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 firstname.lastname@example.org.
Gone are the days when multinational companies could reduce or eliminate their tax liabilities by taking advantage of broad language contained in various income tax treaties that the U.S. has effectuated with other foreign jurisdictions. In 2015, the Organization for Economic Cooperation and Development (OECD) introduced a new framework to aims to prevent businesses from exploiting gaps in different countries’ tax systems and artificially shifting their profits to low- or no-tax jurisdictions. Under this Base Erosion and Profit Shifting (BEPS) Action Plan, barriers have been put into place to block businesses from implementing strategies that had previously allowed them to take advantage of exceptions to U.S. income tax treaties and avoid creating a tax nexus, or a minimum connection, that would have otherwise required them to pay taxes in that country.
By amending tax treaties to ensure that corporate profits are taxed in the jurisdiction where real economic activities generate those profits and create value, the BEPS Action Plan aims to eliminate these legal practices of tax avoidance. In turn, businesses around the globe will not only be required to adjust their financial and tax reporting, but also to plan and prepare revised guidelines for those activities they, their employees, or their agents may take while working abroad.
What is the BEPS Action Plan?
At its core, the BEPS Plan features 15 recommended best practices for increasing tax transparency and information sharing between international tax authorities; improving voluntary compliance with cross-border tax-treaty consistency; and making the taxation of corporate profits more certain and predictable among all participating countries.
How Does Business Nexus Affect Taxability?
One area of particular interest is Action Item 7, which aims to prevent multinational enterprises from artificially avoiding permanent establishment (PE) status, or a “substantial economic presence”, in a jurisdiction that would otherwise trigger a related tax liability in that country. Historically, a PE has been defined to include:
- a physical, “fixed place of business” in that country (a “fixed place PE”), or
- a dependent agent (be it an individual or a corporation) in that country that “habitually exercises the authority to conclude contracts on the enterprise’s behalf,” (a “dependent agency PE”).
These loose definitions, along with several exceptions to the rules, had permitted many enterprises to avoid creating PEs, or business nexus, in foreign countries through a variety of tactics, including commissionaire or toll arrangements, specific activity exemptions (e.g. preparatory and auxiliary services and warehousing facilities), and the splitting up of contracts.
In an effort to curb artificial avoidance of permanent establishment status and accompanying tax liabilities, BEPS Action Item 7 expands the definition of dependent agency PE to include all situations in which a closely related agent or person acts on the behalf of an enterprise. This includes not only the conclusion of contracts, but also any contracting for the “transfer of ownership or granting of rights to use” any property owned by the enterprise, or that the enterprise has a right to use or any contract for which the enterprise promises to provide services.
Under this expanded definition, a multinational enterprise will have a dependent agency PE in a contracting state where it has an agent whose activities “lead to the conclusion of contracts” in the name of the enterprise, or for the transfer of goods or services by the enterprise. The only exception will apply to those enterprises that hire truly independent intermediaries whose businesses are separate and unrelated from the enterprise, and that do not work exclusively for the enterprise.
Action Item 7 also limits taxable nexus to “fixed places of business” where an entity conducts activities that are not considered “preparatory or auxiliary” to its core business. Only those short-term activities that “support, without being part of, the essential and significant part of the activity of the enterprise as a whole” will escape PE treatment. This may include maintenance of stocks of goods for storage, display, delivery or processing, as well as purchases or collections of information for both brick-and-mortar and online businesses. Note, however, that these very same activities may, under certain circumstances, comprise an essential (or significant) part of the operating entity’s business activity. For example, a large, online distributor that makes its money by warehousing the products of others and delivering such products in a timely fashion, may have more trouble arguing that its warehouse facilities are preparatory to its business and not the essence of its business. As such, they may no longer be able to rely on this exception to avoid a local tax nexus in the jurisdiction in which they maintain such warehouses.
These revised definitions may give way to a flood of PE-creating activities for which businesses will be exposed to greater tax liabilities and administrative costs in additional countries, even when they have in place well-established policies concerning the “do’s” and “don’ts” of cross-border activities. In fact, under the BEPS package, businesses will need to reexamine their compliance with the principals of cross-border business activities to ensure that they do not run afoul of these new broader definitions as to when a tax nexus may be created abroad.
How May My Business Minimize Exposure to Permanent Establishment Status?
Businesses and their executives must closely assess their cross-border activities to identify and correct instances in which they may be inadvertently creating taxable PE. For example, consider a situation in which a U.S. company hired one of its foreign subsidiaries to act as a sales agent of its product in a local market. Historically, the sales agent or its employees would not sign contracts with a local customer, but instead, perform all of the negotiations and other related activities that led to the eventual contract signing between the third-party customer and the ultimate U.S. parent company. Under the old definition of dependent agency PE, the U.S. company could first argue that the related subsidiary was independent. However, even if it treated the agent as dependent, the U.S. company could still argue that the agent did not have the authority to sign contracts, and did not habitually do so, thereby allowing the company to avoid a local tax nexus.
Under the new, expanded definition, a related party, such as the one described above, would almost surely be treated as dependent; the company would be unable to make the first argument that the foreign subsidiary could be considered independent under the old definition. Furthermore, under the new definition of dependent agency PE, it is not required that the agent habitually sign contracts. Rather, it is only required that such agent’s activities lead to the conclusion of contracts in the name of the U.S. parent company. In such a case, the same activities that did not give rise to a local tax nexus under the old definition, would, indeed, give rise to a tax nexus under the new rules.
To avoid triggering taxable PE status under Action Item 7, businesses may need to restructure existing sales arrangements, and/or implement new policies and procedure for selling their goods and services across borders in the future. International tax advisors can help businesses analyze the substance of their cross-border activities and make recommendations for restructuring business activities, including transfer pricing adjustments 1) to minimize risk of creating a tax nexus in the first place; and 2) to reduce the amount of the income tax exposure associated with a taxable nexus, if one could not be avoided.
About the Author: Andre Benayoun, JD, is an associate director of International Tax Services with Berkowitz Pollack Brant where he works with inbound and outbound multinational businesses and nonresident aliens on a variety of matters, including structuring for mergers, acquisitions and liquidations; planning for profit repatriation; treaty analysis; tax efficient debt financing; and pre-immigration tax planning. He can be reached in the firm’s Miami office at 305-379-7000 or at email@example.com.