Expert Insight: State Taxation of Cloud Computing and Sutherland Survey Results

Sutherland Asbill & Brennan LLP recently conducted a survey on the taxation of cloud computing, available at . The survey revealed great disparity in both state laws and company approaches to the sourcing of cloud computing sales, but overwhelming consistency in the focus of state audits. In this “Expert Insight,” Bloomberg BNA speaks with Eric Tresh, a partner in Sutherland’s Atlanta office, who answers our questions about the survey results and implications.

BBNA:The vast majority of cloud computing providers responding to your survey indicated that their cloud computing positions have not been challenged for sales tax or income tax purposes. Based on this experience, it appears that states are taking a “wait-and-see” approach on cloud computing issues. Do you agree? Do you think this trend is likely to change in the near future?

Tresh: We do not believe states are necessarily taking a “wait-and-see” approach. Many companies’ cloud computing and digital product offerings are relatively new and thus have not been subject to state tax audits yet. However, as revenues from cloud computing and digital products increase over time, and state auditors become more familiar with the associated issues, we expect increased scrutiny by state tax administrators for both income tax and sales tax purposes.

BBNA:Of the few cloud computing providers that said they had cloud computing audit experience, all of them were audited for sales tax issues. None were audited for income tax issues. What do you think accounts for the difference?

Tresh: It is not surprising that the sales tax issues are attracting the initial attention of state auditors. Much of the writing and speaking on cloud computing and digital product taxation has focused on sales taxation irrespective of the fact that income taxation presents a number of interesting issues. Also, sales tax audits generally require a review of individual transactions, while income taxation audits often are undertaken by looking at transactions in the aggregate. This difference in approach can lead to a more focused discussion of the character of a transaction for sales tax purposes. As cloud and digital product revenues increase, we expect income tax sourcing issues, in particular, to draw scrutiny.

BBNA:Your survey found that the method by which most cloud computing providers source sales of cloud computing services for sales tax purposes varies by state or by the type of service provided. Will this increase the likelihood of two or more states claiming that they are entitled to receive the sales tax revenue generated from the same transactions?

Tresh: The inconsistencies in state law, coupled with the nomadic nature of many cloud and digital product services, provides the potential for more than one state to tax the same transaction for sales tax purposes. Take for example cloud services performed using a computer server in Texas that are used by a customer in New York. It is quite possible that New York and Texas would both claim the right to tax the service. While states generally provide a sales tax credit for taxes properly paid to another state, in practice these credits may be difficult for taxpayers to claim or administer.

BBNA:Another sales tax audit issue facing cloud computing and digital product providers is the characterization of certain transactions as a taxable telecommunications, data processing, or information service. Are there practical steps that cloud computing providers can take to protect against adverse characterizations?

Tresh: There are a number of steps that cloud computing providers can take to mitigate their audit risk. First, we are advising our clients to make sure that cloud computing and digital product contracts and invoices accurately state the nature of the service. For example, we have reviewed a number of contracts that reference “telecommunications” when that is not the service actually provided to the client. Second, we would recommend that any informational or promotional materials, including press releases, describe the services accurately. These sources are easily accessible and available to state auditors, and inaccurate marketing material can be difficult to overcome. Third , we are advising clients to take steps to accurately determine the location of users to minimize sourcing issues. Finally, our clients are becoming more proactive in encouraging investment in states that offer favorable tax treatment of cloud computing and digital product offerings.

BBNA:While nearly half of the cloud computing providers said they apply cost-of-performance sourcing (COP) to receipts from sales of cloud computing services in states that allow COP sourcing, a significant number of respondents indicated that they “sometimes” use COP sourcing or do not use COP sourcing. Does this reflect that cloud computing providers have a difficult time achieving equitable results using COP sourcing?

Tresh: The reason that cloud computing companies only “sometimes” use cost-of-performance sourcing is due, in part, to the fact that only about half of the states allow for COP. Many other states require that cloud computing providers use a market-sourcing approach. Even though several states have attempted to abandon COP, many cloud providers prefer it due to the availability of data regarding a taxpayer’s cost of performing a service compared with the challenges of determining where a service is “delivered,” “benefited from,” or “used.”

BBNA:When applying COP sourcing to receipts from sales of cloud computing services, most cloud computing service providers said the sales are generally sourced to the location of the server. Does this result make sense from a policy standpoint? Would you say that COP sourcing is becoming an outdated concept?

Tresh: In recent years, many states have increased the importance of the sales factor by adopting single or multi-weighted sales factor apportionment regimes. Therefore, a taxpayer’s apportionment results may be heavily skewed, or entirely dependent upon, the sales factor. Any of the methods used to determine the sales factor numerator could produce a result that does not fairly reflect a taxpayer’s in-state business activities. Whether the server location (or some other location) “makes sense” for a particular taxpayer is dependent upon the particular facts and circumstances of the taxpayer and its activities. There are instances where the server location may make “complete sense” for determining apportionment results. Likewise, there may be instances where server locations are unknown or are not reflective of the taxpayer’s business activities. In short, COP, while not perfect, has advantages and disadvantages as a sourcing regime. Similarly, market-based sourcing fares no better because it also has advantages and disadvantages, including the difficulty of determining the location of the benefit or use of a service. COP is not “outdated,” and a market-based method is not a panacea.

Eric Tresh is a member of Sutherland’s Tax Practice Group and focuses his practice on state and local tax matters including tax controversies and litigation, tax planning and policy, and mergers and acquisitions. Eric frequently speaks and writes about state and local tax issues for groups including the Council On State Taxation (COST) and the Tax Executives Institute (TEI).

By Melissa Fernley

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