State & Local Taxes
The cloud encompasses a broad variety of computer services where purchasers obtain access to software, content, or hardware via the internet. The actual computer hardware, software, and content are maintained remotely by the service provider. Purchasers can use smartphones, laptops, and tablets to automatically obtain, on demand, hardware, server time, and network storage without human interaction. The value proposition is that purchasers no longer need to invest large amounts of capital on IT infrastructure; instead, they pay usage-based fees for access to a provider’s equipment and software.
Cloud services can generally be divided into three types, which can be provided to the general public or to a private group:
- Software as a service (SaaS) or application service provider (ASP): This is software that is not loaded onto the purchaser’s server, rather it is licensed from a licensor that maintains the software on the licensor’s (or cloud service seller’s) servers.
- Infrastructure as a service (IaaS): Also referred to as hardware as a service (HaaS), IaaS accepts any software platform and includes storage as a service.
- Platform as a service (PaaS): With PaaS, the host provides a complete software development environment including programming languages so service recipients can create their own software. In other words, PaaS provides the supporting infrastructure to enable the end user to develop proprietary solutions.
The following discussion offers an approach to analyzing the sales and use tax implications of a purchase on the cloud.
Identify the Services Being Purchased
Analysis of the sales and use tax treatment of a purchase begins by reviewing the contract terms and conditions agreed to by the buyer and the terms set forth in an invoice. Purchasers of services are often able to remotely access, via the internet, invoicing terms and conditions governing the services. The sales tax analyst has become one more user who is able to “remotely” evaluate taxability of cloud services.
The evaluation should consider all services and focus on any references to software, data, content, data transmission, infrastructure access, hardware storage, and maintenance. For example, the following are the relevant terms, for sales and use tax purposes, found on the websites of two well-known cloud service providers:
1. Provider A: Provider A permits subscribers to purchase software and to sell access to software to other subscribers (see the exhibit for an example where Provider A has two subscribers, A and B).
The sample contract makes numerous references to software. It provides that the subscriber must have a valid license to use any software that the subscriber stores or retrieves. The contract specifies that the software is not being sold by Provider A and that it may only be used as part of the provided services. The sample contract also sets forth terms for selling the subscriber’s software on the cloud.
The contract on Provider A’s website defines the services provided as web services, which permit subscribers to:
- Store and retrieve content owned by the subscriber.
- Use certain software, including third-party software.
- Sell access to the subscriber’s software to other subscribers.
In the exhibit, Provider A sells access to Subscriber A’s software to Subscriber B for $100 based on hourly usage, which is added to Provider A’s monthly bill to Subscriber B. The terms specify that Provider A acts as a “referrer” of the software and that Subscriber A is the ultimate “seller” of the products.
Provider A retains a $30 commission before remitting the $70 net software usage revenue to Subscriber A.
2. Provider B: Provider B also permits the purchase of software by subscribers and the sale of access to software to third parties. Subscribers are bound by the terms and conditions that define the products and services as follows:
- The subscriber grants Provider B a worldwide license to use, host, and store any content.
- The subscriber is granted a worldwide, royalty-free, nonassignable, and nonexclusive license to use the software provided as part of the services.
- The terms provide that licensed services include various applications to create software, host existing software, or store data.
The terms specify that Provider B is not granting ownership of any intellectual property rights in the services or the content accessed. The terms also indicate that content is the sole responsibility of the entity that makes it available, and that the subscriber retains ownership of any intellectual property rights in the content.
The terms specify that the subscriber must create a password-protected provider account to use the services. Invoicing for applications and hosting are structured as monthly fees based on the number of applications. For a hosted website, invoicing is based on traffic measured in gigabytes per month. Storage is priced by gigabytes per month.
These two examples of terms are typical of cloud services and illustrate that, from a sales and use tax perspective, services typically include:
- Access to certain content;
- A license to use software;
- Data storage;
- Website hosting;
- Web marketing services; and
- Billing services.
The examples illustrate that monthly invoicing for access to software is typically based on the amount of time that the software is used during the month, and that storage is typically invoiced based on the amount of data stored over a billing month. The examples also illustrate that marketing, hosting, and billing services are commission-based, with the provider collecting on behalf of the subscriber-purchaser and retaining a percentage commission. Many states would likely assert that the use of some or all of these services is subject to sales and use tax.
Evaluate Any Nexus Implications
The nexus implications of a purchase are not usually a primary consideration when analyzing a purchase of services. Purchasers determine taxability in states where property and services are used—plants, offices, warehouses, or other locations. However, the purchase of some services offered in the cloud can create nexus in states where the purchaser does not otherwise have a physical presence.
Quill Corp. v. North Dakota, 504 U.S. 298 (1992), remains the law of the land with respect to sales tax nexus. A state cannot require a seller—the cloud provider—to collect sales and use tax unless the provider has a physical presence in the state. The nexus questions emanating from the cloud are whether referrals of prospective buyers to a website can create nexus in a state, and whether the services, such as software licenses, or IaaS, could create a physical presence in the state where the provider’s servers are located. If nexus is created, then it might create a sales (or use) tax collection obligation for taxable sales to the purchaser of cloud services in those states.
