Emerging Tax Issues Surrounding Cloud Computing Transactions By S. Matthew McNeilly, CPA Industry overview Although the term cloud computing can become quite technical and is utilized in many different contexts throughout the technology industry, perhaps the most basic and non-technical description with broad-based application is that something is happening remotely on someone else s servers located somewhere. Essentially, cloud computing customers are utilizing a computerized service via the internet. The National Institute of Standards and Technology ( NIST ) has developed a more technical definition of cloud computing, as follows: Cloud computing is a model for enabling ubiquitous, convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction. 1 NIST has also articulated five essential characteristics of cloud computing. 1. On-demand self-service. A consumer can unilaterally provision computing capabilities, such as server time and network storage, as needed automatically without requiring human interaction with each service provider. 2. Broad network access. Capabilities are available over the network and accessed through standard mechanisms. 3. Resource pooling. The provider s computing resources are pooled to serve multiple consumers using a multi-tenant model, with different physical and virtual resources dynamically assigned and reassigned according to consumer demand. There is a sense of location independence in that the customer generally has no control or knowledge over the exact location of the provided resources. 4. Rapid elasticity. Capabilities can be elastically provisioned and released, in some cases automatically, to scale rapidly outward and inward commensurate with demand. 5. Measured service. Cloud systems automatically control and optimize resource use by leveraging a metering capability. 2 Although the industry is rapidly evolving with new terminology being introduced regularly, there are three primary classifications of cloud services. Infrastructure-as-a-Service ( IaaS ) can be viewed as an alternative to the customer setting up their own on-premises data center. Customers procuring IaaS generally are seeking out such functions as compute capacity or data storage capacity. The IaaS provider maintains the underlying infrastructure, and may or may not provide basic tools or applications 1 National Institute of Standards and Technology Special Publication 800-145, The NIST Definition of Cloud Computing (September 2011), available at http://csrc.nist.gov/publications/nistpubs/800-145/sp800-145.pdf 2 Id. 1
such as operating system software. The customer accesses the requested capacity and is responsible for uploading its own software, data, and other applications. The customer then works with its own data and applications in the cloud computing environment (which is accessible to the customer via the internet). Platform-as-a-Service ( PaaS ) generally includes all characteristics of IaaS, plus an application development platform. The platforms typically include additional features and automation to assist developers in testing and deploying applications. PaaS providers typically provide services and tools above and beyond IaaS to help with configuration and optimization. The PaaS provider may also provide software and databases for customers to utilize. Software-as-a-Service ( SaaS ) is software that is remotely hosted and updated by the provider, and is often governed by a services agreement as opposed to a software license agreement. SaaS customers may generally access the software from anywhere via the internet. As with IaaS and PaaS relationships, SaaS customers are not responsible for maintaining the underlying infrastructure that powers the software application. Practical considerations when procuring cloud computing services As outlined above, the term cloud computing encompasses a variety of service offerings and therefore there is no one size fits all answer to the applicability of sales and use tax to cloud computing transactions. Two cloud providers that offer nearly-identical services may classify their respective product offering differently in the marketplace (e.g., one vendor may consider its offering IaaS and the other vendor may consider its offering PaaS). Regardless, the vendor s description of its own service is not determinative of the taxability of the underlying transaction. Rather, the taxpayer should understand exactly what is being procured from the vendor. For example, is access to software being provided by the vendor along with the computing power? If so, is the software open source? Is the software merely incidental to the overall service being provided or is it the true object of the transaction? Are other services provided in connection with the cloud computing? In addition to understanding exactly what is being purchased, taxpayers also should understand the proper sourcing of the cloud computing transaction. Generally, cloud services are sourced to the location where they are being used by the taxpayer (as opposed to the location of the vendor s server). Obviously, since cloud computing services are designed to be easily accessible from anywhere via the internet, it is impossible to know the exact locations where customers are using the services. To that end, many states source service-based transactions subject to the same hierarchy as all other retail sales. The Streamlined Sales and Use Tax Agreement provides the following sourcing hierarchy for retail sales: 1. When the product is received by the purchaser at a business location of the seller, the sale is sourced to that business location. 2
