Tax issues bring cloud services down to Earth

States in the U.S. are having a hard time keeping up with the cloud, especially when it comes to taxing it.

There have been a bevy of rulings by various states in the past few years related to how cloud services are taxed, but a recent ruling in Utah could be one of the furthest reaching decisions on the topic to date. And experts say it could begin a wave of more states looking to expand their policies of how taxes are collected on the fast-growing adoption of cloud services.

States are increasingly looking to tax the cloud for a simple reason: The rise in e-commerce and cloud computing services have eroded their traditional forms of tax collections they have relied on in the past, says Joel Waterfield, a senior manager at consultancy and accounting firm Grant Thornton. It’s amounted to what Waterfield calls a game of catch up by the states now. “When they’re losing multiple millions of dollars in transactions, they feel they need to recoup some of that tax revenue,” he says.

More and more states are issuing rulings on taxing the cloud, says Kelley Miller, of the firm law firm Reed Smith and a writer for the firm’s TaxingTech blog. In July of last year, there were only four states that had regulations regarding how cloud services would be taxed. By the end of the year that number had doubled and this year already there have been a half-dozen rulings.

Utah is the latest example. In 2010, an undisclosed provider of business conferencing and desktop access tools inquired with the Utah State Tax Commission asking if its cloud-based business collaboration and online meeting SaaS offerings were subject to sales tax. The product requires end users to download a thin client application to access the cloud-based services. In February 2012 the state ruled that web services that charge a fee constitute a sale of a service, and are therefore subject to sales tax. It seems to imply that simply accessing the SaaS application is enough to subject it to a tax liability. “This could really be a harbinger for cloud computing taxation,” says Miller. “Many states may look to Utah’s ruling as a template of how to tax cloud services into the future.”

The Utah ruling is different from how other states have approached taxing cloud services because it includes services that charge users a fee for accessing a software. Other states have had a narrower definition that hinges more on the actual transfer of software from the provider to the user. Kansas, for example, in a series of rulings from the past few years, has noted that when a SaaS application of some sort is downloaded to access the application, then it can be taxed because there is a transfer of software.

Still, other states have even more narrow definitions that are based on where the application is hosted by the provider and whether it has nexus in the state, meaning if it is subject to tax liability. Massachusetts seems to be an example of this. Nexus has traditionally been determined based on a company’s physical presence in a state, so some states will tax cloud services if the application and user accessing the software are both within the state’s borders. Miller and Waterfield say that can be a messy legal proposition because many cloud providers host applications in multiple states to ensure uptime during a disaster, for example.

“States are really all over the map, literally,” Miller says related to their approaches for taxing cloud services. The nuanced differences in the regulations point to the trouble states are having regulating the cloud, says Annette Nellen, who specializes in 21st century taxation at San Jose State University.

“It used to be easy,” she says. Customers would go a store, buy a CD with preloaded software on, get a license for the software and pay a sales tax on it. When downloading of software became commonplace, many states ruled that the transfer of the software – even if it is not a transfer of a physical object – still constitutes a sale, and therefore can be taxed. Utah’s ruling seems to indicate that merely accessing that software, and not just downloading it, can create a tax liability. “I think states are just looking for any possible way they can fit the cloud into the current tax code,” Nellen says.

When states try to squeeze cloud services into existing laws, it makes the jobs of Miller and Waterfield more difficult to analyze the rulings and intentions of the states. Some states, for example, tax data processing services and others tax information services. Does the cloud fall into those? Miller and Waterfield say each provider must look at the tax laws in the states not only where they are located, but also where end users access it. The sales tax, which usually ranges from 4 eight to 8 per cent, is usually the responsibility of the service provider to assess on the customer.

Nellen says there’s an easier way. Hawaii has taken the approach that simply all sales are taxed, including services, which would include cloud services. Only certain items are exempt, such as food and non-elective emergency care services. The more explicitly states can be in terms of outlining which services are taxed and which are not would make the rulings easier to understand, all three experts agree. But Miller says tax policy on a state level is a balancing act between states attempting to meet their revenue projections and officials not over taxing certain industries and emerging technologies.

“It’s politics vs. the revenue needs of the state,” she says. And if the Utah ruling is any indication, more states may be looking to capture some additional tax collections from cloud services.

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Jim Love, Chief Content Officer, IT World Canada

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