Better Your Business

The Tax Risks of Doing Business in the Cloud

Channing Flynn, Partner, Ernst & Young LLP
Kyu Oh | E+ | Getty Images

Cloud computing is a technology megatrend that increasingly affects all industries, from technology companies such as cloud service and infrastructure providers, to brick-and-mortar companies using the cloud to reduce information technology (IT) and infrastructure costs.

However, many CEOs have not grasped the full impact of this trend on their organizations. One important area of oversight is the potential impact on the global tax position of the company.

The promise of cloud computing technologies is to help fill companies' insatiable need to increase capacity and manage information in a way that's scalable. It can save companies from building out significant, new infrastructure and processes as their businesses grow. Many of the largest technology companies today are working to acquire or develop the critical cloud technologies they need to stay competitive.

(Read More: What Is Cloud Computing? CNBC Explains)

As this trend grows and companies continue to expand their cloud footprints globally, they need to be aware of a new breed of tax challenges and consider how tax laws around the world should factor into their decisions about cloud computing.

In working on this topic for our clients, a common theme is the need to obtain certainty and reduce risk as new business models emerge seemingly daily that are global in their reach. The three key areas of tax uncertainty in today's environment are (i) assessment of global withholding taxes on cross-border payments, (ii) creation of taxable nexus in one jurisdiction when conducting business via the cloud from another jurisdiction, and (iii) the broad area of indirect taxation (global VAT, US sales and use taxation, etc.).

These tax concepts can, if unaddressed, adversely impact tax liabilities, risk profiles and overall profitability of cloud computing arrangements. Notably, many of these taxes will apply regardless of whether a company is profitable, as they are taxes imposed on transactions or gross payment amounts — this often comes as an unwelcome surprise to executives when discovered after the fact.

The need to focus on global tax planning is fueled by the lack of tax clarity in regions that are very active in cloud computing. In Asia, for example, the cloud computing market is growing exponentially, demonstrated by the proliferation of companies setting up data centers there. And, Europe has similar challenges. Tax laws in Ireland, home to many leading internet and technology companies, have not kept up with the rapid pace of change of business models associated with the cloud.

(Read More:Is Your Cloud Drive Really Private? Read the Fine Print)

Nebulous – an appropriate description of tax planning in the cloud

In 2013, public and private cloud services will generate a significant part of worldwide IT spending. One silver lining is that incentives and grants may be available for expansion in certain jurisdictions. As this trend accelerates, the challenge is that cloud computing taxation issues are developing much more rapidly than the global taxing jurisdictions can respond with guidance.

To address these basic tax issues, a company must first address fundamental questions as to how it conducts business with its customers or vendors. For example, a CSP must determine whether its revenue is characterized as revenue from a service or as revenue from something else, such as a product sale, a royalty license, a lease arrangement or a bundled package of any number of these. The characterization can have a significant impact on whether sales, withholding or indirect taxes might apply, and can determine the source (i.e., the country or state) from or in which revenue is earned. The key to planning in this area is focused work with the marketing, legal and finance teams to align business expectations with the cloud delivery model — all in line with the intended tax outcome.

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CEOs: Understand that end users may have ultimate compliance responsibility

Indeed, cloud computing is often borderless, but tax regulations and tax compliance requirements are not. That simple-sounding conflict can give rise to complex and potentially material or significant tax issues – affecting a range of end-user companies, as well as the cloud service providers (CSPs) that can provide the infrastructure.

In fact, it is critical that management of user companies understand that cloud users may have ultimate compliance responsibility even though it may appear that most jurisdictions view CSPs as the responsible party for tax purposes. End users must determine how to capitalize on the benefits of cloud computing, while adhering to compliance requirements - regardless of any arrangements struck between CSPs and their users.

In a recent study of North American and European enterprise and small to medium business (SMB) IT decision-makers, more than half are "very concerned" with the monitoring and auditing, regulatory compliance, overall internal controls and data protection capabilities of CSPs.

For end-user companies, using a CSP means inviting another party to all of your business' regulatory compliance activities, ranging from tax requirements to internal controls policies to privacy statutes, industry-specific requirements and other legal considerations.

With this in mind, here are some key questions companies should consider:

•Have I adequately considered tax nexus and the related compliance issues in the selection of my CSP, and are they clearly documented in our agreement?

•Are the filing and tax responsibilities clearly identified among the parties?

•How will I monitor CSP adherence to agreed-upon compliance duties?

•How will the relationship with my CSP adapt to changing tax statutory and regulatory requirements?

(Read more: Five Things to Consider Before Embracing the Cloud)

Channing Flynn is a partner in Ernst & Young LLP's International Tax Services group and the Ernst & Young Global Tax Technology Sector Leader.