Approaches to deploying computing power are moving from the acquisition and self-management model to the subscription model in which we have access to the latest tools and expert third-party managers. This new approach — still evolving in its capabilities and offerings — is often referred to as "cloud computing" and "Software as a Service" (SaaS). Cloud computing and SaaS offer many information technology (IT) management benefits while challenging existing tax rules. The cloud model lets CPAs access software, content such as educational materials and movies, services and storage in a manner where location — an important concept in taxation, is not important. Companies that create and enable the cloud are likely to call their "product" services, while tax agencies may attach a different label.
This article provides a brief overview to new IT approaches and explains the nature of the tax issues that arise. Sales tax is the focal point and a sampling of the limited guidance is covered.
Think of the cloud as servers operated and maintained by a third-party that you access via the Internet. These servers can store data, movies, website, blogs and more. The servers can host software that can be accessed and used from your own computer. With this arrangement, you no longer have to worry about software installation and maintenance and might not need as much computing power or storage on your own computers (or handheld devices). You can access the cloud from any Internet-connected device. Internal IT costs should go down and performance capabilities should improve.
These concepts and practices are not new. If you access bank records via the Internet or have e-mail or a blog stored on a provider's server, you've been in the "cloud." What is new is that more products and services are moving to the cloud. For example, in May 2010, Microsoft announced that its key software products would be available for online use (Reuters, "Microsoft Launches New Office, Duels Google Online," May 12, 2010).
Despite the touted IT efficiencies, there are concerns. Businesses, as well as tax and legal advisers subject to confidentiality rules, have concerns about security and privacy and the level of trust to place in a cloud vendor.
Sales Tax Issues
The information age and its digital products have challenged the historic application of sales tax to tangible personal property. Sales tax questions that arise for software, even without the cloud, include the following:
- Tangible or intangible? Given that software is a code that provides instructions to a machine and can be transferred electronically, it would seem to be intangible. The federal income tax law (IRC §197) treats it as intangible. Yet, software is transferred or housed on something tangible such as a CD or hard drive. Also, state sales tax laws do not define tangible in the context of weight or touch only. Instead, tangible property is often defined as "personal property that may be seen, weighed, measured, felt or touched or which is in any other manner perceptible to the senses" (for example, CA Rev. & Tax. §6016 and VT Stat. Ann. §9701).
As described in South Central Bell Telephone v. Barthelemy, 643 So. 2d 1240 (S. Ct. La. 1994), software is "not merely knowledge, but rather is knowledge recorded in a physical form which has physical existence, takes up space on the tape, disc or hard drive, makes physical things happen and can be perceived by the senses." The court also noted that the fact that "the software can be transferred to various media, i.e., from tape to disk or tape to hard drive or even that it can be transferred over the telephone lines, does not take away from the fact that the software was ultimately recorded and stored in physical form upon a physical object."
Some states, such as Vermont, supra, have expanded their definition of tangible property to specifically include prewritten or off-the-shelf software, while a few, such as California, treat software delivered electronically as intangible (CA Reg. 1502(f)(1)(D)(PDF)).
- Tangible product or service? Custom software has sometimes been treated as a service. For example, in Measurex Systems, Inc., 490 A.2d 1192 (Me. 1985), the court described custom software as a service because its creation "requires high skill" and its "principal value lies in the services of the programmer."
Some states specifically impose sales tax on services that may involve computing and software, such as information services or data processing services. (See Federation of Tax Administrators, Sales Taxation of Services, 2007.)
- Delivery mode: In some states, such as California, software delivered electronically or via "load and leave" where no tangible media is provided to the customer, is not subject to sales tax.
- Maintenance contracts: State laws can vary as to how they treat a software maintenance contract. The "taxability matrix" used in states that adopt the Streamlined Sales and Use Tax Agreement provides a useful example of the many ways that software maintenance contracts can be categorized (SSUTA Taxability Matrix (PDF), March 2010, pages 3 – 4).
- Sourcing: Generally, sales tax transactions are sourced to either the destination or origin of the sale. Issues can arise under the destination approach for software because a customer might purchase multiple copies or the right to make multiple copies that will be used in more than one state.
- True object: In some transactions, it might not be clear as to whether software is transferred or whether it should be considered part of the transaction. For example, many products include software embedded in the hardware, but the bundled product is treated as just hardware. In some transactions, customers may be using the vendor's internal use software to use, view or obtain data. For example, use of computerized tax research tools and obtaining or manipulating data using a vendor's software are typically viewed as services that don't involve any transmission or use of software. The focal point or true object of such transactions is the data and the fact that the vendor's internal use software helped generate the data for the customer is often ignored. However, it is possible that greater use of the "cloud" may alter the perspective on the role of the software in these types of transactions.
Use of software: A few states have issued rulings on the sales tax treatment of cloud computing involving the use of software, data and storage. Generally, states that already tax prewritten software regardless of how acquired (on tangible media or electronically) are likely to reach a similar result for software accessed while stored on a third-party's server. Rulings of two such states are summarized below. States that do not treat the electronic delivery of software as taxable may view software programs in the cloud as nontaxable (for example, Missouri Letter Ruling 5753 (July 16, 2009)).
