Cloud Computing and the Credit for Increasing Research Activities

By Ryan R. Coleman, J.D., LL.M., MBA, and Trevor Salzmann, M.Eng., Philadelphia

Editor: Greg A. Fairbanks, J.D., LL.M.

Credits Against Tax

Cloud computing has created significant changes in information technology and continues to influence various industries and sectors including in the fields of education and government, and for technology companies themselves. Significant investment has been made at the national level. The United States has created a federal cloud strategy with the objective of reducing operational costs via economies of scale across multiple federal agencies. The goal, as laid out by the federal government, is to reduce annual federal information technology (IT) spending from $80 billion to $20 billion (see Kundra, Federal Cloud Computing Strategy (CreateSpace Independent Publishing Platform 2011)).

This item’s focus is on the tax implications for users, providers, and developers of the cloud outside the realm of the government: specifically, how a taxpayer’s rental expenses for cloud computing for purposes of research and development (R&D) of new products and solutions should be treated under the Sec. 41 research tax credit (RTC).

What Is the Cloud?

The “cloud” is a method of outsourcing IT functionality to a virtual environment that allows increased flexibility and scalability in response to supply and demand. The opportunities are endless, and the cloud can significantly shorten the software development life cycle by delivering products efficiently to customers on a global scale.

Cloud service providers (CSPs) are facilitating this revolution. CSPs offer a multitenancy model, thereby creating a secure setting with performance metrics of equal caliber to traditional hosting or dedicated on-premise solutions. There is an increasing trend of software development companies leasing space from the CSPs. This practice creates efficiencies for software development companies by allowing the leasing of storage space necessary for development and testing. Without such an option, the expenses related to on-site hosting of the equipment essential to developing applications is often insurmountable or cost-prohibitive to many taxpayers. In this model, the software developer can test a solution in a live setting, which offers the ability to assess the feasibility and scalability of a solution in a more cost-effective manner.

The growth of the cloud is accelerating. With such rapid development comes significant uncertainty in many facets of the model. For example, the typical ideas of ownership, licensing, purchasing, and administrative issues have been fundamentally altered when compared to historical models of providing software solutions to customers.

Are Cloud-Computing Server Rental Expenses Eligible for the RTC?

To qualify for the RTC under Sec. 41, eligible R&D expenses must be either in-house expenses or contract research expenses. This item evaluates each class and subclass of potential qualified research expenses as they relate to cloud-computing server rental expenses. First, the discussion analyzes the three most common qualified expense class types (wages, supplies, and contract research) as to their appropriateness for classification of these particular costs. After that analysis, the fourth expense class type—rental or lease costs of computers—is examined and determined to be an appropriate classification.

Qualified research (1) must be undertaken for the purpose of discovering information that is technological in nature and the application of which must be intended to be useful in the development of a new or improved business component of the taxpayer; (2) substantially all of the research activities must constitute a process of experimentation; and (3) the experimentation must relate to a permitted purpose.

Wages: Rental expenses for cloud-computing servers and equipment are not “wages” as defined in Sec. 41(b)(2)(A)(i) and Regs. Secs. 1.41-2(c) and (d). These expenses are not compensation payments subject to withholding or any of the other elements of wages under Sec. 3401(a). Nor are the expenses related to qualified services under Sec. 41(b)(2)(B).

Supplies: The term “supplies” is broadly defined to include any tangible property, other than land (and improvements to land) and depreciable property, that is used in the conduct of qualified research under Sec. 41(b)(2)(C). The lease expenses related to the fees charged by the CSPs for the use of their hardware do not fit within this definition.

Contract research: For an expense to qualify as a contract research expense, the expense must either be an “amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research” or an expense related to payments to another person for the performance on behalf of the taxpayer for services that would constitute qualified services within the meaning of Sec. 41(b)(2)(B) and Regs. Sec. 1.41-2(c).

Under Sec. 41(b)(3)(A), 65% of “any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research” is eligible for the RTC. For the CSP rental expenses to qualify as contract research expenses, the CSP services must constitute qualified research. In and of itself, standard CSP service does not constitute research; the CSP rental service fees only provide the taxpayer with the means to conduct its own qualified research. The expenses for CSP rentals do not rise to the level of “qualified services” under Sec. 41(b)(2)(B) and thus would not qualify as contract research expenses.

Rental or lease costs of computers: When a taxpayer meets the requirements for qualified activities under Sec. 41(d)(1), the associated CSP server rental expenses appear to fit most favorably within the classification of rental or lease costs of computers under Sec. 41(b)(2)(A)(iii), which provides that “any amount paid or incurred to another person for the right to use computers in the conduct of qualified research” may qualify for the RTC.

Access to cloud-computing servers through CSPs is merely the modern equivalent of computer leasing that was undertaken in the 1980s and early 1990s. At that time, the cost of computers with substantial data and storage capabilities was prohibitive for all but the largest companies and universities. This expense had the potential to drastically inhibit R&D related to software solutions. Computers of this magnitude and power were necessary to reduce the solutions’ time to market as well as the investment by the taxpayer. The owners of these computers were able to provide access to several lessees (allowing them to use a multitenancy platform to reduce their costs to the end lessees).

Though the technology may have improved and evolved over time, the concept is the same today as in prior decades. Modern technology leveraged by CSPs falls within the requirements of Regs. Sec. 1.41-2(b)(4), which requires that (1) the computer be owned and operated by someone other than the taxpayer; (2) the computer be located off the taxpayer’s premises; and (3) the taxpayer not be the computer’s primary user. When a taxpayer rents from a CSP, the servers are owned and operated by a party other than the taxpayer, the servers are located off the taxpayer’s premises, and the taxpayer is not the primary user of the servers.

What This Means to the Taxpayer

Having established a foundation to properly classify expenses paid to CSPs, it is important to highlight the practical concerns of properly identifying those expenses for both taxpayers and tax practitioners. By the nature of the expense, software companies are apt to have payments to CSPs, especially those with less-developed IT infrastructures. Within the past few years, companies with little or no previous involvement in software development have expanded their investment in web applications and mobile development, often choosing to host applications externally. Even companies with established IT infrastructure have migrated their applications to CSPs, especially when issues of scalability for users and data are present (two areas that often require R&D to solve technical challenges). At the conclusion of development, the company may continue to lease for hosting purposes. Those expenses would not be qualified under any classification of expense for the RTC.

The necessary analysis must determine the qualified development efforts that meet the RTC’s criteria. When evaluating the potential qualified research activities for companies in these situations, it is essential to query the software development managers and review the associated contracts regarding the nature of the payments to the CSPs.

It is important to clarify that these expenses are not for simple file storage, mail hosting, and other similar activities. Further, it is important to delineate what portion of the payments are for hosting software under development versus payments for hosting a stable software release. If the company is undertaking qualified research activities under Sec. 41(d)(1), the associated expenses related to the lease of server space from CSPs to facilitate the software development should be classified as rental or lease costs of computers for RTC purposes.


Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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