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1 State Taxation of Digital Goods and Cloud Computing TEI – Nebraska Chapter February 21, 2012 Eric Tresh Jonathan Feldman
©2012 Sutherland Asbill & Brennan LLP 2 Agenda What is Cloud Computing? Characterization/Taxability Sourcing Specific State Treatment Nexus A National Framework
©2012 Sutherland Asbill & Brennan LLP 3 What is Cloud Computing?
©2012 Sutherland Asbill & Brennan LLP 4 What is Cloud Computing? There is really no one definition – it is a manner of providing a service. Cloud computing generally means using multiple service computers via a digital network (usually the Internet) as through they were one computer. Without a “cloud,” a web server runs a single computer or group of privately networked computers. Capacity may be limited or may go underutilized in times of low load. Cloud application allows thousands of users to share application and server resources, optimizing capacity and costs through a “pay-as-you-go” pricing model
©2012 Sutherland Asbill & Brennan LLP 5 Application Service Providers (“ASPs”) An entity retains custody over (or “hosts”) software for use by third parties. Users of the software hosted by the ASP typically will access the software via the Internet. The ASP may or may not own or license the software, but generally will own or maintain the hardware and networking equipment required for the user to access the software. The ASP may charge the user a license fee for the software (in instances where the ASP owns the software) and/or a fee for maintaining the software/hardware used by its customer.
©2012 Sutherland Asbill & Brennan LLP 6 Software as a Service (“SaaS”) The SaaS model allows the consumer to use the provider’s software applications running on a cloud infrastructure. The applications are accessible from various client devices through a client interface such as a web browser (e.g., web- based email). The consumer does not manage or control the underlying cloud infrastructure including networks, servers, operating systems, storage, or application capabilities. Under the SaaS model a service agreement is almost always executed (vs. a software license agreement or services agreement for an ASP). SaaS model is familiar to most Internet users, and includes such offerings as web-based email, calendars, word processing, and digital photo applications.
©2012 Sutherland Asbill & Brennan LLP 7 Platform as a Service (“PaaS”) The PaaS model allows the consumer to run consumer-created or acquired applications on the cloud provider’s platform. The consumer does not manage or control the underlying cloud infrastructure including network, servers, operating systems, or storage, but has control over the deployed applications and possibly the application hosting environment configurations. An example of a PaaS model includes web hosting and managed services.
©2012 Sutherland Asbill & Brennan LLP 8 Infrastructure as a Service (“IaaS”) The IaaS model provides the consumer the ability to outsource or rent storage, processing, network, and other computer resources upon which the consumer is able to deploy and run software, which can include operating systems and applications. The consumer does not manage or control the underlying cloud infrastructure but has control over operating systems, storage, deployed applications, and possibly limited control of select networking components (e.g., host firewall). An example of an IaaS model includes co-location services.
©2012 Sutherland Asbill & Brennan LLP Cloud Service – Division of Ownership IaaS – Co-location PaaS - Managed HostingSaaS Users Applications Tools OS Hardware Network Physical Customer Service Provider Indicates separation between Provider and Customer
©2012 Sutherland Asbill & Brennan LLP 10 Characterization & Taxability
©2012 Sutherland Asbill & Brennan LLP 11 Characterization – Important Considerations Right to use technology? Right to access software? Right to use tangible personal property (software or hardware)? Exclusive use? Right to own or possess? Receipts from a service, including telecommunications? Internet access included?
©2012 Sutherland Asbill & Brennan LLP 12 Why Does Characterization Matter? Taxability Many states tax sales of tangible personal property and a variety of services. As states look for more revenue, the tax base is expanding to include more and more services. Exemptions Does it qualify for a resale exemption Are there any other exemptions: Manufacturing. R&D, etc.? Sourcing Services and tangible personal property are usually sourced differently, the characterization can create issues
©2012 Sutherland Asbill & Brennan LLP Taxation of Digital Goods Digital Goods Non-Taxable Digital Goods Taxed by Statute Digital Goods Taxed by DOR Position or Case law WA ID AZ NM LA AL ME HI CT DE MA AK AR CO MD CA KS FL GA IA IL MI MN MO MT NC SC VA WV WY OK NY PA OR ND NV NH OH RI VT NJ TX UT SD NE MS TN KY IN WI DC ©2008 Sutherland
©2012 Sutherland Asbill & Brennan LLP Digital Goods Bill possibly to be Introduced in 2012 HI AK CA NV MN WV MA FL CO NY VA AR IA KS MI OH RI MD MO PA IL ND SC OK IN VT GA NJ Digital Goods – Legislative Activity Possible Activity in 2012
©2012 Sutherland Asbill & Brennan LLP How do you determine the character of the transaction? Review Contracts How is the product being billed? Review invoices, bills, etc. How is the product being marketed? Promotional materials, marketing documentation How is the product priced? Bundling, true object test, composition of the different components Is it software or a service? Is a License granted? Price difference for the license?
