Taxing the Cloud, Part 1

Keith Staats, JD Executive Director, Illinois Chamber Tax Institute
Deciphering Today's State & Federal Tax Law

Given the fact that cloud computing is such a hot topic these days, it’s not surprising that the tax treatment of these services at the state and local level is also finding its way into the press.

Cloud computing refers to remote access of computing applications, platforms and infrastructures from a central service provider. Activities that fall within the scope of cloud services include Software as a Service (SaaS), Infrastructure as a Service (IaaS), Platform as a Service (PaaS), Business Process as a Service (BPaaS), Database as a Service (DBaaS), Data Storage as a Service (STaaS), Security as a Service (SECaaS) and Application Programming Interfaces as a Service (APIaaS). Each involves a third party, which provides services that may render a company’s purchase of physical hardware and software unnecessary. In the case of SaaS, for example, the service provider hosts software applications that are available to customers over a network or the Internet.

While a potential bonus for businesses, cloud computing functions present a number of tax issues. It’s not that these issues are new; rather, they are traditional tax issues that need to be applied to an ever evolving business model. My column discusses some of the sales tax issues related to SaaS, specifically.

As with all state tax questions, the main focus is characterization. For example, what is SaaS’ proper characterization for tax purposes? Illinois sales tax imposes a tax on the sale of tangible personal property (TPP), while the Illinois Retailers’ Occupation Tax and Use Tax don’t tax pure services. In the early 1980s, the Illinois Supreme Court ruled that a transfer of computer software didn’t constitute a taxable TPP sale. In response, Illinois law was amended to characterize software sales as TPP transactions subject to Illinois sales tax. The state adopted rules governing software sales, which included software downloads. While these rules have remained in effect and mostly unchanged, they’re silent about SaaS where, arguably, no software is downloaded to the customer’s computer, since the software resides on the provider’s equipment at a remote—and often out-of-state—location.

For a number of years, the Illinois Department of Revenue (IDOR) has wrestled with this. After all, Illinois is no different than any other taxing authority; the inclination is to find a way to tax new types of transactions. To date, the IDOR says the issue is being studied; a firm position one way or the other has yet to be taken.

When evaluating potential tax issues affecting a buyer or seller of cloud services, it’s important to ask the right questions. For one, proper classification under the laws of the buyer and seller’s respective states is paramount. Are they in the same state or separate states? Is this a purchase of tangible personal property, intangible property, a service, or some combination of one or more?

Remember that, as I’ve mentioned, some states tax all services while others tax only specific services, which means that some states may characterize SaaS as a sale of taxable prewritten software. If the buyer and seller are located in separate states, does the seller have nexus with the state in which the buyer is located? Is the buyer located in multiple states and will the services be utilized in multiple states? Does the seller have leased property in the buyer’s state? Will the buyer’s state contend that, in the case of SaaS, the buyer has constructive possession of the software, which makes the transaction a taxable licensing of software even if there is no physical download?

With respect to TPP versus a service, TPP is often defined as something that can be felt, touched, held or possessed. In the context of this review, analysis also has to consider the True Object versus the Incidental to Services Test in bundled transactions. In other words, is the buyer purchasing a service with only an incidental non-taxable (to the buyer) transfer of TPP, or is the true object of the purchase the acquisition of TPP? Itemizing services separately from TPP may be critical in minimizing state taxes. Some states, in fact, measure whether a transaction is TPP or a service based on the percentage of one or the other to the total.

Once characterized, the states’ methods of sourcing have to be reviewed and applied. States may not have specific guidance on how to source SaaS, and they are definitely in catch-up mode when it comes to updating or enacting new and current relevant legislation. Sourcing SaaS among states can be very complex. The question is, should the transaction be sourced based on the seller’s location, where SaaS is used, or some other location? Then, after working through the Sales and Use Tax issues, the cloud services provider has to tackle how the services are taxed under various state income tax laws. But that’s a discussion for another column.

In the next issue I’ll explain how a number of states are attempting to tax cloud services, and how sourcing plays into this.

Keith Staats is a director in Grant Thornton’s State and Local Tax (SALT) practice in Chicago, and has been involved in tax planning, consulting and dispute resolution in all areas of state and local tax. He has served as General Counsel of the Illinois Department of Revenue (IDOR), was involved in the development of Illinois tax policy, reviewed and evaluated all tax-related legislation proposed by the Illinois General Assembly, contributed to the drafting of all tax legislation proposed by the Governor and was a member of the IDOR Informal Conference Board. He has represented taxpayers before both the Informal Conference Board and the Board of Appeals. Keith also has worked for a large international law firm and was involved in multi-state tax planning, consulting and litigation. He is a professional affiliate member of the Illinois CPA Society, and is a member of the American Bar Association, the Illinois State Bar Association, the Chicago Bar Association and the Board of Directors of the Civic Federation of Chicago.