I think I just figured out the iCloud folder confusion.
If you tag a file with the iCloud tag it will show up in the iCloud tag in the finder sidebar. Any subsequent file saved to iCloud will also show up in the iCloud tag in the Finder sidebar.
Well done! Quick question, if you tag a file with the iCloud tag, which happens to be in your local documents folder, will it automatically sync that file up to iCloud in the respective application?