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Sales and use taxes have historically been imposed on the consumption of tangible personal property, and recently that tax base has been expanded in a few states to include specific types of services. In this article, Ernst & Young's Michael Wasser and Rebecca Helmes discusses managing the risks of multiple taxation and financial reporting of cloud based transactions.
By Michael Wasser and Rebecca Helmes
Michael Wasser is a senior manager in the National Tax department at Ernst & Young LLP in Washington, D.C. Rebecca Helmes is a state and local tax senior with Ernst & Young LLP in Washington, D.C.
As the US economy incorporates new technologies, states have struggled to adapt their manufacturing-age sales and use tax structures to the 21st century. Sales and use tax is a tax on consumption that was historically imposed on transactions in which a buyer and seller exchanged tangible personal property. Over time, several states expanded their sales and use tax bases so that specifically enumerated services became subject to sales and use tax, too.
Now one of the biggest and most vexing tax challenges for businesses is states' varying treatment of cloud computing transactions for sales and use tax purposes. Unlike traditional sales and use tax transactions, not only is the character of each cloud transaction up for debate (is it tangible personal property? Is it a taxable or non-taxable service?), but so is the taxable location at which cloud transactions occur. The answers to all of these questions determine how a cloud transaction is treated for sales and use tax purposes. Cloud computing controversies can turn on how a cloud transaction is classified and how authority to tax the transaction is determined. Unfortunately for taxpayers, states' classifications and sourcing of cloud transactions are not always consistent, and this introduces significant risk to business taxpayers—the vast majority of whom use some kind of cloud computing in their operations. States have taken varying approaches to establishing their respective policies on taxation of cloud services, either through passing laws or by administrative rules or interpretive guidance, with varying degrees of success. This disparate patchwork of laws, regulations, administrative and judicial decisions ultimately leads to uncertainty regarding where and how sales and use taxes apply to purchases or sales of cloud computing; this presents the risk of multiple taxation and corresponding financial reporting challenges. Fortunately, taxpayers do not have to accept this risk—they can actively manage it.
“Cloud computing” is a general term that can refer to several different kinds of transactions. Taxpayers must look at the facts and circumstances surrounding each transaction in order to determine how each should be characterized for purposes of determining taxability. According to the National Institute of Standards and Technology (NIST), “[c]loud computing is a model for enabling convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.”
Cloud taxation challenges can also manifest themselves in an income tax and property tax context, but this article focuses only on sales and use tax risks and considerations. The sales tax due on a cloud transaction is based first upon how a state classifies it, and then upon how the transaction is sourced. Is the transaction classified as tangible personal property? If yes, it is most likely subject to tax. Is the cloud transaction a service? If so, services are largely exempt unless specifically enumerated as taxable by statute.
To help determine the taxability of a transaction, cloud computing has typically been categorized under one of three service models—Software as a Service (SaaS), Platform as a Service (PaaS) or Infrastructure as a Service (IaaS). Under the most common SaaS model, vendors supply hardware infrastructure, software and a front-end portal by which the user interacts with the provider. In many states, SaaS is immediately identified and taxed through the lens of “remotely accessed software.” SaaS covers a broad enough spectrum of product offerings, however, that the presumption that the product equates to software may be inaccurate. SaaS could also be classified and taxed as one of several other things, such as telecommunications and information services. Taxpayers must analyze the full spectrum of potential alternative classifications and consider the potential taxability of each in every relevant jurisdiction. PaaS is a set of software and product development tools hosted on the provider's infrastructure. Sometimes those who provide SaaS and PaaS are called Application Service Providers (ASPs), allowing customers to access software on a provider's system. Finally, IaaS provides virtual servers with unique IP addresses and blocks of storage on demand. Despite these attempts at clarity, the line between tangible personal property and services is blurred when cloud transactions are involved. For example, even if all states agreed on one definition of SaaS (which they do not), taxability varies among them. Sometimes states classify SaaS/remotely accessed software as falling within the definition of tangible personal property for sales and use tax purposes, which generally makes it taxable. Other states consider remotely accessed software to be a service, making it non-taxable unless state law specifically enumerates otherwise.
