There is a storm on the horizon for providers of cloud-based services as states determine whether and how to tax these services.  Service providers should act now to anticipate upcoming tax issues for their particular business models.  Aggressive state activity could impact a service provider’s sales tax collection responsibility and an end-user’s income tax filing responsibility.

State tax nexus – which must be present if a state is to tax a company’s business income or its sales of products or services – is largely fact dependent.  Historically, states have imposed tax on the sale of tangible personal property.  Businesses providing services have largely escaped taxation of these services.  These principles were codified with traditional “bricks and mortar” businesses in mind.

For the past two decades, states have struggled to amend long-standing statutes to address the taxation of digital products.  State legislatures have failed to develop a consistent method of taxing, for example, a digital download of software.  Some states remain steadfast in only taxing tangible personal property provided to taxpayers in their states.  Other states now impose tax on certain services provided within their states.  Still others have adapted their statutes to now tax downloads of digital products or web-based software.  Cloud computing is a further technological evolution that will stretch traditional state tax principles.

Cloud-based services challenge states, providers, and buyers of those services to define exactly what is being bought or sold.  SaaS, PaaS and IaaS models apply to distinct user groups, but all are predicated on borderless global networks.  Should a state treat cloud-based products as tangible personal property or as a service?  How do states tax these services, if at all?  If a business is located in California, servers are located in Washington State and the consumer is located in Arizona, which state’s laws apply?  California’s because the business is headquartered there?  Washington’s because the servers are physically located there?  Or, Arizona’s because the end-user is located there?  The answers to these questions can result in meaningful tax differences that will impact a business’s bottom line.

States have begun to look at cloud computing as a new source of revenue.  In 2009, the State of Washington enacted a statute which specifically taxes SaaS providers.  Other states have issued letter rulings addressing specific fact scenarios.  Missouri ruled that SaaS services hosted on an out-of-state server are not subject to sales tax when accessed by an in-state user.  In contrast, New York has concluded that it can impose a tax on software hosted on an out-of-state server and accessed by an in-state user.  Rulings such as these can subject a provider whose operations are out-of-state to a state’s sales and use tax regime.

States are also focused on end-users as a source of revenue.  Some states have characterized the licensing of cloud-based services as a lease of tangible personal property.  Property leased in a state could result in income tax nexus for the user of cloud-based services.  This could mean that a business that licenses, for example, SaaS products in another state will unwittingly expand its income tax footprint, subjecting it to filing income tax returns in that state.

States will continue to find ways to tax cloud-based services in an effort to fill their coffers with revenue.  Businesses – both providers and users of cloud-based services – should understand the changing tax landscape to avoid being caught in the storm.

If you have any questions, please contact Brendan Lund at blund@carr-mcclellan.com or at (650) 342-9600.