Originally written by Terry Grayson-Caprio, CPA, and Jeff Corser, CPA
Originally published in SCACPA's CPA Report magazine
The fact that many companies are thinking about or are already doing “business in the cloud” is well-documented. But as South Carolina-based businesses consider moving to the cloud to help save costs and increase efficiencies, a sometimes overlooked part of the planning and decision-making process may be the potential tax implications related to cloud operations. Without input from their tax departments, companies can face potential tax risks, loss of cost-saving opportunities and decreased return-on-investment for cloud projects.
State Tax Factors
One area of potential tax risk that cloud providers and end users may need to address is domestic sales/use tax and income/franchise tax issues.
In the United States, sellers are required to collect sales tax on taxable transactions in the states where they have a physical presence (“nexus”). Inconsistent state guidance on the taxation of cloud services can create customer service issues and potential tax liabilities for cloud providers as well as their customers. To help address these issues, cloud providers will need to understand both the characterization and sourcing rules for each state in which they have nexus.
The same is true for consumers of cloud services. Every state that imposes a sales tax also imposes a compensating use tax. To the extent a provider does not charge sales tax on the sale of cloud services, it is the consumer’s responsibility to assess whether a tax is due. Given the lack of clarity, consumers should consider reviewing all purchases from their cloud providers to determine whether sales tax was over- or under-collected.
Consumers may be able to take advantage of use-based sourcing rules and business input exemptions to reduce their potential liability. Consumers may also want to understand where a provider has nexus and a corresponding collection obligation to ensure they are appropriately fulfilling their use tax responsibilities.
The South Carolina Department of Revenue has issued several rulings addressing certain types of cloud services but the conclusions vary depending on the specific fact patterns. The Department, however, has consistently held that remotely accessing software in a Software as a Service transaction constitutes taxable “communication services.” Recently, however, the Department found that a taxpayer bundling access to software online—which would be subject to tax if purchased alone—and related medical billing services was in fact providing a nontaxable data processing service because the “true object” of the purchaser was the non-taxable data processing associated with the billing service.
While these rulings are helpful in understanding how the Department analyzes certain cloud services, the Department has yet to provide any general guidelines on taxation of cloud services or the treatment of income from the provision of cloud services. It should also be noted that South Carolina offers an exemption for computer equipment used in connection with a technology intensive facility (e.g., data center) provided certain conditions are met.
In light of these and other developments, it is critical that cloud providers and end users both in South Carolina and across the country stay current on the rules in the states in which they operate. Providers should also consider the additional system requirements needed to support proper invoicing and customer exemptions.
In addition to sales tax, providers also need to establish positions on state income tax apportionment. Characterizing income, defining income producing activity, identifying cost of performance, evaluating effectiveness of existing organizational structures, reviewing transfer pricing arrangements, and evaluating data center sites/incentives—all must be considered when doing business in the cloud.
International Tax Considerations
For organizations doing business overseas—whether as a vendor or a customer—it is important to consider value-added tax (VAT) and other transactional tax rules. Purchasing cloud IT services as compared to a traditional IT model raises several questions. For example, as a cloud user, is any VAT cost you bear recoverable? Would your VAT answer change if your cloud contract were worded such that bundled elements of the service were invoiced separately? Do you understand your VAT self-assessment responsibilities to avoid possible penalties?
Addressing transfer pricing tax risk is another key consideration when moving to the cloud. When cloud IT costs are pushed-out to your global organization, how are you going to document that the allocation is a supportable “arm’s-length” charge for each affiliate bearing the resulting cost? Cloud users should work closely with cloud providers and tax advisors to help build a workable methodology and have access to necessary information (possibly only available from the provider).
Some multi-national cloud users are considering implementing IT solutions that can help capture the resulting cost savings and efficiencies in tax-favored jurisdictions. Given the potential IT cost savings from cloud-related IT solutions, this can be a significant opportunity. Capturing these potential savings typically requires early collaboration with the user’s IT professionals, IT partners (including cloud providers) and tax advisors.
As these and many other tax issues related to the cloud continue to develop, cloud providers and end users in South Carolina and across the country need to carefully monitor them and manage the associated risks and opportunities.
Terry Grayson-Caprio, CPA, is the managing partner of KPMG LLP’s Greenville office. A SCACPA members since 1991,she serves on the Managing Partners Task Force , a past board member and previously served on the Finance Committee and Technical Standards Committee.
Jeff Corser, CPA, is a tax managing director based in KPMG LLP’s Charlotte office.
The information in this column is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.