©2012 Sutherland Asbill & Brennan LLP 16 Taxability of New Technology Models With new technology models evolving, states are making every attempt to tax these new models under existing provisions. Method of delivery Custom vs. canned Data processing? Information service? Telecommunications? State taxing authorities continue to rely on letter rulings and informal administrative guidance to set forth their policies in regards to cloud computing services. Such rulings and notices provide limited guidance to the business community and can also cause more uncertainty.
©2012 Sutherland Asbill & Brennan LLP 17 Taxability of SaaS State taxability positions range from: Not an enumerated service Not a sale of software (tpp) because no transfer/delivery/control Taxable service Information service – NY Data processing service – TX, OH Digital automatic service – WA Computer-related services – CT Communication service – FL, SC Tangible personal property License to use – MI Non-possessory use or constructive possession – NY Lease – Chicago Rental if software resides on a server in the state – KS, PA, TN Not taxable because server is not in state
©2012 Sutherland Asbill & Brennan LLP 18 Taxability of Paas Service has experienced tremendous growth because of cost savings associated with outsourcing technology needs. Popular among software developers because they can use their own applications and the tools, infrastructure and computing power of the PaaS. Little state guidance Because many PaaS service providers provide both applications and tools, likely that states will attempt to characterize as the sale of software
©2012 Sutherland Asbill & Brennan LLP 19 Taxability of IaaS Service has experienced tremendous growth because of technological advances Look to state’s taxability of various services Hardware maintenance Software maintenance Repair labor Security services Electricity Data maintenance Limited State Guidance Vermont – Web hosting services are not taxable Texas – Web hosting and remote storage services are taxable data processing services Texas – Data backup services including server imaging and routine tape backups are taxable data processing services
©2012 Sutherland Asbill & Brennan LLP 20 ITFA Preemption? Does ITFA preempt states from taxing certain digital services? In 2007, the definition of “internet access” under ITFA was expanded to include “a homepage, electronic mail and instant messaging (including voice- and video-capable electronic mail and instant messaging), video clips, and personal electronic storage capacity, that are provided independently or not packaged with Internet access.” ITFA section 1105(5)(E). What does the word “personal” mean?
©2012 Sutherland Asbill & Brennan LLP 21 Bundling As Cloud Computing offerings contain multiple types of services, taxpayers should be aware of state bundling rules. The Streamlined Sales Tax Agreement provides that a bundled transaction occurs when two or more distinct products are sold together with one itemized bill. States may impose tax on the full sales price of the bundles transaction if any part of the bundle is taxable, or may look to use a “true object” or “primary function” test to determine whether the true object of the transaction is taxable. (CA & NY)
©2012 Sutherland Asbill & Brennan LLP 22 Sourcing
©2012 Sutherland Asbill & Brennan LLP 23 Sourcing Overview The sourcing of a digital item is dependent upon its characterization. For interstate sales, if taxable as: Tangible Personal Property Generally destination Consider subsequent use Consider concurrent use (prewritten computer software) Services Varies by state. May be: Benefit (Market Sourcing) Performance (COP) Consider multistate benefit Digital Goods Not clearly defined. May be: Destination Benefit Consider multistate use
©2012 Sutherland Asbill & Brennan LLP 24 Sourcing Issues What are the problems? For sales tax, concepts of destination and benefit are not easily applied to digital items. Seller may have no idea where the receipt of the items takes place, or where the item is used. For purchasers, location of use may not always be known – or may be from multiple locations. Is “Use” at server location or user location? States vary, by way of example: Alabama – Server location New York – User location Trend towards user location, but be mindful of states that include software or digital products in their definition of tangible personal property – these states may take a more traditional view of where these items should be sourced – one location.
©2012 Sutherland Asbill & Brennan LLP Step 1: A Customer at Dulles Airport uses her Wi- Fi to access the Apple store. The Apple store server is located in TX. Step 2: She downloads three movies which are charged to her Apple account – her billing address is in CO. Which state has the right to tax? The Problem
©2012 Sutherland Asbill & Brennan LLP 26 Multiple Points of Use (“MPU”) The MPU provisions were repealed from the SST Agreement. Member states required to repeal by January 1, 2008. The Multiple Points of Use (“MPU”) Exemption permitted a business purchaser of computer software, digital goods and services, which are concurrently used, to apportion, self assess, and remit use tax in all jurisdictions in which it will be used. Generally, purchasers are allowed to use an apportionment method so long as it is reasonable, consistent, uniform, and can be supported by their books and records.
