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February 15, 2012

With the pervasiveness of cloud computing, you may have witnessed a state tax assessor acting on an extreme tax position in an effort to apply dated tax concepts to a technological new world. Tax treatment varies from state to state, and some states’ positions make logical sense, while others are difficult to fathom. Services may or may not be subject to sales and use tax as services; or services and intangibles could be deemed the taxable sale of tangible personal property. Although the majority of states still do not impose sales and use taxes on services, some have specific carve-outs for data processing and information services that could deem cloud computing taxable. Purchasers of cloud services can be in for the biggest surprise if a state deems the services subject to use tax where the seller was not required to withhold the sales tax.

What Is Cloud Computing?

Services provided through the cloud generally consist of software or hardware hosted at central locations, with remote access granted to multiple users through the Internet. The major categories of cloud services include:

  1. Software as a service (SaaS);
  2. Platform as a service (PaaS); and
  3. Infrastructure as a service (IaaS).

SaaS providers are also known as application service providers (ASPs). An SaaS provider hosts an application or software on its own infrastructure (hardware, network, servers, operating systems or storage), and its consumers access and interact with the software over the Internet. A great example of SaaS is web-based email accessed through an Internet browser.

PaaS providers are similar to SaaS, except that consumers use their own applications developed through tools provided by the PaaS provider. Like SaaS, the consumer’s application is hosted on the PaaS’s cloud infrastructure, and the consumer does not have to maintain the cloud systems.

IaaS providers give consumers control over processing, storage, networks and other fundamental computing resources. The consumer does not have to manage the remaining pieces of the infrastructure (such as the hardware).

According to the National Institute of Standards and Technology (NIST), cloud services maintain five essential characteristics:

  1. On-demand self-service: Clients can adjust their computing capabilities (server time, network storage, etc.) without human interaction with the service provider.
  2. Broad network access: The services are accessed over networks through a client’s own platform (e.g., Internet browser).
  3. Resource pooling: Computing resources are pooled to serve multiple clients without their control or knowledge; specific resources are not dedicated to individual clients.
  4. Rapid elasticity: Cloud services can seamlessly expand or contract to meet the client’s demands.
  5. Measured service: Cloud systems resources are managed automatically, with transparency between the client and provider.

Incentives for Cloud Computing

Cloud computing is emerging as a cost-saving option. The main attraction to cloud computing is the potential savings on capital investments and maintenance expenses. A company can pay a subscription fee for software accessible over the Internet. The subscription avoids investment and maintenance costs but likely forfeits some control over software program choices. Self-service and network access is touted as providing the consumer with a seamless experience. Rapid elasticity is deemed to give a company the option of purchasing as much or as little service, software or hardware as needed. Resource pooling and measured service alleviate concerns about capital investments and maintenance costs.

State Tax Exposure

The Importance of Realizing State Tax Implications

Failure to properly collect and remit sales and use tax can have significant implications. A company that fails to collect sales tax and is later assessed by the state often may not be able to seek tax reimbursement from its clients without a tax indemnity clause. Therefore, failure to withhold can become a real tax cost. To make matters worse, a corporation’s officers, directors and even shareholders and employees may be liable for the payment of such taxes. These exposures can also impact the financial statements.

One unpleasant surprise for companies has been use tax assessments resulting from states’ aggressive interpretation and application of law. For example, if the out-of-state cloud provider did not charge sales tax because of its own lack of nexus, purchasers have been receiving use tax assessments from states deeming the services taxable in one of the ways discussed below. Thus, consumers of cloud services must also understand these tax complexities to avoid potential surprises from tax auditors.

Navigating the State Tax Exposures

Providers of cloud services can analyze the magnitude of their potential exposure by addressing the following three points:

  1. Where are their customers located and how much revenue is earned from each state?
  2. Has nexus been established in any of these states?
  3. If yes, does the state impose tax on the cloud activity?

Companies must look to where they have left footprints with which a state could assert nexus. The most convincing determinants of taxable presence are the company’s physical locations, such as offices, employees and agents. Nexus is assumed if a company has permanent physical presence such as an office in the state, but a company’s fleet of traveling employees (e.g., salespeople) requires further analysis. Salespeople can cause nexus for sales tax purposes because Public Law 86-272 applies only to income taxes. Key customers typically require frequent visits from executives or company representatives to maintain a working business relationship. A state may assert those trips are enough to establish taxable nexus, therefore creating a sales and use tax collection obligation where a company may not have any permanent physical presence. Any analysis will require consideration of where the company’s salespeople, employees and agents travel on company business and the frequency of such visits.

To make matters worse, the once “bright line” physical presence nexus standard (at least applicable for sales taxes) has been muddied over the years by states’ nexus assertions combined with a silent U.S. Supreme Court. Companies must face the reality of states asserting economic nexus and affiliate nexus concepts (e.g., “Amazon law” concepts) whereby a link on a third-party website can lead to a state tax assessment.

