elements that may be delivered
at different points over the relationship,
and the accounting model is inuenced
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 through
the 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-specic 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 careful
forecasting 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 nancial 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 prot margins, especially when the effort
related to professional services occurs before the associated
revenue.
F
or 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.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 3
The following discussion seeks to address some of the more common considerations for CSPs
when structuring customer contracts. Please note that, generally, the customer arrangements
will be subject to the accounting provisions of Accounting Standards Codication Topic 605-25
(including the ASU 2009-13, Multiple-Deliverable Revenue Arrangements, as codied in ASC Topic
605-25), 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 during
a relationship period. Therefore, the accounting model will be affected by the CSPs ability to
separate these elements into discrete units of accounting, and the ability (or inability) to separate
the 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 sufcient 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 conditions
are met:
> The customer has the contractual right to take possession
of the software at any time during the hosting period without
incurring a signicant penalty, and
> It is feasible for the customer to run the software either on
its own hardware or on a third partys hardware.
A signicant penalty embodies two distinct concepts: (1)
the ability to take delivery of the software without incurring
signicant costs (i.e., a nancial penalty), and (2) the ability to
use the software separately without a signicant 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 possession
or 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 signicant features and functionalities of the
software, a service based on the software is being delivered.
2 Unless otherwise noted, all technical references in this section are to the current FASB Accounting Standards Codication (ASC) Topic 605-25, Multiple Element
Arrangements. The more familiar, precodication reference is EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables.
Revenue recognition
2
T
he 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 specic facts and circumstances. While we have
identied 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-specic 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.
ACCOUNTING IMPLICATIONS
4 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 5
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 satised 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 specic 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
difcult for a CSP to establish VSOE due to the signicant
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 dened 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-specic 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 criteria
Guidance 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 or
items 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 benet from the up-front services (e.g., if
subsequent renewals are priced at a bargain to the initial
up-front fee).
ACCOUNTING IMPLICATIONS
6 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
Limitations on allocating the consideration
The 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.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 7
Timing of revenue recognition
Once 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 specically 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 xed 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 fullled in a different pattern over the
contractual term of the arrangement or the expected period
during which the specied 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 congure 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.
ACCOUNTING IMPLICATIONS
8 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
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 eld 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.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 9
Costs incurred subsequent to implementation
The costs of fullling 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 implementation
Direct 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 prot 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 rst 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 specically to perform
these 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.
ACCOUNTING IMPLICATIONS
10 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
Customer perspective up-front costs incurred for cloud implementation
Rather 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
denition 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 benets 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.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 11
What lies ahead
T
he boards are working toward a converged revenue
recognition standard that would replace most
transaction- and industry-specic revenue recognition
accounting guidance in U.S. GAAP, including guidance in
areas such as accounting for software arrangements, with
broad-based principles applicable to all customer contracts.
In response to constituent comments, the boards have
tentatively agreed to eliminate or modify some of the guidance
in their original proposal that would have created signicant
changes to current U.S. GAAP. Nonetheless, notable differences
from current U.S. GAAP still exist. Some selected areas that may
warrant CSP attention include the following areas:
Identify the Separate Performance Obligations in the
Contract. Identifying separate performance obligations would
require greater judgment when evaluating a bundle of goods or
services to determine whether they should be accounted for
as a single performance obligation or as separate performance
obligations. A vendor would account for a promised good or
service as a separate performance obligation if it is capable of
being distinct, and is distinct within the contracts context. The
boards tentatively agreed to provide indicators that would be
assessed to determine whether a good or service is distinct in
the contracts context. For example, a CSP would need to assess
whether the software license and services are both distinct. If a
vendor grants a software license that is not distinct because the
customer cannot benet from the license without the additional
service, the vendor would account for the combined license and
service as a single performance obligation satised over time (as
compared to current guidance where a CSP evaluates whether a
hosting arrangement contains a software deliverable within the
scope of the software revenue recognition guidance).
Additionally, the proposed guidance notes that certain activities
a vendor must undertake to fulll a contract are not performance
obligations because those activities do not transfer goods or
services to the customer. Many CSPs determined, based on the
amendments to ASC Subtopic 605-25
3
, that they could separate
certain of their implementation and other up-front professional
services on the basis that such services have stand-alone value
to the customer. CSPs would likely reach similar conclusions
relative to similar professional services under the proposed
guidance; however, setup activities that do not transfer any good
or service to the customer generally would not be considered
performance obligations.