Many states, including Arkansas, California, Connecticut, Georgia, Illinois, New York, North Carolina, Rhode Island, and Vermont, have adopted various laws providing that the presence of affiliates driving click-through revenue in the state creates a presumption that a remote seller has nexus in that state. A number of states have introduced legislation containing similar provisions. Further, other states, such as Pennsylvania, have taken the stance that they do not even need legislation to compel a remote seller to collect the tax in their state if that remote seller is paying a commission to an in-state representative for referrals to the remote seller’s website.
For example, Provider A above is paid a commission by the subscriber based on the amount of the subscriber’s software that was sold to third parties. If it is assumed that Provider A is also soliciting sales in states on the subscriber’s behalf, then the subscriber arguably has nexus in those states, and the subscriber then can be compelled to collect sales tax on its sales of software by Provider A in states that tax remotely accessed software.
The nexus analysis relating to the purchase and sale of cloud computing may require careful consideration of the location of the equipment used by the seller to provide computing services. Servers could be located in more than one jurisdiction. IT managers may be able to assist with the determination of where a provider’s servers are located.
Consider Strategies to Minimize Click-Through Nexus
Most of the states that have laws creating a presumption of nexus based on the presence of so-called “click-through” affiliates also provide a mechanism to rebut that presumption by obtaining affidavits from affiliate providers. It might be feasible for purchasers to seek affidavits that would state that the provider and its affiliates have not solicited sales in exchange for the commissions paid for software sold on the site.
It is almost always a good idea to register and start collecting sales tax if it is determined that a significant risk of nexus and a tax collection obligation may exist. Otherwise, taxes (including interest and penalties) that might otherwise be collected from a customer can be assessed against the seller.
Determine Likely Taxability of Services in All States of Use
Cloud service providers may not be collecting sales (or use) tax on their services in all states where purchasers are using the service because the provider may not have nexus in states where customers are located. Accordingly, purchasers that are not charged tax by the provider in their states of use should consider the taxability of the services in these states. Typically, a tax matrix is created that considers the taxability of each of the services purchased in the states of use. The matrix should provide the authority relied on for the tax decisions. In the sample terms and conditions described above, many states would likely assert that taxable products and services are being sold based on the references to software, content, and processing services.
States vary on the provisions they apply in asserting tax on remotely accessed software. Currently, 19 states employ a variety of approaches to tax such remotely accessed software or SaaS. A detailed discussion of all 19 states is beyond the scope of this item; however, the following examples show how some of these states seek to tax remotely accessed software.
New York’s policy is that access to software on a remote server by a New York purchaser is a taxable use of software in New York (New York State Dep’t of Tax. and Fin., Advisory Opinion TSB-A-11(17)S (6/1/11)). New York and other states that tax information will likely investigate whether any references to “content” in the terms and conditions refer to the sale of taxable information. Ohio looks to tax access to software that includes a data-processing element (Ohio Rev. Code §§5739.01(B)(3)(e) and 5739.01(Y)(1); Ohio Admin. Code §5703-9-46).
While South Carolina does not tax the electronic delivery of software, it may seek to tax remote access to software as a “database access transmission” telecommunications service (see S.C. Dep’t of Rev., Rev. Rul. 05-13 (8/21/05)). Other states may assert that taxable information or digital products are inherently included in the cloud services provided. The location or “sourcing” of the cloud sale should also be considered when the location of the customer using the service is not clear.
Some purchasers may determine tax based on the location where bills are paid; however, the precise location of users of taxable services should be considered—the state of actual use may not tax the services purchased. In some states, the tax base could be reduced by unbundling taxable and nontaxable charges. In New York, for example, separately stated services to software are exempt from sales and use tax. Other states have specific exemptions for web-hosting services.
Where substantial savings might be achieved through unbundling, purchasers should contact the cloud service provider and request an itemization of the charges for each service. Some otherwise taxable services may qualify for resale exemptions, to the extent that content or software is resold to purchasers’ customers. Production or manufacturing exemptions should be considered by purchasers who may be using software accessed on the cloud to produce other software or tangible property for sale.
Implement Results of Analysis
Purchasers should modify use tax accrual policies and procedures to self-assess tax on taxable services in states where providers are not charging tax. Use-tax matrices should be updated to reflect purchases. The location of use should be reflected in accruals, and documentation with regard to the sourcing of use should be retained.
Monitor Tax Laws and Policy Changes
Purchasers should plan to revisit tax matrices and tax decisions on cloud services frequently. Nexus and taxability laws and policies in this area are subject to frequent change. Pennsylvania recently changed its policy with respect to the sourcing of remotely accessed software (see Pa. Sales and Use Tax Ruling No. SUT-12-001 (5/31/12)). The various click-through nexus provisions are subject to ongoing constitutional challenge (see Amazon.com, LLC v. New York State Dep’t of Tax. and Fin., 913 N.Y.S.2d 129 (N.Y. App. Div. 2010); and Performance Marketing Ass’n v. Hamer, No. 2011 CH 26333 (Ill. Cir. Ct. Cook Cty. 5/7/12)). Meanwhile, many state legislatures have pending bills that would adopt various affiliated nexus provisions.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.