As technology evolves at a breakneck pace, states and taxpayers are struggling to apply old laws to new innovations. In no area of state taxation is this challenge more apparent than in the taxation of cloud computing.
With the advent of cloud computing, the days of purchasing a software CD at a bricks and mortar store are numbered. Instead of a physical download, customers now can access software stored on servers thousands of miles away.
Cloud computing is a big business—to the tune of tens of billions of dollars—that affects the top and bottom lines of many CPA tech clients.
The growth of cloud technology means that what used to be clearly the sale of tangible personal property —shrink-wrapped software in a box—is now digital, accessed remotely, updated instantly, and challenging to classify for sales and use tax purposes. This creates unique sales and use tax challenges for those providing and those purchasing cloud offerings.
To understand these challenges, practitioners need to have a basic understanding of cloud providers’ offerings. The National Institute of Standards and Technology’s document, The NIST Definition of Cloud Computing, provides a helpful definition of cloud computing and also explains the differences among three service models: software as a service (SaaS), where the customer uses an application that is running on the provider’s remote server; platform as a service (PaaS), where the customer creates or deploys applications on the provider’s remote server; and infrastructure as a service (IaaS), where the customer uses processing, storage, or other computing resources on the provider’s remote server.
The taxation of cloud computing varies from state to state based on the type of cloud service offering the consumer purchases. Some states may treat a cloud offering as a nontaxable service while others may tax the offering as tangible personal property or a taxable (enumerated) service.
The determination may change if the users also have an option to download anything to their devices or receive a copy of any portion of the offering on a tangible medium. Further, sales and use tax classifications vary from state to state. One state may have a specific cloud offering classification while others fit the offering into existing classifications of tangible personal property, nontaxable services, or enumerated services. Therefore, to make state-specific classification and taxability determinations businesses need to review each state’s specific guidance applicable to the offerings.
Taxation of SaaS
Of the three types of cloud computing, states have provided the most guidance on the taxation of SaaS. The majority of the states that have provided guidance have done so through the issuance of private letter rulings or tax department pronouncements. Because most of the guidance is provided through rulings, taxpayers and state officials must evaluate how the facts of the published guidance apply to a variety of different fact patterns. For example, New York and Texas have issued administrative rulings applying the existing statutory guidance to SaaS to find it taxable in those states.
It should be noted that, across the states, SaaS has been classified as software, information services, data processing, computer services, or communications. Accordingly, taxpayers cannot rely on one particular state’s classification as the classification in another state. Let’s look closer at a couple of specific examples.
In an advisory opinion, New York determined that a customer’s accessing form templates on a website is taxable as access to prewritten computer software. Prewritten computer software is included in New York’s definition of “tangible personal property” (N.Y. Dep’t of Tax. and Fin., Technical Memorandum TSB-A-13(22)S (7/25/13)). In this instance, customers accessed form templates online, filled them in with the necessary information, and either downloaded them to their computers or printed them. The ruling provides that although customers do not have the right to “alter, change, or control” the underlying code of the software itself, customers gain constructive possession of the software and the “right to use, control, or direct the use” of the software through the ability to alter the content by filling in the forms. The forms are not available without the right to access to the software.
In a Texas administrative hearing decision, an out-of-state vendor sold a software license to a taxpayer with users all across the country (Tex. Comptroller of Pub. Accts., Admin. Hearing Decision 44,040 (3/24/05)). The software was hosted on a server outside of Texas. The CD with the software was delivered to the taxpayer in Maryland, but the taxpayer had users accessing this software remotely in various states, including Texas. The software CD was never brought into Texas. The decision stated, however, that for purposes of Texas sales and use tax, the absence of the physical medium (the CD with the software) in the state was not in itself proof that taxable use did not occur in Texas. Specifically, the decision stated that software residing on an out-of-state server was used in Texas when a taxpayer “[brought] up the software on a computer in Texas.” The decision further stated that, for taxability purposes, the licensing of a software program was considered the equivalent of a lease or rental of tangible personal property and was, therefore, taxable.
A few states have updated their statutes and regulations to define SaaS and clarify its taxability. For instance, effective July 1, 2015, Tennessee updated its statutory definition of software making the sale of SaaS to Tennessee customers taxable (Tenn. H.B. 644 (2015)). Specifically, Tennessee now includes in the definition of a taxable use of computer software “the access and use of software that remains in possession of” the seller and is remotely accessed by a customer “for use in this state” (Tenn. Code §67-6-231(a)(2)).
Taxation of IaaS and PaaS
In contrast to SaaS, very few states have addressed the taxability of IaaS and PaaS. In a 2014 ruling, Tennessee determined that IaaS was not taxable because there was no transfer of tangible personal property and IaaS is not otherwise enumerated as a service in Tennessee (Tenn. Dep’t of Rev., Rev. Rul. 14-14 (12/1/14)). Following the same logic, South Carolina concluded that a sale of computing power delivered over the cloud as well as cloud storage services were nontaxable services because they were not communications services and no tangible personal property was sold otherwise (S.C. Dep’t of Rev., Private Letter Ruling 14-2 (8/26/14)). In a 2014 information guide, Nebraska specifically addressed SaaS, PaaS, and IaaS as nontaxable cloud computing services (Neb. Dep’t of Rev., Information Guide: Nebraska Sales and Use Tax Guide for Computer Software (rev. 1/21/14)).
In Connecticut, the sale of PaaS, IaaS, and SaaS are generally taxable as “computer and data processing services.” The state broadly includes computer and data processing services in the definition of taxable services and specifically includes time, programming, code writing, etc., as examples of computer and data processing services (Conn. Gen. Stat. §12-407(a)(37)(A)). However, computer and data processing services enjoy a favorable sales tax rate of 1% (Conn. Gen. Stat. §12-408(1)(D)(i)).
Taxpayers should continue watching developments in the states where they operate for the updates regarding the taxability of cloud offerings. With more and more traditionally tangible offerings moving to a hosted delivery model, states are likely to continue issuing additional guidance on the taxability of such offerings.
Alesia Lewis is a state and local tax manager at PwC.