Amazon Nexus

While “Click-through” or “Amazon” nexus has predominantly been discussed in the context of online retailers of tangible goods, the implications of affiliate nexus already impact the taxation of cloud computing in a significant way. The concept has been applied to the relationship between out-of-state Internet retailers and their in-state affiliates that help facilitate the sale of goods over the Internet. Independent persons, “affiliates,” who post a link to an out-of-state business for a share of the revenue generated by the link are sufficient presence to establish nexus for the out-of-state business and require it to collect sales tax, according to a constantly growing number of states. Thus, cloud service providers’ use of in-state agents or affiliates to drum up business in remote locales (one of the selling points of cloud services) may be deemed sufficient presence for sales and use tax purposes. Consider that New York’s Amazon law applies to “a person making sales of tangible personal property or services taxable under this article” (emphasis added).

States Pushing “Crazy”

Indiana considers data to be tangible personal property for purposes of imposing sales and use tax. Imagine the surprise of the business owner who was assessed tax, interest and penalties for unpaid use tax in Indiana after paying a flat fee to access and print credit reports. (IN Letter of Findings No. 09-0411, 2010) Presumably, it would have been easier for Indiana to impose a tax on services than to concoct a definitional fiction.

Utah considered the act of storing data on a server located in its state (regardless of whether any server space was specifically allocated) akin to leasing tangible personal property in the state. (Utah Private Letter Ruling 08-002 — 2009; rescinded December 1, 2010)

State Taxation of Software

Because cloud services have a software component, a state’s treatment of software often must be considered. Some states will focus on the software to circumvent the fact that their tax law does not impose tax on the cloud service. Further, most states make a distinction between “canned” and “custom” software in determining whether the software is tangible property or a service.

Prewritten software is “canned” software that is not designed or developed to a customer’s specifications. Generally, states consider prewritten software akin to tangible personal property and therefore taxable — as opposed to custom-designed software, which is typically considered a nontaxable service. Prior to delivering software solutions through cloud-hosted servers, seemingly old-fashioned delivery methods had occupied the state taxing authorities. States have ruled on whether software downloaded over the Internet or installed on-site with all tangible property (disks) subsequently removed (known as “load & leave”) were taxable. Typically, the intangible character of downloaded-software transactions caused them to be nontaxable. However, an increasing number of states now impose tax on such transactions anyway. A state’s current position on those delivery methods may shine a light on its position toward cloud services.

Current State Guidance on Taxation of Cloud Services

Many states treat cloud services as they do prewritten software. Arizona taxes licensed canned software under the same rules as personal property rentals. (AZ Private Taxpayer Ruling LR04-010) Idaho considers the temporary transfer of operational control to canned software a sale or lease of tangible personal property and taxable. (IDAPA § 35.01.02.027.04.b) Utah has ruled that cloud services are taxable if they originate from servers located within the state. (Private Letter Ruling, Opinion No. 09-003) Other states that would impose tax on the sale of access to canned software on remote servers include Indiana, Massachusetts, Michigan, New Mexico, New York, Vermont and WashingtonLouisiana had provided in a revenue ruling that software accessed remotely is taxable, but the Department of Revenue repealed the implementation of that ruling. (Rev. Ruling No. 10-001 (3/23/2010); repealed, Revenue Information Bulletin No. 11-010 (5/23/2011))

A handful of states have ruled that cloud services fall within taxable categories such as data processing, information services or communication services. Connecticut taxes data-processing services and software transferred electronically at the data-processing rate. Hawaii considers all services taxable, therefore including cloud services. The District of Columbia also taxes data-processing services, which include:

  • Processing of information for the compilation and production of records of transactions;
  • Maintenance, input and retrieval of information;
  • Provision of direct access to computer equipment to process, examine or acquire information stored in or accessible to the computer equipment;
  • Word processing, payroll and business accounting, and computerized data and information storage and manipulation; and
  • Any system or application programming or software. (D.C. Code Ann. §47-2001(n)(1)(N)(i))

The definition of data-processing services is fairly broad and likely to include cloud services. Other states treating the sale of cloud services as taxable services include Ohio, South Carolina (as communications services), South Dakota, Texas and West Virginia.

Alvarez & Marsal Taxand Says:

Even though federal legislation that would require online sellers to collect sales tax regardless of nexus has more momentum now than ever before, no one can predict when or if such legislation will be enacted. Until then, navigating state tax exposures of cloud services requires a steady hand at the helm. Providers and consumers alike must look ahead to avoid potential state tax pitfalls, as well as look back to see what potential issues have been left in their wake. States are reaching farther for tax revenue than ever before, and they will not likely stop at the clouds.

Author

Tony Fuller
Managing Director, San Francisco
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George Yu, Senior Associate, contributed to this article.

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As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
 
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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