Saving taxes with the cloud based tax planning
The non-profit Tax Analyst reported that of nine states that have recently issued administrative guidance on the taxability of cloud computing services. Two states determined that the services taxable. The remaining seven determined that cloud computing is not taxable.
The tax savings is not because seven states determined that cloud computing services are not taxable. Classifying the income as service income invokes a sourcing rule. Income is foreign source if the person providing the service is outside the U.S. Like Zerox, the person providing the service for a cloud based or web based business is the computer. Like Zerox, the place of service is where your “box” (a copier or a smartly programmed computer) is located.
Here is why: The cloud’s income tax nexus is where the server is located. The tax law for service income is based upon last Century’s economy. Humans, and only humans, provided services. The tax situs of service income is the location of the human. By forming the correct type of a corporation to own the server, you can shift the income to a tax free state or even a tax free country.
First blood was drawn on the IRS when they attempted to tax Xerox on its revolutionary photographic copier. This was the first battle between the exponential entrepreneur and the bureaucracies of government. The IRS could not believe that the copier was was providing the service of a photographer and his darkroom.
Here is what’s happened to the IRS: In the early 1970’s the first plain photo copier was available. Of course, the U.S. Government wanted them. At the same time Congress enacted a tax incentive for a business buy or lease equipment. This tax incentive was not available if you leased to a government or a non-profit organization.
On Xerox’s tax returns, it claimed the tax incentive.
Xerox claim that its copiers were providing the same services as photography studio developing a picture (back them pictures were taken on film). The photocopier was to be viewed not as equipment but a tiny dark room with a robot developing the film. The IRS went nuts.
Not only did the court agree with Xerox’s arguments. It set a legal precedent for another feature of economy of the future: machines can provide personal services.
According to the court, the evidence proved that Xerox’s customer, the US government, wanted more than just a machine. “In essence, therefore, the customer paid for an end result, i.e., the number of copies made, and not for use of a machine…” the court ruled.
The court provided a thorough historical review of machines providing a service, citing switchboards and vending machines as relevant examples. The court provided the key factors to consider when determining whether equipment creates service income or rental income. If you want the court language, then please click on this link.
For example, in a lease, the customer (lessee) acquires a legal interest of some specified duration in the property itself. The customer has substantial control over the property including the right to deny access to others including the owner.
By contrast, a service contract allows the owner (Xerox) access to its property (the copier) and the right to freely substitute property in order to meet its contractual obligations. Xerox supplied the paper, the ink and the maintenance and repairs.
The lessee’s (the Government) right was to receive photographs (which is how we got the phrase “photo-copy) on plain paper. The service was identical to that produced in a “dark room”).
The fact that technology can take over a role previously filled by a human does not lessen the value of the work from a tax perspective. Considering that the judges in the Xerox case came to this conclusion back in 1981, the ruling was extraordinary. No one would have foreseen that a few decades after the ruling, huge advances in technology would enable machines to provide more services than ever before.
How Tech Replaced Human Services in My Business
E-commerce business often own software that is replacing human services. These businesses are a candidate for moving offshore and saving taxes. I have included the story if my business to demonstrate how many software is replacing humans.
In my personal experience running my accounting firm International Tax Counselors, I’ve quickly transitioned from relying heavily on people to technology to perform the same services. Here’s a quick snapshot of the firm’s back-office operations in 2006:
Besides my accounting staff, I had two full-time employees, an office manager and an assistant manager. Both were solely dedicated to providing administrative support.
As you can tell, running a small accounting firm demanded a tremendous amount of administrative support. I spent $160,000 annually for the salary and health and retirement benefits, office space, telephone system, computer system, paper, postage for hard copy advertising, book printing and seminars. .
They booked my travel arrangements, paid bills and performed many tedious, time-consuming tasks. In those days, we mailed out hard copies of tax returns. This required printing out two copies (one for the client and one for me), binding the packets and mailing them from the post office, which, of course, required them to stand in line and purchase certified mailing. Each return and client activity was entered into an expensive database.
