For how long can U.S. SaaS companies dodge taxes by operating abroad?

U.S. software companies are shifting operations abroad and selling more of their products as SaaS to take advantage of income tax savings.

American actor and entertainer Arthur Godfrey once declared, "I am proud to be paying taxes in the United States. The only thing is, I could be just as proud for half the money."

This sentiment is pretty widespread among Americans -- if there's an option to either pay taxes on something or not, most people and businesses would choose the latter. And no, I'm not just talking about political conservatives.

Microsoft was able to save over $4.5 billion in taxes on goods sold in the U.S. for three years, ending in 2011, by setting up a data center in Puerto Rico.

One way to escape paying taxes is by taking business elsewhere. Residents of Massachusetts, for example, are no strangers to making a trip to New Hampshire to avoid state sales tax on alcohol. If all you needed to buy was a single bottle of wine, you might suck it up and shop in Massachusetts for the sake of convenience and gas money. But if you were planning to stock up for a party of 50 people, the trip north would be worth the huge sales tax savings.

Booze procurement strategies aside, the same principle applies to the cloud market. With the potential cloud tax savings reaching billions of dollars, it's no wonder big U.S. software companies have begun shifting their operations abroad. They're selling more of their products as Software as a Service (SaaS) from data centers in those locations -- a level of flexibility made possible by the cloud -- to take advantage of the host country's income tax savings, according to the Wall Street Journal's Digits blog.

VMware is one such company jumping on the "I'll take my business elsewhere" bandwagon, successfully cutting its federal tax bill over the past three years after conducting much of its business from Ireland -- outside the reach of U.S. tax burdens. Microsoft was also able to save more than $4.5 billion in taxes on goods sold in the U.S., from 2009 to 2011, by setting up a data center in Puerto Rico, where the company is subject to a lower tax rate. Other U.S. software companies have also reported paying more income tax to foreign governments than to their own, including Autodesk, Salesforce.com, CRM and Websense, according to Digits blogger Steven D. Jones.

With all this otherwise taxable income being earned outside of the U.S., the federal government has started to take notice -- and who can blame it? The Internal Revenue Service (IRS) reacted in 2011 by creating a new position for its office, director of transfer pricing, and many SaaS companies have stated that they have since been approached by the IRS with transfer-pricing inquiries. Whatever else the IRS has up its sleeve in order keep businesses' income local is unclear, since the agency didn't respond to questions from The Wall Street Journal about whether it was further investigating taxation of SaaS products.

More on cloud legalities

The cloud: A tax-free zone?

The legal issues of cloud computing: Data location

Taxing intangible, remotely delivered, information-driven products is still fairly new territory for states and the federal government, which is one of the reasons regulations and taxes on cloud services haven't been completely nailed down yet. This taxation gray area was highlighted back in May 2012 when Vermont issued a "cloud computing tax," sending enormous tax bills and penalties to many businesses that had subscribed to cloud services. After an outcry from customers forced to shell out thousands of dollars in sales tax, Vermont eliminated the tax and issued full refunds. 

Companies will never stop exploring ways to find a better tax deal outside the country's borders, and cash-strapped U.S. and state governments will continue to be unhappy until they've received their cut of the income. It certainly doesn't help clarify anything from a regulatory standpoint when the "product" is a service: the ultimate intangible entity. If there's only one conclusion to be made from all of this, it's that cloud taxation laws are still very much a work in progress.

Let us know what you think about the story; email Kara Deyermenjian, assistant editor.

This was first published in January 2013

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