Recent actions in two states – Pennsylvania and Vermont, are reminders of the challenges of applying our mostly 20th century tax laws to 21st century transactions. They are also reminders of the need to fully understand the facts (and technical operation) of any transaction and to carefully read and verify the meaning of the words used in the taxing statute.
Generally, state sales tax applies to transfers of tangible personal property. Many states have expanded to include some services and digital items. Software licenses challenged sales tax rules because of its intangible nature (although some view it as tangible if in a box) and the fact that it is usually licensed rather than sold outright. Software licenses are often not problematic today because states have clarified the treatment via changed statutes, tax agency guidance or court cases.
The new challenge is cloud computing. While there are variations on forms of cloud computing, let’s focus on the situation where a customer can access and use software while on the seller’s computer (server). Nothing is transferred; the customer just pays for use of the software. (To get a better understanding of cloud computing and its variations, I highly recommend information from NIST, such as this 1-page document.)
Well, use without possession sounds like a service and most states don’t tax services. But, the result seems to be the same for both the cloud computing transaction and the purchase of a software license where it is loaded onto your own computer – you get use of the functionality of the software. So, some states reach a result that the cloud computing transaction is subject to sales tax. For example, per Indiana Information Bulletin #8 (Nov. 2011):
“Prewritten computer software maintained on computer servers outside of Indiana also is subject to tax when accessed electronically via the Internet (i.e., “cloud computing”). The accessing of prewritten computer software by Indiana residents constitutes a transfer of the software because the customers gain constructive possession and the right to use, control, or direct the use of the software.”
In contrast, earlier this year Kansas issued Opinion Letter O-2012-001 (2/6/12) holding:
“Charges for hosted software services are not taxable as sales of “prewritten computer software” under K.S.A. 79-3603(s) because the software that is installed on a remote server isn’t delivered to subscribers or installed on their computers. The service provider has title and possession of the software. … Such software is not taxable as a sale of prewritten software so long as the software is not billed to subscriber as a separate line item charge.”
Well, back to Pennsylvania and Vermont …
The Pennsylvania Department of Revenue issued Ruling No. SUT-12-001 (5/31/12) on cloud computing. It holds that “accessing taxable canned software is taxable when the user is located in Pennsylvania.” Despite that holding, a reading of Statute 31.1 sounds like sales tax primarily applies to sales or use of tangible personal property. The ruling though refers to the Tax Reform Code of 1971 Section 7202(o)(1) which defines “use” as “The exercise of any right or power incidental to the ownership, custody or possession of tangible personal property and shall include, but not be limited to transportation, storage or consumption.” That still seems like a stretch since there is no ownership, custody or possession or tangible personal property.
The Pennsylvania ruling also provides that there is no sales tax owed if the end user is located outside of the state, “even if the cloud server that hosts the software is located in Pennsylvania.” That seems to support that the Department’s theory/approach that access to the software via the “cloud” is just as if the customer had purchased it at or from a Pennsylvania store.
In May, the Vermont legislature passed and the Governor signed H-782 to impose a tax moratorium on charges for remotely accessed software after 2006 and before 7/1/13. “Charges for remotely accessed software” means charges for the right to access and use prewritten software run on underlying infrastructure that is not managed or controlled by the consumer or a related company.”
Apparently, the legislation stems from a statement in Vermont Technical Bulletin 54 – “Prewritten software that is licensed for use and available from a remote server is also taxable.” That is not exactly the same as all cloud computing transactions though because there is not always a license agreement and the license is more like a transfer than is a cloud computing service. (For a bit more on the Vermont issue, see this 4/2/12 BloombergBusinessweek article.)
So, apparently there will be more discussion on the cloud computing topic in Vermont. AND, H-782 that was enacted also calls for creation of a 7-member Sales and Use Tax Study Committee to “examine the sustainability of the sales and use tax in the context of Vermont’s changing economy.” “Specifically, the committee shall consider: (A) the taxation of software, platform, and infrastructure as services accessed remotely; (B) the taxation and sourcing of sales of tangible personal property made via the internet; and (C) the feasibility of taxing services more broadly than under current law.”
The report is due to the legislature by January 15, 2013.
That all sounds good as most state sales tax systems are still taxing the 20th century economy which leaves them with an eroding base that tends to cause the tax to be inequitable, inefficient and with too high of a rate. (For more on that, please check here and here.) Not specifically mentioned, but also a 21st century item to consider for adding to the sales tax base are digital downloads purchased by consumers (not businesses).
The bottom line …
- States need to devote time to analyzing the variety of cloud computing transactions and determine how existing statutes apply to them. Guidance should be issued with the answers.
- Legislatures need to determine how statutes need to be updated to properly address taxation of cloud computing services, with an emphasis cloud transactions of individual consumers.
- Taxpayers and practitioners need to carefully analyze the facts of any cloud computing arrangement to understand the legal arrangement among the parties, whether anything was transferred and how to characterize what the customer is getting. The tax law should be carefully reviewed to see how it applies.
What cloud computing tax issues have you encountered? Any clear and correct guidance you have come across?
Gary Hutto says: 
Rick Kristof 