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Cloud computing taxes pose big questions for vendors, users

As states develop different standards for taxing cloud computing services, uncertainties remain for cloud vendors and users alike.

Whether run by kings, congresses or parliaments, the government has historically been on the lookout for new sources of tax revenue. Cloud, it seems, is one of the latest advancements to be put under the revenue microscope. And while much uncertainty remains about how cloud computing taxes will work, cloud vendors and users should prepare for the impact.

"As businesses struggle to compete, they are facing new headwinds in the form of taxation on cloud-based activities," said Eli Bowman, CFO of Codero Hosting, an IT hosting provider based in Overland Park, Kansas. "This is especially daunting for startups and small businesses that are trying to launch new ideas or competitive alternatives."

One of the biggest challenges surrounding cloud computing taxes is the uncertainty. Cloud vendors rely heavily on software, but it has never been clear under U.S. law whether cloud should be treated as a service or royalty -- each of which has a different tax treatment.

The U.S. Treasury department is "on the verge" of releasing regulations later this year aimed at defining and taxing cloud computing transactions, according to Channing Flynn, international tax partner and global technology tax leader at Ernst & Young, a global professional services firm, headquartered in London. "I think the SaaS (software as a service) and IaaS (infrastructure as a service) companies are anticipating that they will be clarifying this, and likely will define those organizations as generating service income rather than license or royalty income," he said.

The complicating factors surrounding cloud computing taxation

Despite steps toward addressing some of the complexities of cloud computing taxes, challenges remain.

As businesses struggle to compete, they are facing new headwinds in the form of taxation on cloud-based activities.
Eli BowmanCFO of Codero Hosting

For instance, globally, the tax treatment of cloud computing has sometimes lumped IaaS and SaaS companies with providers of digital content. The Organization for Economic Cooperation and Development has an initiative under the Base Erosion and Profit Shifting effort to clarify the status of cloud and digital services, Flynn said. However, this effort has not made much progress, potentially causing individual countries to adopt widely different approaches for taxing cloud services.

Meanwhile, a similarly chaotic approach to cloud computing taxes is emerging within the U.S.

"The federal law is something [the 50 states] can look to and agree with, and when it comes to income tax, they often do -- but there is no requirement that they do so," Flynn said.  What's more, the cloud sales and use taxes in different states are "imposed based on complex nexus rules that determine whether the activity falls within the individual state's jurisdiction."

Nexus is a complicated concept for determining if a company has a taxable presence in certain locations. It can be based on a number of factors, such as where a company has a local sales force, or where it houses its servers.

A cloud provider and its end-user customers need to be careful that SaaS, for example, is not subject to sales and use tax by state-specific definitions or legislation that is intended to create sales tax nexus, said Asif Muzaffarr, director of tax at inDinero, a provider of accounting services and software, based in San Francisco. In the absence of specific legislation, states sometimes go beyond classification as a service or product and use the SaaS customers' location to assess tax in that jurisdiction.

"Regardless of the method employed by the state to determine its tax, if the state classifies the SaaS as either a service and/or product that is subject to tax, the taxpayer may exercise some due diligence to make sure that their activities meet the state's definitions," Muzaffarr said.

Because there is no standard, some states tax SaaS as software, regardless of the fact that it is transmitted electronically, said Monika Miles, principal at Miles Consulting Group, a tax consulting firm based in San Jose, Calif. Some states do not tax SaaS, even though they view it as software, because they don't tax software that's electronically transmitted. Meanwhile, some states tax SaaS as a service, and some haven't decided at all, Miles said.

As for federal legislation, the Marketplace Fairness Act proposes to make it easier for states to tax interstate transactions, Miles said. However, it's once again on hold in Congress -- a perennial pattern for that particular piece of legislation.

So, while much remains unsettled, cloud users should pay attention to the evolving cloud computing taxation landscape in each jurisdiction where they do business. It seems likely that more tax liabilities are on the way, which will ultimately impact the cost of cloud services. And in the case of use taxes, cloud customers might potentially become liable for taxes in situations that aren't immediately obvious.

"We see that the wheels are in motion for states to modify old, or enact new, legislation to make sure they get a piece of the 'cloud' pie," Muzaffar said.

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