The following is a recently published Article on the relationship between sales and communications tax compliance and Mergers & Acquisitions (M&A) in the Cloud Computing and Communications sectors. The Firm is sharing this Article with Clients for informational purposes.
Unless you’ve had your head buried in the proverbial sand, it would be impossible to miss the consolidation wildfire that is rapidly consuming 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 Verizon’s acquisition of Terremark, soon followed by Time Warner’s addition of NaviSite, CenturyLink’s purchase of Savvis, and Hewlett-Packard’s pick-up of Autonomy in addition to dozens more transactions, big and small. The consolidation fire hasn’t been contained within the “computing” space either, having recently spread to cloud “communications” courtesy of ShoreTel’s link-up with M5 Networks and the just-announced marriage of Masergy and Broadcore. Even the rapidly evolving “collaboration” sector is primed for some M&A action. It seems everything that happens to be in or even near “the cloud” has become 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.
Companies currently operating in the “cloud” sector, providing hosted computing or hosted Internet telephony (“Voice over Internet Protocol” or “VoIP”) services to consumers (particularly small and medium sized businesses), in the market to attract acquisition partners, certainly have good reason to be optimistic. However, along with the optimism comes a heavy dose of reality. To close a deal on financial terms which truly reflect the value of your organization and its future earning capacity, you must confront those ticking time bombs you’ve either been ignoring or praying away. I’m referring to 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 and/or negotiating a purchase price adjustment reflecting the increased risks and financial exposure.
When it comes to the application of federal, state and local taxes and various government fees to cloud based services, confusion has reigned supreme over 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, where 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 IP telephony. Thereafter, 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, which clarified that states not only have unfettered rights to tax VoIP, they also have authority to extract Universal Service Fund (“USF”) fees from providers of VoIP services. 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 times, the lack of any pre-existing 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 appeals arising under so-called “Amazon laws,” which expand traditional notions of nexus to reach remote and Internet-based transactions, and watching as other states begin to impose taxes on downloadable and hosted software solutions. But, even though 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 or considering entering into the “cloud” through an acquisition or merger.
This brings us back to the purpose of this article – the effect of tax and fee compliance (or lack thereof) in the context of a consolidating marketplace. It is the duty of financial advisors and attorneys both representing buyers seeking to acquire cloud-based businesses and sellers seeking to unload these companies to help 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 that the issue of compliance will be a strong card in negotiations with the seller. 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 which ultimately yields more value for both the seller and buyer. Minimizing uncertainties over tax and regulatory compliance also makes for smoother negotiations because it allows both sides to 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 is nearly impossible to eliminate risk entirely. But identifying and managing risk before stepping up to the negotiating table with a prospective buyer can and will 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 pay for itself.
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.
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