In New York, the nuance and nature of the cloud computing service makes the difference between taxable and non-taxable transactions. Generally, software is taxable if the customer is remotely accessing it, but the transaction is non-taxable as a service if the software provider is doing more than providing the customer's access. By statute, the sale of prewritten computer software is subject to tax as the sale of tangible personal property, and the definition of “sale” includes the grant of access to software. Meanwhile, in its administrative provisions, the New York Department of Taxation and Finance invented a SaaS-specific “constructive possession” standard, through which the state finds that a transfer of possession has occurred if there is actual or constructive possession, or if there has been a transfer of the right to use, or control or direct the use of, tangible personal property.
The constructive possession cannot be too attenuated, however, and its application is very fact-specific. Consider the following two examples. The New York Department of Taxation and Finance recently determined that the fee an individual paid for a tablet-based health monitoring product, which gives caregivers access to a web portal where customers remotely use the taxpayer's software to create care plans for users, is a taxable sale of prewritten software, because accessing the software by customers is deemed a transfer of possession when customers gain constructive possession of it. In contrast, another ruling by the New York Department of Taxation and Finance classified a taxpayer's subscription to a provider's cloud computing power to run an application of its choosing as non-taxable. The Department differentiated the cloud computing product, a use of the computing power, from products where a vendor's transfer of the right to use prewritten software to customers is what a customer primarily seeks from the vendor.
These two rulings illustrate how critical the specific facts of each transaction are to the management of risk associated with tax impositions on cloud products and services. From a broader perspective, such administrative approaches to setting policy are not ideal, because they create more uncertainty and questions of legitimacy than when legislatures engage in the legislative process by seeking outside input and collaborating to fulfill their constitutional law-making authority. While some states have enacted legislation affirmatively evidencing a legislative intent to tax these products, others have done so through administrative edict. This raises questions as to the legitimacy of these “administrative impositions,” creating additional uncertainty and corresponding risk management challenges.
Conflicting approaches occur regularly, exposing just how far apart states are from uniformity. For example, in June 2015, the Chicago Department of Finance issued a ruling stating that for the purposes of the city's personal property lease transaction tax, it considers SaaS to be taxable as a nonpossessory lease of a computer. Meanwhile, Vermont took several years to figure out exactly whether the sale of remotely accessed prewritten software should be subject to tax. In 2011, the Vermont Tax Department administratively changed a long-standing policy and explicitly indicated that software remotely accessed over the internet is taxable as software (as tangible personal property). However, upon challenge to the validity of this policy reversal after audit assessments were issued against Vermont-based SaaS providers, the Vermont Legislature adopted a moratorium on enforcement that expired July 1, 2013. The sale of prewritten remotely accessed software became taxable by statute at that point, but the Legislature took action again. Beginning July 1, 2015, the Vermont Legislature clarified via enacted S. 138 that charges for the right to access remotely prewritten software are not considered charges for tangible personal property. That essentially means that Vermont once again treats charges for access to prewritten computer software over the cloud to be a computer service or intangible transaction for sales and use tax purposes, and these transactions are generally not taxable in Vermont.
Other states have or are going through related conflicts that stem from administrative pronouncements of cloud taxability. For example, the State of Michigan's administrative imposition on cloud-based software precipitated prolonged litigation in Michigan's Auto-Owners Insurance Co., in which the Michigan Court of Appeals held that prewritten computer software programs that did not include the delivery of “code that enabled the vendor's system to operate” were exempt from Michigan's use tax, because the software category did not satisfy Michigan's criteria that prewritten computer software must be delivered, in any manner. The Michigan Department of Treasury had litigated the case to attempt to enforce its administratively devised cloud tax policy, but later conceded defeat, announcing in early 2016 that it would give Auto-Owners full retroactive effect. In the interim period before the issue was settled, many taxpayers had unnecessarily collected and remitted or paid the illegal tax. Others chose not to and had to manage contingent liabilities pending the outcome of the case.
Arizona is another state that has changed course on its cloud tax treatment, but not for the better. This past spring, the Arizona Department of Revenue formally changed its tax position and administratively determined that a cloud storage file is tangible personal property and the provision of cloud storage is subject to transaction privilege tax (TPT) under the personal property rental classification. Taxpayers challenged it, alleging that Arizona misinterpreted and misapplied the statute, and argued that there is no transfer of software to the customer and that no single customer has exclusive possession, use or control of the software products. Arizona courts have held that exclusive use is a requirement in order for a product to be considered to be leased. However, the taxpayer settled the case out of court, so the ambiguity around cloud tax treatment will remain until another litigant elects to challenge the administrative provision.
