Software In The Clouds…The Tax Answer May Be a Bit Foggy!

Over the last few years, state taxing authorities have eyed the growing digital products market as a potential lucrative source of revenue and/or as an increasing erosion of their tax base.

The latest controversy regarding the taxability of software is “cloud computing.” Cloud computing is an arrangement to access and use hardware and software hosted on the server of a vendor for a fee. 

Many state statutes do not specifically address cloud computing and states are taking differing positions regarding the sales and use tax treatment of a cloud model. Without any uniformity, there is greater risk of multiple jurisdictions applying tax to the same transaction given the borderless nature of cloud computing, which presents both compliance and enforcement challenges.

What is cloud computing?

In layman’s terms cloud computing typically encompasses the delivery of common business applications that the user can access online through a web browser. More formally, the U.S. National Institute of Standards and Technology’s (NIST) definition of cloud computing includes five essential characteristics: on-demand self-service; broad network access; resource pooling (e.g., multi-tenancy); rapid elasticity and usage-based billing (i.e., pay as you go).

In practice, the cloud has been defined as having three primary service models:

  • Infrastructure as a Service (IaaS), which is raw computing power, storage and network bandwidth;
  • Platform as a Service (PaaS), which is database, development tools and other components required to support the delivery of custom applications; and
  • Software as a Service (SaaS), which includes applications both general, such as word processing, email, spreadsheet, and specialized, such as customer relationship management (CRM), enterprise resource management (ERM), etc.

Over time, the market has evolved such that you can buy a subset of any of the services offered within these three models. Other ancillary cloud services include content delivery, ecommerce, networking, messaging, and payment and billing. Ancillary services may be taxable even if offered with cloud service (e.g., physical storage, discs, tapes, etc.). As such, the bundling of taxable with nontaxable services can taint the entire transaction and could increase the amount of tax paid or collected on a given transaction.

Generally, there are three parties to the cloud computing transaction – the customer, the software vendor and the hosting company. In some cases, the hosting company and the software vendor may be the same company. In a typical arrangement, the customer contracts with the vendor to use software. Then the vendor contracts with the hosting company to house and maintain the software. Ultimately, the customer interacts directly with the hosting company to access software/applications. 

Cloud Computing Sales & Use Tax Issues

From a software/service provider perspective, the biggest concern is to determine in which states they have nexus, and thus, a potential filing obligation. The software/service provider must consider its physical presence (e.g., servers, software, sales and service people, business development activities, etc.) and any nexus it may have from affiliate relationships. The software vendor must also consider whether the license or use of the software gives the software vendor nexus in the host state.

The two primary issues that impact both the service provider and the consumer are the characterization of the transaction and where the transaction is sourced.

Characterization of The Transaction

States can characterize transactions in a variety of ways in an attempt to tax the transaction as tangible personal property, a taxable service or possibly a bundled transaction. A taxing jurisdiction will usually make the following inquiries when determining the characterization of the transaction:

  • Does the customer receive a copy of the software? 
  • Does the seller use the software to provide a nontaxable service?
  • Does the seller license software to the purchaser for the purchaser’s own use?
  • How do the parties characterize the transaction in the sales contract and invoices?
  • Is the seller required to provide additional services as well as giving access to the software?
  • If the seller provides both services and software, do the contract and/or invoices separately state the charges?

States will not always agree on characterization of what was purchased. For example, basic computing can be classified in one of four ways: 1) as a non-taxable service; 2) as a taxable information service; 3) as a taxable communication service; or 4) software as a service (SaaS). Messaging can be treated as a nontaxable service or as taxable communication services. The following provides examples of how states can characterize cloud computing services for sales and use tax purposes.

Taxable Services
  • Ohio: Providers of internet access and online services are providing an electronic information service subject to Ohio sales and use tax to the extent that the service is provided to a consumer for the consumer's use in business. 
  • Texas: The state recently ruled that fees for accessing a hosted software application were deemed to be taxable data processing services, regardless of whether the data entry was performed by the customer. Texas, like other states, does allow for the apportionment of services provided to out-of-state customers.
  • New York: The state taxes information services. In a recent ruling to a taxpayer providing web-based subscription services for a fee, New York determined that if a common database is used to generate reports or otherwise disseminate information, the information sold is subject to sales.
  • South Carolina: A number of state rulings determined database access charges would be included in taxable communications and charges by the application service provider (ASP) are similar to charges by database access services and therefore subject to tax.
  • Washington Business and Occupations Tax (B&O): Gross income received for providing remote access to applications on the host's servers are subject to the B&O tax when the service is performed in Washington.
Transfer or Lease of Tangible Personal Property

In jurisdictions where cloud computing transactions cannot be classified as a taxable enumerated service, rulings have been issued indicating that the transaction is really a transfer or lease of tangible personal property. For example:

  • New York:  A state ruling determined that the location of the code embodying the software is irrelevant, because the software can be used just as effectively by the customer even though the customer never receives the code on a tangible medium or by download. The accessing of software by customers constitutes a transfer of possession of the software, because the customer gains constructive possession of and gains the right to use, control or direct the use of the software.
  • Utah: The state has ruled that hosting software and customer databases are taxable as a “lease” or “rental” of server space, even though no specific server space is assigned to the user.
  • City of Chicago: The city has ruled that where possession of the computer is not transferred, use of a computer is deemed to occur at the location of the device used to access the computer.

Sourcing the Transaction

With regard to the sourcing of a transaction, it is difficult for the vendor or hosting company to determine the location of the customer and/or where use occurs. Some states may source the transaction where the taxable product or service is used. Other states may source it based on the location of the servers. Some states may even source it where the office of the cloud computing provider resides. Generally, it will be based on destination where the customer accesses or uses the software/service. A tax jurisdiction will raise the following questions when determining sourcing:

  • Where is the cloud computing located?
  • Is the vendor or the hosting company physically present in the state?
  • What state has the right to tax it?
  • Is actual possession of the software/hardware required?
  • Is multiple jurisdiction use a factor?
  • Where are the datacenters located?
  • Where is the software housed?
  • Can the hosting company’s in-state activities be attributed to the software vendor?

In determining whether the transaction is taxable, it is helpful to look to a state’s treatment of ASP, SaaS, hosted, cloud computing and electronically delivered software. Further, analysis is required to determine what is actually received by the customer. Is it access to computer software? Is it access to infrastructure? Are they bundled transactions? Prewritten software or even hardware may also be part of the cloud computing arrangement. In a bundled transaction, some states will tax the entire transaction unless evidence supports the taxable component is de minimis. Others states require components be separately stated to be exempt. Regarding planning, taxpayers need to develop a corporate policy that supports the following whenever practical:

  • receive software in an electronic form;
  • specify the delivery method and sourcing in the contract and purchase order;
  • consider incorporating a certificate of electronic delivery into the contract which is signed by both parties;
  • require documentation of proof of e-delivery (e.g., a copy of license keys or email from software vendor with access codes); 
  • involve tax personnel in major purchases to scrub contracts for troublesome language;
  • consider services related to the purchase and how they may be taxed; and
  • educate purchasing to decline acceptance of TPP (e.g., back-up disc).

Given the wide range of benefits associated with cloud computing services, specifically, the reduced corporate expenditures on costly purchases and maintenance of computer hardware and software, servers and data centers, we will continue to see those services expand. State taxing authorities will undoubtedly continue to develop policy through the issuance of administrative rulings and guidance, promulgate rules and propose legislation to capture this important growing revenue source.