Louisiana Revenue Ruling No. 10-001 (PDF) (2010) relies heavily on South Central Bell, supra, in analyzing the tax treatment of software and stored data on servers located both in- and out-of-state. The Department of Revenue (DOR) explains that viewing the electronically delivered property on a computer screen in Louisiana makes it tangible as it is perceptible by sight and sound. It is enough that the product might be stored, used interactively on the computer or viewed, even if only momentarily, to have a taxable transaction.
New York ruling TSB-A-09(33)S (PDF) (August 2009), involved customer use of prewritten software on the vendor's server located outside of New York. The Department of Taxation and Finance addressed the nature of the transaction in terms of whether the software was taxable and whether there was a "sale" as defined under New York law. New York sales tax law treats prewritten software as tangible personal property. In addition, "sale" can include the right to use. The Department concluded that the location of the software code was not important because it could be used by the customer even though not received on tangible media or via download. In addition, accessing the software enabled constructive possession. Finally, the vendor's "service" label was not controlling.
Services vs. use of software: Some rulings seem to struggle with identifying the true nature of the transaction; for example, is it:
- Customer use of software on the vendor's server or
- The vendor's use of the software to provide a non-taxable service to a customer.
A few rulings in New York involved online education provided via use of the vendor's software platform. In TSB-A-06(5)S (PDF) (February 2, 2006), learning was viewed as the primary objective of Internet-based instruction rather than sale of software. Thus, sales tax was not owed. In contrast, in TSB-A-09(2)S (PDF) January 21, 2009), access to online learning via the provider's "highly interactive" software was found to be taxable and sourced to where the software was used. Similarly, see TSB-A-09(3)S (PDF) (January 29, 2009). The Department reconciled the 2006 ruling by noting that there, the service "included, at no extra charge, significant non-automated academic support."
Sourcing: After finding that accessing software and other materials on third-party servers was taxable, the Louisiana DOR noted another challenging issue — situs (or sourcing), which it described as "a quagmire of points incapable of being administered for taxation purposes." However, the DOR resolved the quagmire by deferring to prior legislative action on a similar issue for communication services. The DOR ruled that situs for downloaded content and software licenses was the customer's place of primary use. (Revenue Ruling No. 10-001 (PDF))
In New York ruling TSB-A-09(33)S (PDF), the situs of the software use was held to be the location in which employees used the software. If the software was used by employees in and of New York, the receipts attributable to employee users in New York were taxable.
The Streamlined Sales & Use Tax Agreement (PDF) (SSUTA; September 30, 2009) provides sourcing rules intended to apply to products whether in the form of "tangible personal property, a digital good or a service" (§309 and §310). These rules provide a sequence of scenarios on how a product is received to determine its source. The first possible sourcing point is the seller's business location if the product was received there. If not, the sale is sourced to the location where received by the buyer. (See §312 for the balance of the sourcing sequence.)
SSUTA §311 defines "receipt" as the first to occur of the following: "A. Taking possession of tangible personal property, B. Making first use of services or C. Taking possession or making first use of digital goods." SSUTA §312 on multiple points of use was repealed in 2006. Clarification on the application of the rules to various cloud computing products and arrangements would be helpful. (Note: New York and Louisiana have not adopted the SSUTA.)
Additional Tax Issues
In addition to issues noted above, providers and users of cloud computing may face tax issues such as the following:
- Whether software or other digital items used by someone in a state, particularly in which the state treats it as tangible personal property, can create sales tax nexus for the provider.
- Sourcing and apportionment of revenues from cloud computing for income tax purposes, particularly when the location of users may be unknown or may change from day to day.
- Where cloud vendors might be subject to local business taxes.
- How new uses of cloud services might affect the definition of internal use software under the federal research tax credit (§41(d)(4)(E)).
In addition to tax issues, the cloud likely also has opportunities for tax compliance and administration. For example, storage and dissemination of tax data for taxpayers, tax agencies and between the two groups might be improved. In addition, the cloud might enable lower cost solutions to tax compliance.
Cloud computing will likely grow as service providers offer even more services and attract larger size customers. In a New York Times article, Jeff Bezos predicts that someday Amazon's revenues from cloud computing will match those of its retail operations (April 18, 2010).
While limited state tax guidance exists, tax advisers will be challenged to determine taxability and location for many cloud transactions. Contract terms, the true object, the location of the parties and property must be carefully reviewed along with state tax rules to determine if any cloud computing charges are subject to sales and other taxes in any states.
Guidance will likely be slow to materialize as tax agencies continue to understand the nature of the transactions and legislators determine whether law changes are needed. If states continue to broaden their sales-tax base to include digital items and more services, the taxability of many cloud-computing transactions will diminish, although sourcing issues would remain. Time will tell if Congress steps in to help resolve that issue in a uniform manner as it did earlier via the Mobile Telecommunications Sourcing Act (P.L. 106-252; July 28, 2000). In addition, states may create new sales-tax exemptions if existing rules seem too broad when applied to the cloud, such as causing online education to be taxable. Stay tuned.
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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.