2. When the product is not received by the purchaser at a business location of the seller, the sale is sourced to the location where receipt by the purchaser occurs, including the location indicated by instructions for delivery to the purchaser, known to the seller. 3. If neither of the above apply, the sale is sourced to the location indicated by an address for the purchaser that is available from the business records of the seller that are maintained in the ordinary course of the seller's business when use of this address does not constitute bad faith. 4. If none of the above apply, the sale is sourced to the location indicated by an address for the purchaser obtained during the consummation of the sale, including the address of a purchaser's payment instrument, if no other address is available, when use of this address does not constitute bad faith. 5. When none of the previous rules apply, including the circumstance in which the seller is without sufficient information to apply the previous rules, then the location will be determined by the address from which tangible personal property was shipped, from which the digital good or the computer software delivered electronically was first available for transmission by the seller, or from which the service was provided (disregarding for these purposes any location that merely provided the digital transfer of the product sold). 3 Additionally, certain states have provided specific guidance as to the presumption of the location of use with respect to cloud computing services. For example, in its guidance document on digital products (which include digital automated services) and remote access software, the Washington Department of Revenue stated that the majority of such sales will likely be sourced according to the buyer's billing address since most businesses will not know the actual location of the buyer at the time of the purchase. 4 Similarly, when discussing remote-access software in Pennsylvania Sales and Use Tax Ruling No. SUT-12-001, the Department of Revenue articulated a rebuttable presumption that if a purchaser s billing address is in Pennsylvania, then all users are located in Pennsylvania. Recent developments with respect to state taxation of cloud computing Below is a non-exhaustive list of recent state tax developments (legislative changes, administrative guidance, and court cases) with respect to cloud computing. Michigan The Michigan Court of Claims recently ruled that the taxpayer s access to third party software hosted remotely was properly characterized as a nontaxable service as opposed to the sale of prewritten computer software. The court determined that the taxpayer did not take delivery of the software. Rather, what was transferred was information and data that had been processed using the third-party purchasers software, hardware, and infrastructure. 5 Further, the court determined that although computer software was involved in the transactions, the taxpayer did not obtain the requisite level of 3 Streamlined Sales and Use Tax Agreement, 310A. 4 Digital Products Bills (ESHB 2075 & SHB 2620), 05/03/2010 5 Auto-Owners Insurance Company v. Department of Treasury; Court of Claims, Case No. 12-000082-MT (March 20, 2014). 3
control required to satisfy the definition of use of the software. According to the court, the taxpayer accessed the computer power of third-party providers and controlled the output of information by entering data but did not control the underlying software that may have been used by the third-party provider to complete the necessary tasks. 6 Finally, the court found that even if software was delivered to the taxpayer, the software was in fact simply an incidental component of the principal transactions for the various services 7 that the taxpayer procured. Idaho H.B. 598 takes effect July 1, 2014, and excludes from the definition of tangible personal property computer software that is delivered electronically; remotely accessed computer software; and computer software that is delivered by the load and leave method where the vendor or its agent loads the software at the user s location but does not transfer any tangible personal property containing the software to the user. 8 The legislation replaces and expands a partial exemption for remote software that was enacted in 2013 via H.B. 243. Notably, H.B. 598 deletes provisions from H.B. 243 that taxed remotely-accessed software if either (1) the primary purpose of such software was for entertainment use, or (2) the vendor also offered the same or similar software for sale in a storage media or by electronic download. Illinois The Illinois Department of Revenue recently issued a general information letter regarding the applicability of the state s telecommunications excise tax to a taxpayer s cloud-based services. Specifically, the taxpayer provided a cloud collaboration service offering that provided remote hosting of software that provided enhanced functionality for a customer s phone system. The customer was responsible for all on-premises phone equipment and was responsible for its own telecommunications connection to taxpayer s data center. In its response, the Department stated that in general, when a customer utilizes services provided by a company as described herein, by means of the customer s existing telecommunications, internet, or network connections, for which the customer pays its own third-party telecommunications provider, the company would not be providing telecommunications under the Telecommunications Excise Tax Act. 9 Nebraska The Nebraska Department of Revenue recently updated the July 2011 Nebraska Sales and Use Tax Guide for Computer Software and provided guidance therein regarding IaaS, PaaS, and SaaS. Cloud computing is defined as services which allow customers to access and use computer software, servers, operating systems, databases, and other computing resources via the Internet. Charges for these cloud 6 Id. 7 Id. 8 Idaho Code 63-3616(b) 9 Ill. Dep t of Rev. Gen. Info. Letter ST 13-0074-GIL (November 26, 2013). 4
computing services are not taxable regardless of the location of the underlying software or infrastructure. Arizona The Arizona Department of Revenue recently issued a private taxpayer ruling regarding the applicability of Arizona s transaction privilege tax to two of the taxpayer s service offerings. The first offering allows customers to obtain and control computing capacity that is provisioned remotely. The taxpayer offers its customers a choice between open source and third-party operating system software as part of its service offering. The second service offering allows customers to store, retrieve, and maintain content, data, applications, and software on the taxpayer s servers. The taxpayer also provides optional tools for use with the second service offering. The Department found that the first service offering involved the renting of tangible personal property since the customers had control over how long they utilized the service and did not need to utilize the assistance of taxpayer s technicians to start or stop the service. However, the Department found that the second service did not meet the rental criteria under Arizona law since the service provided storage capacity only and did not involve the right to control or possess software or other tangible personal property 10 and thus was a nontaxable service. 10 Ariz. Dep t. of Rev. Private Letter Ruling LR13-006 (June 25, 2013). 5