Allocating the Transaction Price to the Separate
Performance Obligations. Unlike the current requirements
in ASC 605-25 on limitations on allocating the consideration,
the proposed guidance does not contain such a restriction, and
therefore features in CSP arrangements 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)
may not result in deferral of revenue as long as CSPs are entitled
to the amount of contingent consideration.
Contract Costs. Under the proposed guidance, costs to fulll a
contract and incremental costs of obtaining a contract recognized
as assets would be amortized on a systematic basis consistent
with the pattern of transfer of goods or services to which the
3 FASB Accounting Standards Update No. 2009-13, Multiple-Deliverable Revenue
Arrangements, available at fasb.org
ACCOUNTING IMPLICATIONS
12 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
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 specically (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 nal standard in
2013. CSPs should stay tuned as adopting the proposed revenue
standard may be a signicant task for some organizations
because of the pervasive effect revenue can have on various
nancial 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.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 13
Tax issues associated
with cloud
14 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
M
ost 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 specic tax treatment must rely on
careful planning to achieve the desired results. On the plus side, however, addressing the
issues posed by a cloud computing operation may offer opportunities for a CSP to develop
a more tax-efcient structure.
For some CSPs, determining the tax
consequences of a cloud computing
transaction will be a relatively straightforward
exercisethe tax treatment will ow neatly
from the natural design of the transaction.
For other CSPs, especially those that may
desire a specic type of tax treatment that
may not ow 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-ts-all conclusions can or should be drawn about a
CSPs operations. For CSPs desiring a specic tax treatment,
careful planning will likely be necessary to achieve the desired
results.
Generally speaking, CSPs transitioning from a more traditional
business 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-efcient structure. Diligence and planning
are key.
General considerations
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 15
Classifying cloud computing transactions
The proper classication of a transaction depends to a large extent on whether, as part of the
transaction, the transaction involves a transfer of a property (including a property right) to the
customer. In many, if not most, cloud computing transactions, there will be no such transfer
and the rules governing the taxation of services income should apply. However, there may be
circumstances where property is transferred to a customer, in which case the CSP will have to
consider whether the income earned is treated as sales, rental, or royalty income (all of which
involve the transfer of either a copyrighted article or an intangible property right). Where the
transaction involves a transfer of property, classication will depend upon the nature of the rights
the 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,
nonspecic servers. Once the project is nished, the CSP sends
the customer a detailed electronic report constructed according
to the customers specications. 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. Classication is the rst step
because the Internal Revenue Code (Code) generally treats
the income derived from each of these types of transactions
differently, with specic tax provisions applying to each type.
Some of the other determinations impacted by transaction



classication 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 classied, apply the
sourcing provisions applicable to the type of income earned by
the CSP from such transactions.
4
4 For 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 Tax
Convention.
U.S. federal tax considerations
TAX CONSIDERATIONS
16 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
Example two
On the other hand, consider a customer with very specic
research needs that contacts the CSP for access to the service
providers computing infrastructure. The CSP makes a specic,
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 the
Web 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 specic 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 specic physical portion
the CSPs property, e.g., a specic 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 classication.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 17
Outbound and inbound taxation considerations
The Codes subpart F provisions accelerate the inclusion of income on a U.S. CSPs tax returns
where the service providers controlled foreign subsidiary (i.e., a controlled foreign corporation
earns foreign base company income. The transaction classications described previously
can 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 tax
landscape is not static, and CSPs should keep a vigilant eye on new legal developments and plan
or 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. ofce 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 whether
income is U.S.-source or foreign-source. For example, a U.S. CSP may claim foreign tax credits on a
U.S. tax return only to the extent the U.S. taxes against which the credits are being applied relate
to foreign source income. A foreign CSP will be interested in the source determination, since the
source may affect whether U.S. withholding taxes are imposed on payments it receives from its
cloud 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 under
the 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 classied 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 classication 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 must
be split between the country where the property is produced
and the country where the sale takes place (e.g., where title
and benets 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
18 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
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 the
presence 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 activities
may 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 of
whether software maintained in electronic format within a given state will be sufcient to create nexus.
In addition to the federal tax issues described above, numerous state and local tax issues arise in
connection 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 afliates 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.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 19
Cloud Computing: U.S. Tax Compliance Complexity
for Foreign Subsidiaries, James Carr, Jason Hoerner,
Shirish Rajurkar, Chanin Changtor. The Tax Executive,
January/February 2012.
