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Tax implications of cloud computing

By Billy Joubert, a Tax Director at Deloitte

Cloud computing has been described as equivalent to using an electricity grid. Instead of maintaining a full IT infrastructure, companies using this model 'plug into' a cloud solution, which is provided by a third party via the Internet, as and when they need to.

Another similarity with an electricity grid is that cloud computing service providers sometimes bill according to what is referred to as the utility computing model – in other words, customers pay according to their actual usage of resources from the grid. The alternative billing methodology is a subscription model.

From a tax point of view, perhaps the main feature of this model is that, for users of a cloud, IT-related capital expenditure is greatly reduced. This means that instead of claiming capital allowances, users should qualify for tax deductions in respect of payments to their providers.

The relative attractiveness of a cloud computing solution may be affected by the availability of tax allowances. The pain of up-front expenditure associated with an IT infrastructure may be mitigated by tax allowances – particularly if the IT expenditure is associated with a project which qualifies for special allowances such as an R&D project. Of course, tax should probably not be the main factor which determines the choice of a company's IT strategy; however, it can be a significant part of the value proposition of each option and should not be disregarded.

A feature of economic activity conducted via the Internet is that it can be difficult to locate where that activity is taking place. The physical location of economic activity (including providing services) has traditionally been a significant factor in the determination of where the resultant profits get taxed. Double tax agreements (DTAs) between countries generally envisage physical premises. Therefore, where a company which is a resident of one country (Country A) ventures into Country B, it is generally the existence of facilities such as an office, workshop or factory which give rise to a taxable presence in Country B for that company.

However, the Internet means that it is possible to conduct a significant amount of economic activity within a country with little or no physical presence there.

Therefore the international tax community – including the OECD – is grappling with understanding what nature and degree of IT activity gives rise to a taxable presence in a country. The location of physical IT infrastructure such as servers may be a significant factor. Therefore, the trend towards cloud computing – which effectively abolishes the need for an IT infrastructure – represents another challenge for tax planners and the various bodies which seek to regulate tax planning.

A cloud computing solution may be part of a strategy for a multinational enterprise which is seeking to avoid creating a taxable presence in a particular country.

These complexities result from an inherent contradiction: tax systems around the world seek to tax profits generated within a defined jurisdiction (such as South Africa), whereas economic activity – and the profits resulting from that activity – is increasingly happening on a seamless basis. The cross-border nature of economic activity is nothing new. But the Internet has exponentially accelerated this trend. And the cloud computing phenomenon represents a further refinement, which can make the location of profits even harder for tax authorities to pin down.

The tax implications of economic activity via the Internet are not limited to income tax. VAT systems around the world also grapple with how to treat income generated via the Net. Many countries have – and South Africa is exploring – so called 'place of supply' rules. These rules seek to define where services are deemed to have been rendered for VAT purposes. In practice, these rules generally distinguish between supplies of services from business to consumer (where the supply is typically deemed to take place in the jurisdiction of the supplier) and from business to business (where the supply is deemed to take place where the recipient, or customer, is located).

These rules represent a pragmatic approach to the complexities of services provided via the Internet. They define the tax consequences by reference to the location of the parties participating in the transaction and effectively ignore the intervening technology. Therefore, where such rules exist, it probably makes no difference whether the services are provided via the cloud or via an IT system belonging to the service provider. This is because the location where the supply is deemed to take place will be determined by the location of either the supplier or of the recipient.

However, it should be borne in mind that South Africa does not yet have place of supply rules in its VAT Act.

Of course, there are other factors which may affect the appropriateness of a cloud computing solution in specific cases. Any enterprise which generates significant VAT exempt income (such as a financial institution) might be adversely affected by changing to an outsourcing option since this would result in it incurring additional VAT, a significant portion of which it would be unable to claim as input tax.

Where there will be a difference is in the case of an in-house IT system or vendor that also makes exempt supplies. Here, outsourcing via the cloud could increase the cost by the amount of VAT on salary equivalent costs.

Cloud computing is an exciting trend and may be the ideal solution in the right circumstances. However, companies considering this option need to satisfy themselves regarding operational factors such as security and reliability. They also need to plan carefully around the financial implications of the options. It may be, for example, that considerable savings can be achieved since a cloud computing solution avoids unnecessary expenditure and under-utilised resources. However, as this article has hopefully demonstrated, tax represents an important factor in quantifying the potential financial benefits of the available options.

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