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Cloud Computing: Cloud mergers and acquisitions

There can be sales taxes and government fees associated with the mergers and acquisitions of cloud computing services.

Jonathan S. Marashlian and Allison D. Rule

There has been a wildfire of consolidation sweeping through the cloud computing and communications industries. It seems nary a week goes by without yet another merger or acquisition involving a cloud computing provider.

Last year alone saw the Verizon acquisition of Terremark, followed shortly by the Time Warner Cable Inc. acquisition of NaviSite. CenturyLink Inc. purchased Savvis, and Hewlett-Packard Co. picked up Autonomy. There were also dozens of other transactions of all sizes. The consolidation fire hasn’t been contained within the computing space, either. It has also spread to cloud communications, with the ShoreTel link-up with M5 Networks and the recently announced joining of Masergy Communications Inc. and Broadcore.

Even the evolving collaboration sector is primed for some M&A action. It seems everything that happens to be in or even near the cloud is the newest Wall Street darling. The M&A flames show no signs of slowing as computing giants and players in the traditional telecommunications marketplace look to round out their service portfolios with more cloud products and services.

Give and take

Companies operating in the cloud sector, and those providing hosted computing or hosted Internet telephony (Voice over IP [VoIP]) services to consumers, are currently quite attractive to acquisition partners. Those companies certainly have good reason to be optimistic if they’re looking to be acquired. However, along with the optimism should come a heavy dose of reality.

To close a deal on financial terms that truly reflect the value of your organization and its future earning capacity, you must confront those ticking time bombs you’ve been ignoring. This means your company’s potential exposure to unpaid or underpaid sales taxes, fees, and associated interest payments and non-compliance penalties.

Prospective buyers will look for any potential liability for tax or regulatory compliance deficiencies. Buyers will leverage their findings and take appropriate action to protect themselves, either by setting up a reserve account or negotiating a purchase price adjustment reflecting the increased risks and financial exposure.

When it comes to applying federal, state and local taxes and various government fees to cloud-based services, confusion has reigned supreme for the better part of the past decade. One reason for the confusion is the government’s inability to maintain pace with technological advancement. Inconsistencies and lack of uniformity have resulted from the natural process of state and local governments playing catch-up.

This is acutely evident with the application of state and local taxes to cloud communications services. The majority of jurisdictions initially waited for the green light from the Federal Communications Commission (FCC) before extending traditional communications, sales and other taxes to Internet telephony services.

Soon after the FCC first signaled its approval to tax VoIP back in 2005 in the veiled text of its Vonage Preemption Order, several jurisdictions including New York either clarified existing tax regulations, passed new laws or started enforcing rules that were already on the books against Internet telephony. Many state and local jurisdictions followed suit, but the progression was anything but uniform or universal.

By 2010, the FCC had removed all uncertainties with its Nebraska/Kansas Declaratory Ruling. This clarified that states not only have unfettered rights to tax VoIP, they also have authority to extract Universal Service Fund fees from VoIP services providers. As this history illustrates, although states and localities arguably had the right to tax VoIP from the very introduction of VoIP technology in the mid-1990s, it took another 10 to 15 years for taxation to catch up.

A similar evolutionary process is currently underway with respect to the taxation of cloud computing. Without the FCC acting as a signaling beacon—and, often, the lack of any preexisting statutes in place to address cloud-computing taxation—the progression has been far more inconsistent. Many states remain on the sidelines waiting to see how courts respond to rising appeals under the so-called “Amazon laws.” These laws expand traditional notions of nexus to reach remote and Internet-based transactions. Many states are watching as other states begin to impose taxes on downloadable and hosted software solutions.

Although the rules are often unclear and diverse in their application to various forms of cloud-based services, taxes and government fees remain an important issue for all businesses currently operating in or considering entering the cloud through an acquisition or merger. This brings us back to the effect of tax and fee compliance (or lack thereof) within the context of a consolidating marketplace.

Complex transactions

The financial advisors and attorneys representing buyers seeking to acquire cloud-based businesses and sellers seeking to unload these companies have a duty to maximize value while minimizing risk. There are few risks bigger than those associated with less-than-stellar compliance with taxes, government fees and regulations.

A buyer typically knows enough about the history of taxation and regulation surrounding technology-centric businesses like cloud computing and communications to recognize the issue of compliance will be a significant factor during purchase negotiations. Smart buyers will seek to exploit any weakness in their acquisition target. As such, it behooves the smart seller to take steps to minimize uncertainties.

Fewer uncertainties mean less risk. This ultimately yields more value for both the seller and buyer. Minimizing uncertainties over tax and regulatory compliance also makes for smoother negotiations because it lets both sides remain focused on the positives and avoid being distracted by a plethora of unknowns.

In the uncertain and rapidly changing legal environment associated with the dynamic and rapidly evolving technologies and services available through the cloud, it’s nearly impossible to entirely eliminate risk. Identifying and managing risk before stepping up to the negotiating table, however, can make the process smoother and will result in greater value for the seller.

By acknowledging and outlining your potential exposure to liability for non-compliance with tax and regulatory obligations on your cloud-computing service before entering into negotiations, you can maximize the ultimate value of the sale. The cost of the evaluation will most certainly pay for itself.

Jonathan S. Marashlian
Jonathan S. Marashlian is the managing partner at Marashlian & Donahue LLC, a Washington, D.C.-area law firm specializing in telecom and technology matters, with concentrations in cloud computing and state and local taxation.

 

Allison D. Rule
Allison D. Rule is the co-chair of the Marashlian & Donahue LLC Communications Taxes and Fees Practice. She assisted in the preparation of this article.

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