An article by members of KPMGs International Corporate Services
(ICS) practice can help tax executives gain greater visibility into
these difcult issues. ICS Partner James Carr, Principal Jason
Hoerner, Director Shirish Rajurkar, and Senior Associate Chanin
Changtor presented a hypothetical case study involving a U.S.
multinationals foreign subsidiary to illustrate the potential tax return
reporting and ling issues faced by taxpayers engaging in cross-
border cloud computing.
As the authors stated:
Taxpayers operating in the cloud face uncertainty in determining
the appropriate compliance obligations due to the age of existing
guidance on software-based transactions, the facts-based nature
of the technical issues, and the lack of clear guidance on how
traditional tax principles are to be applied in the context of a cloud
business.
Cloud Computing, A Canadian Perspective,
Mark Worrall, October 1, 2012
State Taxation of Cloud Computing:
A Framework for Analysis, Walter Hellerstein and
Jon Sedon, Journal of Taxation, July 2012
Tax Implications of the Cloud, Brett Weaver and Reid Okimoto,
Puget Sound Business Journal, November 4, 2011
KPMG Cloud Tax Technical Literature
Characterization of cloud computing transactions for state and local sales
and transaction tax purposes
Sales and transaction-based taxes can present signicant challenges for cloud computing service
providers. Because these taxes are measured by a companys gross receipts or gross sales price
without a deduction for expenses or cost of goods sold, they are likely to be applicable even
when the company generates losses for net income tax purposes. In addition, these taxes create
a large monthly compliance burden as well as a signicant audit risk as a result of the general
lack of interpretive guidance related to cloud computing transactions. Specically, audit issues
may involve whether cloud computing transactions should be treated as a taxable sale of tangible
personal 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 purposes
As with state sales and transaction-based taxes and the federal income tax, in the state income tax
context the critical issue centers around the characterization of the cloud computing transaction as
either a sale of tangible personal property or a sale, lease, or license of services or intangibles. How
a transaction is characterized determines whether Public Law 86-272 is applicable, as well as how
receipts will be sourced for apportionment purposes.
TAX CONSIDERATIONS
20 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
Transfer pricing considerations
Establishing and maintaining a cloud computing business will raise issues involving transfer
pricing, 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 taxable
presence 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 in
uncharted waters where clear guidance rarely exists.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 21
Conclusion
22 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
I
t 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 nancial 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 benets
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 associated
with operating in the cloud may unlock signicant value for their organization.
Building a Successful Cloud Provider Service Accounting and Tax Considerations | 23
Clarity in the Cloud
The survey examines three different perspectives with
regard to the adoption of cloud and provides insight into
the forces shaping the cloud market
Embracing the Cloud
This report looks at the ndings of our Clarity in the
Cloud survey from a CSPs perspective
Tax in the Cloud
Our new report addresses a number of direct and
indirect tax issues, challenges, and opportunities that
can arise when adopting cloud services
Exploring the Cloud
This 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 rms 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 signicant accounting, tax customer
management, and operational considerations.
Across KPMGs global technology industry network,
we have extensive experience in CSP business
models and as a rm we have the commitment
to continue our leadership in this space.
Gary Matuszak, Global and U.S. Chair,
Technology, Media & Telecommunications
How KPMG can help
KPMG CLOUD PUBLICATIONS
24 | Building a Successful Cloud Provider Service Accounting and Tax Considerations
About the authors
Gary Matuszak is 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 inuenced 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 Barsten is an Audit partner in KPMGs Silicon Valley
ofce. 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 DeVaughn is an Audit partner in the Technology sector,
based in the Silicon Valley ofce. 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 Thomas is a Tax partner in KPMGs Silicon Valley ofce.
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 and
taxation 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
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
Technology, Media & Telecommunications
408-367-4757
gmatuszak@kpmg.com
Jana Barsten
Global Audit Sector Leader, Technology
408-367-4913
jbarsten@kpmg.com
Rusty Thomas
Global Tax Sector Leader, Technology
408-666-4067
rcthomas@kpmg.com
2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member rm of the KPMG network of independent
member rms afliated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved. Printed in
the 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 individual
or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is
accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information
without appropriate professional advice after a thorough examination of the particular situation.

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