Navigating Tax Nexus in the Cloud by Karen A. Lake, CPA
Posted on August 18, 2017 by Karen Lake
There is no doubt that the rise of interconnectivity between networks, devices and apps have helped businesses in virtually all industries improve operational efficiency and personalize the customer experience. While more than half of U.S. states have made some progress in defining the sales taxability of digital goods and software, either by adopting the standards set out by the Streamlined Sales Tax Governing Board or through their own definitions, there remains a lack of definitive agreement on the parameters that define the sales and use taxability of intangible cloud-based products and services. Many providers of cloud computing, video streaming and online research offerings assume that the sale of their software and service delivery methods are intangible and therefore exempt from the collection and remittance of sales tax. In reality, cloud computing sales can often create economic nexus and trigger a sales tax liability based on the type of software sold and the delivery method employed.
When Does Cloud Computing Create Taxable Nexus?
There are many ways that businesses can create economic nexus, or a minimum legal presence, in a state that will require them to pay and/or collect sales and use taxes within that state. Obvious activities include owning property or employing workers in a particular state. However, with the rise of cloud services and online transactions, many states have been pushing the boundaries of “physical presence” as defined in the Supreme Court decision in Quill vs. North Dakota in order to collect taxes from out-of-state businesses that make online sales in their states. Common examples of laws for which businesses may qualify as operating in a state without even knowing it include online click-through nexus solicitation and referral laws, affiliate nexus for businesses that pay commissions to remote sellers located in other states, or nexus based on a business’s payroll or it sales activity that exceeds a statutory threshold within a state.
Complicating the determination of nexus and exposure to a state’s sales and use tax are laws involving the sales of software and cloud-computing services. Whether cloud computing is subject to sales tax depends on how each state characterizes the software (canned or customized, tangible or virtual, or product or service) and the method used to deliver it to an end user. More specifically, providers must ask how a state characterizes Software-as-a-Service (SaaS), Platform as a Service (PaaS), and Infrastructure as a Service (IaaS). Is the software considered tangible personal property (TPP), a service or an intangible? Who controls the end product, the software company or the out-of-state purchaser?
Some states have made progress addressing the taxability of the SaaS models, for which software is hosted in one state but licensed for remote use by customers in other states. Those states that impose sales tax on SaaS transaction do so because they consider the model to involve the following qualities:
- a sale of prewritten or canned software that it considers to be “tangible personal property,” or
- a sale of computer or data processing “services,” which many states, such as Arizona, expressly characterize as taxable services.
However, the challenge with sales and use tax compliance is a lack of consistency in the guidance from one state to the next. For example, SaaS transactions are not taxable in 29 states, but in Florida, this rule applies only when the software is considered a service and does not include the transfer of tangible personal property. In 2015, the New York Department of Taxation and Finance addressed the taxability of Infrastructure as a Service (IaaS) cloud computing by ruling that businesses providing its customers with access to computing power are, in fact, delivering a non-taxable service and therefore exempt from sales and use tax in the state.
As states update their nexus standards, businesses must remain alert to evolving laws and their potential sales and use tax liabilities based on the goods or services they provide.
Applying the Right Sales Tax to the Right State
When the sale of a cloud service is taxable, the provider must identify the state or states to which it should source the transaction. Typically, sourcing depends on how a state characterizes a transaction as either 1) the sale of tangible personal property sourced to its destination or use, or 2) the sale of a service sourced to the location where a benefit is derived.
For the latter, the benefit may be derived in multiple states for which a taxpayer should apportion the tax base and impose tax on only that portion of the service for which the benefit is being received in the taxing jurisdiction. This information must be included in contract terms, especially when a purchaser intends to use the service concurrently in multiple states, for which it must provide the seller with the percentage of use in each taxing jurisdiction. In turn, the seller may charge sales tax based on the percentage of use allocated to each of the applicable taxing jurisdictions in which it has sales nexus. When the seller does not have a nexus or responsibility to collect sales tax in a particular jurisdiction, the responsibility for remitting use tax on the service would fall to the purchaser.
However, cloud-computing sellers often have a hard time distinguishing where the benefits of their digital product or services will be derived. Is it the location where the purchaser runs the software on its server or where the end user is located? Is it the jurisdiction when the purchasing entity is located or where the purchasing business’s ultimate users are located?
While few states provide specific answers to these questions, it is advisable that cloud computing sellers, at a minimum, apply a consistent approach to all of their sales/use tax allocations. Additionally, it behooves sellers to identify in their sales contracts the location where a purchasers’ users are located as well as indemnification language to protect the cloud service provider from any future sales and use tax liabilities.
Businesses must consistently assess their exposure to sales and use tax liabilities, especially as a growing number of states are overextending their reach and enacting their own economic nexus laws in order to fill their eroding coffers and generate tax revenue from outside their borders, including the cloud. For example, Alabama passed a law that requires out-of-state retailers to collect and pay sales and use tax when their gross receipts or total sales of tangible personal property to Alabama customers exceeds $250,000 per year. Similar economic nexus laws based on annual sales thresholds have been adopted by other states, including Colorado, Indiana, Massachusetts, North Dakota, South Dakota, Tennessee and Vermont.
One potential glimmer of hope that may help online businesses avoid an overabundance of regulations and corporate income tax liabilities has come from Representative Jim Sensenbrenner of Wisconsin who recently introduced the No Regulation Without Representation Act of 2017. Under the proposed HR 2887, states would be prohibited from taxing or regulating a business’s interstate online commerce unless such business or individual has a physical presence in that state’s jurisdiction. Should Congress approve the bill, online businesses and cloud service providers have the ability to sell across any state line free of sales and use tax, as long as they do not have a physical presence in a jurisdiction. In the meantime, businesses operating in the digital age must take the time to navigate carefully through treacherous waters of conflicting sales and use tax laws.
About the Author: Karen A. Lake, CPA, is an associate director in the Tax Services practice of Berkowitz Pollack Brant and a SALT specialist who helps individuals, businesses and non-profit entities navigate complex federal, state and local taxes, credits and incentives. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at email@example.com.