The Taxman Cometh for Your Cloud Services

If you think cloud computing services can seem amorphous and hard to define, just wait until tax auditors start to dig into sales and income derived from them, experts warn.

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TaxesWhile it may be all the rage in the technology space today, cloud computing has been largely flying under the radar of state tax collectors, but that’s about to change as auditors get a better handle on how to tax both sales and income from cloud services, according to legal experts.

The tax spotlight on cloud could, at least initially, result in some confusion for service providers unsure how to keep track of the many jurisdictions and taxable elements inherent in even the most basic cloud computing arrangements.

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A recent survey by Sutherland Asbill & Brennan, a national law firm headquartered in Atlanta that focuses on corporate tax issues, found cloud services companies all over the map when it comes to figuring out what, if any, sales or income tax they owe particularly when their cloud infrastructures and the services they provide cross state lines.

Are taxes owed to the state where the service provider resides? Where the customer is billed? Where the data center is located? Perhaps all three? The reality is many of the finer points of taxing cloud computing have yet to be worked out, experts say.

In a new Q&A with Bloomberg BNA, Attorney Eric Tresh, a member of Sutherland’s tax practice group and an expert on state and local tax issues, says the honeymoon period for cloud computing is ending and service providers should expect government tax officials to come calling soon.

“Many companies’ cloud computing and digital product offerings are relatively new and thus have not been subject to state tax audits yet,” said Tresh. “However, as revenues from cloud computing and digital products increase over time, and state auditors become more familiar with the associated issues, we expect increased scrutiny by state tax administrators for both income tax and sales tax purposes.”

For now, Tresh says, tax auditors are likely to remain focused on sales tax rather than income tax because the individual sales transactions are slightly easier to pin down than the aggregate revenues derived from cloud computing services as a whole. But as service providers start making more money, rest assured the states will become increasingly interested in income tax levies as well, he says.

For the time being, however, the primary complications are sorting out where sales taxes are legitimately owed and trying hard not to be taxed twice for the same sale.

“The inconsistencies in state law, coupled with the nomadic nature of many cloud and digital product services, provides the potential for more than one state to tax the same transaction,” said Tresh. “Take for example cloud services performed using a computer server in Texas that are used by a customer in New York. It is quite possible that New York and Texas would both claim the right to tax the service. While states generally provide a sales tax credit for taxes properly paid to another state, in practice these credits may be difficult for taxpayers to claim or administer.”

Tresh advises clients in the cloud space to take three steps to solidify their footing in the slippery realm of state and local taxes.

* Make sure all contracts and invoices for cloud computing services accurately state the nature of the service. Don’t lump them into catch-all categories like “telecommunications” if that’s not what they are.

* Ensure all of your promotional materials, marketing collateral, press releases and the like describe your services accurately. State auditors have easy access to the same information your clients have and they’ll be looking at it to determine the nature of your business.

* Take the time to accurately determine the precise location of all facets of your cloud offerings --from provider data centers to end-user client offices – in order to minimize sourcing issues.

Tresh said many cloud services companies prefer to track taxable sales by cost-of-performance (COP) sourcing (usually fixed on where the servers are) rather than by a true market-sourcing measure based on where a service is delivered or used. In fact, both are imperfect he says.

“Any of the methods used to determine the sales factor numerator could produce a result that does not fairly reflect a taxpayer’s in-state business activities,” said Tresh. “Whether the server location, or some other location, makes sense for a particular taxpayer is dependent upon the particular facts and circumstances of the taxpayer and its activities.

“There are instances where the server location may make complete sense for determining apportionment results. Likewise, there may be instances where server locations are unknown or are not reflective of the taxpayer’s business activities.”

The complete Bloomberg BNA interview with Eric Tresh is available here.

The Sutherland Asbill & Brennan report is available here (PDF).

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