In general, the facts and circumstances of the transaction figure prominently in whether and how a cloud transaction is taxed. For example, in Missouri, the Department of Revenue recently determined that an out-of-state company's charges for text messaging services via a cloud-based network are subject to Missouri sales and use tax as a taxable telecommunications service. In support of this, the Missouri Department found that the company transmits information, including text messages and other data, from its customer's computer network to the customer's patron's cellular telephone. The Missouri Department further reasoned that the company provides its customers with a unique telephone number through which messages are sent and that the customer would not be able to send and retrieve text messages without the company's text messaging service unless the customer engaged another telecommunications provider or built its own system. Therefore, the out-of-state company had to collect and remit sales tax on its sale of services to Missouri customers. Telecommunications have historically been subject to a specialized tax regime, in contrast to SaaS, the taxation of which is relatively new and still developing. Taxpayers can reduce risk by fully evaluating all contracts and purchase and sale documentation in order to properly characterize the true nature of the product or service being purchased or sold. This creates the foundation for a defensible tax filing position.
In some states, taxes on cloud transactions end up in a whipsaw situation. This can occur, for example, when a state treats a cloud transaction as tangible personal property for the purposes of imposing tax on a cloud provider's sale of the product, but then inexplicably characterizes the exact same transaction as a service for purposes of preventing the provider from access to manufacturing or resale exemptions on the purchase of the variety of components comprising the cloud product (e.g., servers, telecom, electricity, software components, and cooling apparatus). Manufacturers of tangible personal property are typically entitled to statutory exemptions on the inputs and equipment purchased for use in producing the product. This demonstrates the unintended consequences of a state's characterization of a service as tangible property, and this whipsaw has yet to be resolved in the subject states.
For example, in a 2013 Indiana letter ruling, the Indiana Department of State Revenue rejected the taxpayer's argument that the tangible personal property (computer software and hardware, including servers) that the taxpayer acquired to provide computer services to its clients was exempt from sales and use tax under the manufacturing equipment exemption. Indiana characterizes SaaS as tangible personal property, and the taxpayer claimed the exemption based on the equipment being directly used in the direct production of tangible personal property. Instead, the Indiana Department found there was not enough information provided to establish the taxpayer used the tangible personal property in that way.
Once a state classifies a transaction, how does it determine where the transaction occurs and at what point tax is imposed? Just as states classify similar transactions differently, they apply differing sourcing provisions as well. For sales and use tax purposes, states might source a transaction based on the location of the user, the location of the service, the office of the cloud computing provider, or upon other factors. Sourcing a cloud transaction to the user's point-of-access location may be the most common, with almost half of the states that impose sales and use tax responding in a survey that they source varying combinations of SaaS, PaaS or IaaS to the user's location. Other jurisdictions responded that they source cloud transactions to the location of the service. For example, New York sources software based on where the software is used. However, one jurisdiction responded that it sources cloud transactions based on either the user's location or the location of the service (District of Columbia), and others (such as Texas) responded that they source based on the user's location or the office of the cloud computing provider. In light of this varying treatment, multistate taxpayers must track and keep detailed records of their transactions to avoid potential multiple taxation.
One state legislature — Tennessee — took up cloud sourcing issues in 2015, but the scope of the changes are somewhat unknown because the sales tax regulations have not been written yet. As enacted, HB 644 and SB 603 (the Revenue Modernization Act) expand the state's sales and use tax to software that may be located outside of the state but used by consumers in Tennessee.
Taxpayers should have some degree of certainty regarding whether and in which jurisdiction a particular cloud transaction is taxable, for both tax purposes and for financial reporting purposes. The current patchwork of cloud tax provisions does not provide that kind of certainty. Perhaps even more importantly, taxpayers should be able to feel confident in the legitimacy of tax impositions on cloud products by having the merits of such impositions publicly vetted and adopted through the constitutionally prescribed legislative processes, rather than through administrative interpretations. Changes in leadership can signal a change in policy, and taxpayers must be careful when this occurs, particularly when administrative determinations establish tax policy. Each state has the right to design its own taxability framework, but states would create far more stability and predictability by holding fast to transparent, public legislative processes. They could also ease compliance burdens for taxpayers by employing uniform definitions related to cloud transactions.
Washington State provides a good example for how to engage in a public legislative process. In 2009, Washington expanded its sales and use tax base to encompass digital goods, including streamed or remotely accessed digital products via H.B. 2075. In spite of the breadth of this imposition, the business community has not complained about this approach, and they were provided clarity as to what is and is not taxed, as well as guidelines to reduce the burdens of administering the tax.
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