Most sales tax laws were written in the middle of the twentieth century and never envisioned a science fiction world of cloud computing. Today, cloud computing is a reality, however, the laws that seek to tax the revenue generated in the cloud has not kept pace. Accordingly, we often see instances of states or taxpayers trying to put the proverbial “square peg into the round hole”.
Sales Tax – Basic concepts applied to the cloud
The basic questions asked when looking at US state sales tax requirements are;
- Does the entity making the sale have sufficient nexus to be subject to sales tax obligations?
- Is what the entity selling considered taxable?
- If there is nexus and the item sold is considered taxable, where did the sale occur?
Does the entity have nexus?
We discuss nexus in a traditional sales world in our article on this website which we recommend that you review. In the area of e-commerce and cloud computing, however, the analysis of what creates nexus is not always clear.
Cloud computing seeks to utilize excess capacity of several servers to accomplish the storage and processing requirements of various users. Sometimes, these servers are owned by the user, other times, they are not. There are uncertainties as to whether merely owning servers in a state is sufficient business contact to create nexus. As an example, a company does business in State A, but owns computers and hard drives located offsite in State B. Some commentators will say that the computers and hard drives are property of the company physically present in state B which creates nexus. However, what happens if there is no actual business conducted by the entity in state B and the computers and hard drives are located in an offsite back-up facility operated by a third party? Does the presence of this hardware create nexus when there is no active business activity, or can the hardware be ignored as a de-minimus presence? Each different state will have a different position on this issue.
What happens if the company only contracts with the offsite back-up facility to provide back-up and archiving services where the service provider owns the equipment? Does the presence of intangible data on the computer in this instance create nexus? Again, depending upon the state, some states will categorize the transaction as providing a service and others will see the transaction as the rental of hardware that creates nexus.
In some cloud computing applications, such as on-line banking or investment management, your company’s account information is stored on the service provider’s website and you may not know where the storage location is. Pretty much every state will agree that although your company’s private data is stored in the files, the file actually belongs to the bank or investment manager, so the date doesn’t generally create nexus for you in that state.
Is the sale subject to state sales taxes?
Generally sales taxes in the US are imposed on the final sale at retail of tangible personal property and certain enumerated services. The definition of a sale is fairly consistent from state to state. In Washington, for example, a sale is defined as, “… any transfer of the ownership of, title to, or possession of, property for a valuable consideration, and includes the sale or charge made for performing certain services.” Leases and rentals, by virtue of transferring possession of property are generally also considered to be sales.
The definition of tangible personal property as it applies to software is a bit more nebulous. All of the states understand pre-written or canned software to be a ‘good’ rather than a service and as such, canned software is generally taxable. Where someone buys custom written software, the states will view the nature of the transaction as the sale of a professional service and the charges for writing the software may be excluded from the tax base. Some states such as California will allow that canned software delivered electronically is the sale of an intangible and is not subject to the sales tax. Other states such as New York and Texas don’t differentiate between electronic or physical delivery and view canned software as always taxable. License agreements that convey certain rights similar to the purchase of software are treated the same as the sale of software. But, what is the taxability of software that is only accessed and used in the cloud where no license is offered and no rights of ownership conveyed?
Software used in the cloud is often categorized by the vendors as “software as a service” (“SAAS”) rather than a sale of software. When attempting to determine whether to collect and remit sales tax, these transactions are more difficult to fit into the traditional definitions. For those states where the electronic delivery of software is not taxable and computing services are not taxable, figuring out the taxability of SAAS is generally not as problematic since whatever it ends up being still results in an exempt sale.
Sales tax differences
For the states where electronically delivered software and data processing services, such as New York, are taxable, how the transaction is categorized becomes more important. In New York, the transaction will likely be considered taxable in any of the following situations;
- the sale is considered a sale of canned software delivered electronically
- the sale is considered a sale of a data processing service
- the sale is considered a license agreement
- the sale is considered a rental of storage space or data processing capability
- the sale is considered a sale or rental of bandwidth
- the sale is considered a rental of computer hardware
Vermont is one state that taxes electronically delivered software that has recently addressed the issue. On May 10, 2012, the House and Senate sent a bill to the Governor that would impose a temporary moratorium on the taxation of remotely accessed software. The bill clearly separates software as a service accessed in the cloud from purchased software that is merely delivered by download. We expect to see similar legislation from other states in the future.
Where did the sale occur?
In cloud computing, the excess capacity used can be in one of several locations, often simultaneously, so determining where to apply the tax can be problematic.
As an example, a person working for a Boston based company boards a flight in Atlanta heading for Seattle and uses the airplane’s wi-fi connection to work remotely on a file in the cloud for a Dallas client. The file is originally opened within the excess capacity on a server in Los Angeles and the software being used is accessed remotely on the same server. During the session the Los Angeles server has a problem and seamlessly moves the file and the access to a server with excess capacity in Canada. The cloud service provider’s offices are in Chicago. Which state sales tax is appropriate in this instance? With the sale of a widget, it’s fairly easy; the state where the widget ended up.
Generally, for transactions like this, the states are moving toward taxing the service where the benefit of the service was enjoyed or used. The question is still murky because the Boston company enjoyed the benefit of the services are considered taxable , charge the Boston company sales tax for the service appropriate to Massachusetts, where the user is based? Do they charge the Illinois tax because that’s where the vendor is? Maybe the proper tax would be California which is where the transaction started. Arguments could be made to support charging the tax in Georgia, California, Texas, or Washington, or do they not charge tax because the service occurred in Canada?
The questions get very murky and the guidance at this time is very sparse. We recommend that you contact us so that we can fully review your situation and make recommendations on the appropriate classification of your sales.
AG TAX LLP Can Help
If you have any other tax-related queries, and/or need assistance with tax planning/filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
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