Pennies from Heaven

By Daniel Gayer September 10, 2014

Have you ever done business in the cloud? Does your company store digital files on servers you do not own? Do you use software that you access remotely and don’t have installed on your computer or mobile device? Have you ever purchased a movie, song, or other media via digital download? Do you sell software or other digital media electronically?  If so, did you ever pay sales tax or think about how sales tax might apply to these transactions?

Before the recent rise of the internet and e-commerce, determining the correct jurisdiction and sales tax treatment of a particular sale was a relatively simple matter. Nearly all sales involved tangible personal property – physical items that can be seen and touched such as books, cars, and equipment – and the sales were typically made at a physical location. If no exemption applied, sales tax was paid to the state containing that physical location.

The e-commerce revolution complicated things with the rise of internet sales where tangible goods are ordered through a website and delivered from the seller’s warehouse in one state to a customer in another state. States struggled for years and continue to struggle to catch up to the pace of technology and figure out how to track these sales and what legal framework to use to determine where and at what rate tax should be paid. Although this area continues to evolve as shown by recent high-profile cases with major players in the e-commerce field such as Amazon.com challenging the existence of nexus (a company’s connection to a particular state – necessary before a state may require the seller to collect tax on sales made by that company delivered to customers in that state), the basic rules are clear. If the seller has sufficient nexus in the state where the customer receives the goods, then sales tax is due to the customer’s state.

The cutting edge of sales tax in the e-commerce world has now shifted into the cloud: how should sales be taxed when no physical product is involved and an electronic product is transferred by electronic means in return for electronic payment? This new framework is increasingly becoming the dominant mode for the sale of movies, music, periodicals, books, and software. The software arena is becoming even more complicated with the rise in cloud computing where businesses that might previously have purchased software on a CD and installed that software on their own computers now instead purchase the right to access and use the software installed on another company’s computers via the internet. In sales tax parlance, such transactions are labeled “Software as a Service” (SaaS). The term SaaS encapsulates the core difficulty in analyzing these transactions from a sales tax perspective – is the character of the transaction the sale of a product (generally subject to sales tax), or a service (generally not subject to sales tax)?

As of this writing, Arizona, Connecticut, the District of Columbia, Hawaii, Indiana, Massachusetts, Michigan, New Mexico, New York, Ohio, Pennsylvania, South Carolina, South Dakota, Texas, Utah, Vermont, Washington, and West Virginia tax SaaS transactions. Each of these states has a somewhat different rationale for why SaaS transactions should be taxed. Some define software to be tangible personal property no matter how it is transferred to the customer, and other states have created special taxable categories for data processing services with an expanded definition to cover SaaS. Every year new states are taxing these services and expanding their capacity to identify taxable transactions and issue audit notices for situations where tax should have been paid based on their new rules.

What does this mean for taxpayers? If you own, work for, or advise a business that has contracts for the use of cloud based software and/or data storage, you may be subject to tax. Due to the pace of technological change and the often hurried and disjointed efforts of states to catch up, many sellers in the cloud market are not up to date on the latest changes and may fail to collect sales tax where they should. Sellers may also correctly determine that they do not have nexus in a particular state, in which case they may correctly not collect sales tax. In either case, the end user may be liable for use tax, and with annual fees for cloud-based software quickly climbing into the tens or hundreds of thousands of dollars even for modest sized companies, the potential exposure with tax rates ranging from 5-10% can add up very quickly! As with the initial e-commerce boom with the sale of tangible property in the late 1990s and early 2000s, states’ sales tax enforcement and rule making are lagging behind the pace of technology, but they are catching up quickly, and you can expect to see many more states taxing SaaS transactions and stepping up their enforcement over the next several years.

If you think sales taxation of cloud-based software may impact your business, please contact me, Merrill Barter, Chris DeRosa, or your BNN tax professional for a detailed analysis of your specific situation. In future articles, we will be going into more detail about the rules in states such as Massachusetts, New York, Texas, and California that may be of particular interest to our clients and we will also consider sales taxation of digital products such as music, movies, and periodicals accessed electronically.