Today, technology replaces all of the administrative support I once hired people to provide. And the best part? It costs me a fraction of the cost of hiring people.
Here’s what changed in eight years:
- Now, the big data systems are inexpensive and in some cases free, I use it to keep track of every client activity, every client correspondence.
- The iPhone is a better telephone system than my hard line system of 2006. I no longer look up phone numbers. I merely ask Seri to call someone. When I receive a call, the caller names show up on my phone.
- PDF files and emails (which are a better because of hyperlinks and attachments have replaced paper. Of course, postage is almost nothing. This book, as you know, is Kindle or print on demand by Amazon. I no longer have a book production costs.
- The cost of a server, fireproof backup and an IT contractor is than $100 a month because of the cloud.
- A seminar is now GoToMeeting. Better than the hard facility rented rooms because, the whole world can attend. A seminar was a $1,000 or more. GoToMeeting is $49 per months.
- Travels is now on line with a few taps on my IPad. My staff is no longer booking my travel.
- IPhone: Like many smartphone owners, my iPhone is not only a cell phone. A mobile office fits in my pocket. Everywhere I go, I can access documents stored in the cloud or look up a tax law.
- Cloud software: I encrypt and store all my documents in a secure server that I can access and update anywhere in the world.
- GoToMeeting: I use this to have “face-to-face” meetings with clients all over the world.
- E-mail system: I e-mail documents rather than mailing them out. I know longer have a staff typing an envelope and making a paper file copy of the cover letter.
- Online calendar: I have Seri keep track of my appointments and book my own appointments with a calendar that’s automatically updated to my iPhone and e-mail system.
- Bill paying? Well my banks on-line bill pay automatically pays e-bills and sends out re-occurring checks.
- While a Xerox was important, now I rarely make paper copies. I scan and save the image on my computer.
Machines at Your Service: Self-Checkout
Many machines are providing human services. Advances in technology are changing the way business is conducted every day. In the digital age, computers allow companies to glean massive amounts of information instantly, replace human staffers and cut costs dramatically.
Think about the last time you went shopping for household supplies. Did an actual person scan each item, tell you the total amount, collect your payment and bag your purchases? Or did you go through the self-checkout lane and use the machine?
National US chains like Safeway, Home Depot and Wal-Mart offer self-checkout lanes, and more are likely to follow. According to a 2013 article in Time magazine, retail industry experts foresee a future where shoppers will use their phones’ bar code reader to scan items as they shop. This would allow them to pay and walk out without having to wait in line.
It seems inevitable that technology will replace people in providing certain services primarily for the cost savings. In many situations, people actually prefer dealing with machines. According to a global study by Cisco on the retail shopping experience, 52 percent of consumers prefer to check out without the help of a human cashier.
If I were planning a tax strategy for the companies that manufacture self-checkout machines, I would definitely incorporate the lessons from the Xerox case. Self-checkout machines are clearly providing a service rather than a rental.
The Xerox Case and Your Business
Consider the e-commerce industry alone and the thousands of websites conducting transactions for customers without any human interaction. Previous generations once depended on travel agents, for example, to book their vacations. Now, more people are accustomed to using sites like Travelocity, Priceline and Expedia to plan their trips.
If you owned one of these web base ecommerce companies, you could avoid all state and U.S. taxation by having a foreign corporation own the computer server in a tax haven.
I encourage you to consider the Xerox case and how it applies to your business. Can you place your big data operation in a foreign corporation with a server in foreign country? If so, you can save taxes by hiring this foreign corporation.
Think about your expenses, your equipment and what value your cloud activities offers to your customers. Can you segregate the invoicing and shift the income to a no tax state or a tax haven?
International Tax Planning for the Entrepreneur is easy to read and understand.
Learn more with my easy to read book, International Taxation in America for the Entrepreneur. Amazon has the Kindle edition on sale for $9.50 on this link.