Five Trends to Watch in the Technology Sector

IN THIS ARTICLE

1. What’s the current outlook for the technology sector?

2. How is the merger & acquisition landscape shaping up?

3. Do you anticipate any major changes to research & development investment?

4. Speaking of hiring, how has the pandemic impacted the problem of the tech skills shortage?

5. Should tech companies be worried about the ongoing international debate about taxing digital services?

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After a year of dramatic growth, several strategic issues will impact tech companies as they position themselves for an even stronger, post-pandemic future. From R&D investment to M&A prospects to varied digital services taxes, the tax departments for technology companies have a lot to track. For perspectives on where the industry is headed and the tax challenges that await, trust the combination of Bloomberg Tax’s expertise and Bloomberg Intelligence’s business data and analysis.

1. What’s the current outlook for the technology sector?

Anurag Rana: From a market perspective, there will continue to be more spending in hot technology areas such as cloud, analytics, data warehousing, and cybersecurity, and less spending on maintaining older systems. What we’re seeing is that total IT budgets are remaining static, while the allocation of dollars shifts over time from the maintenance of technology assets to investment in newer areas.

That said, the areas that saw massive acceleration in revenue growth over the past year such as ecommerce, videoconferencing, electronic signature, collaboration, and other cloud-based applications will continue to grow in 2021 but at a much more normal pace. We don’t expect to see the 300% growth rates that we saw at the height of the pandemic. While the future is bright for these and other technologies that help people work remotely, it’ll be difficult for tech companies to repeat or continue to match last year’s growth rates.

2. How is the merger & acquisition landscape shaping up?

Rana: Particularly for tech companies, there are very positive signs for a healthy M&A environment this year. First, companies have a lot of cash on their balance sheets. Second, their stock valuations are good relative to a year ago. Third, companies need access to more expertise in the hot technology areas of artificial intelligence, machine learning, cybersecurity, cloud, and analytics.

There are, however, two caveats to this prediction. One concern is that valuations remain higher compared to historical levels, which could deter or delay some companies from participating in M&A activities. The second potential area of concern is ongoing antitrust sentiment and discussions that may prevent the largest companies from participating in acquisitions.

If companies with trillions in market cap cannot participate in the M&A market, it will make it extremely difficult for smaller companies to get funding. However, we are seeing the rise of the SPAC (special purpose acquisition company) phenomenon, with more venture-backed tech companies turning to SPACs to fund growth, so that route may turn into an alternative if the deep-pocketed firms can’t take part in M&As this year.

Dominick Schirripa: It is rare for tax to be the deciding factor in whether a deal happens. However, tax uncertainty can influence the business side – not knowing whether, or how, particular activities are going to be taxed can cause potential deals to be delayed or abandoned.

The Biden Administration has proposed several new taxes and tax increases on corporations and other businesses – and has floated ideas for more. But more details are needed on many of these proposals before we can say how exactly they would operate and therefore how they might factor into business decisions like M&A.

In addition, the extremely tight margins in both houses of Congress mean that some of these proposals may be substantially amended or may be dropped altogether because they lack the votes. That could result in a “wait and see” approach for some companies when tax considerations are a factor in a potential deal.

[Find out how to keep up with the demands of M&A activity with primary sources, practical tools, and analysis from other tax experts.]

3. Do you anticipate any major changes to research & development investment?

Rana: Unlike some other industries, R&D spending isn’t cyclical in the technology sector. We don’t see wide swings based on economic cycles. Instead, tech R&D generally continues to grow in a steady fashion, as a function of revenue. The only thing I anticipate is a potential for slight acceleration of spending because of the increase in usage and the need for new functionality. Otherwise, I believe the R&D climate will remain stable and healthy.

You see this particularly in software and IT services companies, which make up the larger portion of enterprise IT spending market. These companies have historically been financially stable and have remained so throughout the pandemic. Their margins are strong, and they have a lot of cash on their balance sheets.

Overall, they didn’t significantly change their R&D plans in the face of the pandemic. They didn’t cut R&D spending because of fears of a slowdown. Instead they continued to spend a healthy amount on R&D, with hiring remaining on pace.

Schirripa: A scheduled tax change that is part of the Tax Cuts and Jobs Act (§174) will further complicate planning for R&D acquisition and investment—and potentially discourage investment in R&D in the future. Starting in 2022, firms that invest in R&D must amortize these costs over five years, starting with the midpoint of the taxable year when the expense occurs. For research conducted outside the United States, costs must be amortized over 15 years.

This will be the first time since 1954 that companies will have to amortize their R&D costs, rather than immediately deduct those expenses.

4. Speaking of hiring, how has the pandemic impacted the problem of the tech skills shortage?

Rana: This is the biggest issue the tech industry faces today. We’re seeing growing shortages of cybersecurity, cloud workers, data scientists, and other skilled tech labor.

However, the pandemic created an interesting opportunity to begin addressing the talent gap. What we saw emerge is the increased reliance on the remote delivery of services. Previously, only very large implementations relied on some component of an offshore delivery model. Now, many implementations are being completed entirely remotely.

This creates a bigger opportunity for the offshore industry to work remotely from areas such as India, Eastern Europe, and Latin America. That would help fill some of that skills gap that we’re seeing right now within tech companies. Instead of trying to hire people in Silicon Valley, tech firms can have more of a disaggregated workforce all over the world. I think that’s a big shift coming over the next few years.

Annabelle Gibson: With a shift to a disaggregated workforce, companies should be mindful that hiring remote employees in other countries could have tax implications by creating a taxable presence in jurisdictions in which they may not have had one previously.

Treaties with the United States may provide some protection for income tax purposes, but other taxes will continue to apply, including social security, payroll, and value-added taxes. Some countries relaxed measures on how they viewed employees’ presence in their country due to the pandemic, but relaxed measures from 2020 aren’t permanent.

If employees remain remote permanently, businesses should be mindful to evaluate the tax implications of having employees working in jurisdictions outside of the United States.

5. Should tech companies be worried about the ongoing international debate about taxing digital services?

Gibson: The variety of taxes targeting the digital economy has grown in recent years. The OECD released its Blueprints on the Pillar One and Pillar Two proposals in October 2020 and is expected to release a final consensus agreement among the 130+ Inclusive Framework member countries by mid-2021.

In the meantime, at least 10 countries have proposed or enacted unilateral digital service taxes, which target a variety of digital activities and services, including digital advertising. Several other countries have enacted rules for when businesses establish a significant economic presence in a country in absence of a physical presence, and several countries have also enacted or proposed withholding taxes on the provision of digital services by foreign providers. And, the European Commission is planning on releasing a digital tax proposal for the European Union in mid-2021, replacing unilateral measures in member countries, that would become effective in 2023.

This proliferation of DSTs and related measures has led to a maze of rules and guidance for businesses to navigate to determine if they are subject to tax in these countries and to ensure they maintain compliance with tax obligations. In the United States, DSTs by trading partners has led to investigations and possible trade actions by the United States Trade Representative, as the U.S. has taken a position that DSTs unfairly targets technology companies based in the U.S.

While it seem like countries have decided to forge their own path forward to tax the digital economy, many remain optimistic that the OECD Inclusive Framework will reach a global consensus by the middle of this year, which would stop implementation of unilateral measures and provide businesses with guidance on how digital activities would be taxed globally in the future. But, even after a consensus is reached, countries will have to implement the guidance into domestic law, which could take several years.

Bottom line, DSTs and digital taxes aren’t going anywhere any time soon, and technology companies, along with other businesses with digital activities, should continue to monitor what’s happening in the digital tax landscape in the months and years to come.

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