Cloud Taxes and Accounting: A Beginner’s Guide for the CIO

May 30 2016 | by Yoav Mor

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Over the last 20 years the Internet has revolutionized the way we do business. Federal tax and accounting laws, however, have struggled to keep up with the changes in the way we buy and sell products and services online.

One area that has proved a particular challenge is cloud computing. In the early years of the cloud, things were much simpler. On-demand computing was treated just like any other service, which meant companies didn’t need to pay sales tax on their cloud usage. But now cities and states across the US have been turning their attention to the cloud services sector in a bid to make up for lost revenue on traditional product sales. Already, around half of US states levy taxes on cloud services. And, with the rate of adoption showing no signs of slowing down, more states are likely to follow.

On top of this, new rules that apply to the upfront cost of migration are set to have financial implications for traditional enterprises entering into a cloud computing arrangement. In this post, we’ll explain the meaning of the new ruling and walk you through the basics of cloud taxes.

Upfront Implementation Costs

If you’re considering or in the process of a move to the cloud then how do you handle the cost of migration in your books? Do you treat it as an expense? Or do you capitalize the cost and write it off as depreciation over several years?

Whether you rearchitect your applications to the cloud or just rehost them, the upfront cost could be significant. So treating it as a capital investment may make more financial sense. But, according to a recent update by the Financial Accounting Standards Board (FASB), this is now only possible if the cloud computing arrangement includes software licenses. The ruling, which came into force in December 2015, also states that this only applies to the software license element of the arrangement. Otherwise you should account for the new cloud solution as a service contract. So for IaaS users, who typically host their applications in the public cloud, upfront migration costs should be treated as an expense and not a capital investment.

Monthly Vendor Charges

More than 20 US states now impose cloud taxes on cloud services, including Texas, New York, Illinois, Pennsylvania, Ohio, North Carolina and Michigan. Major states that don’t currently levy cloud taxes include California, Florida, Georgia and Virginia. Vendors use your main billing address to determine your tax location—or contact address if you don’t have a payment method on record.
Rates vary between about 5.5% and 9.5% for combined state and local sales tax. But each state has its own set of rules on which use cases and types of cloud service are taxable. For example, in Ohio, cloud services intended for personal use are exempt, but may be taxable when used for business.

Across the US as a whole, certain types of transactions are also exempt from sales tax. These include purchases made by US governmental entities and businesses that intend to resell a product or service and therefore don’t constitute the final end consumer. This may apply to some IaaS users, such as resellers on the AWS Reserved Instance Marketplace. If you’re based in a state that levies cloud taxes but you believe you’re exempt then, in most cases, you’ll need to provide your cloud vendor with a valid tax exemption certificate.

Be Prepared for More Changes

Many organizations are strongly opposed to the FASB ruling on cloud implementation costs and want an accounting treatment that better reflects the economics of the transaction. But both state and national laws are continually changing, as authorities seek to offer clearer, more explicit and consistent guidance on cloud computing accounting.

The cloud services industry is still relatively young. So changes to the law are inevitable. And just because a state doesn’t levy cloud taxes right now doesn’t mean to say it won’t do so in the future. Be prepared for more changes. And remember that many of the changes to sales tax won’t just apply to the cloud, but across the entire services sector.

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