©2012 Sutherland Asbill & Brennan LLP 27 Sourcing Approach State law and regulations often does not provide an answer/approach. Rather, a “range” of sensible/acceptable answers is the norm. Washington – Special exemption Business must report and pay use tax on that portion of the digital products, digital code, prewritten software, or remote access software used in Washington. Taxable amount determined by ratio of in-state users. Generally, digital products and remote access software are used in Washington when the buyer first accesses, downloads, possesses, opens, stores, enjoys, or receives the benefit of the service in this state. A buyer may not claim a multiple points of use exemption for personal use. Most auditors will look for a sensible approach that reflects a system of assigning sales to locations where the service is being “received.”
©2012 Sutherland Asbill & Brennan LLP 28 Specific State Treatment of Cloud Computing
©2012 Sutherland Asbill & Brennan LLP Nebraska Nebraska has little guidance with respect to cloud computing Tangible personal property includes prewritten computer software. Neb. Rev. Stat. Sec. 77-2701.39. Receipts from prewritten computer software are taxable “regardless of the manner in which it is conveyed.” 216 Neb. Admin. Code Sec. 1-088.01. Nebraska Information Guide No. 6-511-2011 (7/2011) Nebraska DOR has opined that cloud computing services were not taxable as a rental of tpp if vendor retains title to software and user gets no ownership rights True regardless of location of server
©2012 Sutherland Asbill & Brennan LLP Iowa Recently, the Iowa Department of Revenue issued a Policy Letter stating that hosted software isn’t taxable. The service provider sells software to physician practices. The software is located on servers outside of Iowa and accessed over the Internet. Software is not downloaded or transferred, and there is no transfer of title. The hosted software is not taxable because there is an exemption in the Iowa code for electronic transfer, and thus the service provider’s services fell under the exemption under Iowa Code Sec. 423.3(67). Iowa Policy Letter 12300002 (January 11, 2012).
©2012 Sutherland Asbill & Brennan LLP Kansas Kansas recently issued an Opinion Letter reaffirming its stance that cloud computing isn’t taxable. Kansas Opinion Letter No. O-2012-001 (February 6, 2012) The facts were the same as the facts of the Iowa service provider described above, likely the same taxpayer. Because the services are not enumerated as taxable services under Kansas statute, the services are not subject to sales tax. This is consistent with the Kansas Department of Revenue’s historical position. See Private Letter Ruling No. P-2009-005 (June 26, 2009); Information Guide EDU-71R, Revised Sales Tax Guidelines: Taxing Charges for Computer Products and Services and Internet Related Sales and Services (July 23, 2010)
©2012 Sutherland Asbill & Brennan LLP Illinois Illinois DOR recently explained the tax treatment of hosted software transactions ST 12-0002-GIL 1/06/2012 Facts Company provides Internet based hosted marketing services to clients to help evaluate and perform direct marketing Product developing and hosting performed in headquarter state Company grants only right to use software platform on its server Ruling No sales tax on software license if: Evidenced by signed agreement; Agreement restricts customer duplication; Agreement restricts sublicensing or transfers Online acceptance by clicking box not sufficient
©2012 Sutherland Asbill & Brennan LLP 33 Nexus
©2012 Sutherland Asbill & Brennan LLP 34 Nexus In order for state to force an out-of-state vendor to collect and remit sales tax, there must be a substantial nexus between the vendor and the state Quill “physical presence” rule Although many states and the SSTP have defined canned software as tangible personal property, does not necessarily mean that meet physical presence Most states’ law are not equipped to handle nexus issues related to remote access Texas – No nexus from Texas based Internet hosting services for customer (Tex. Tax Code 151.108)
©2012 Sutherland Asbill & Brennan LLP 35 A National Framework
©2012 Sutherland Asbill & Brennan LLP 36 The Solution – Federal Legislation Digital Goods and Services Tax Fairness Act of 2011 (HR 1860/S 971). A measure seeking to establish a national framework for the state and local taxation of digital goods and services (downloaded apps, cloud computing services, etc.).
©2012 Sutherland Asbill & Brennan LLP 37 Federal Legislation Why a national framework is needed States and localities, desperate for new revenue sources, are already eyeing this expanding part of the economy as a source of new tax revenues, without first ensuring that digital goods and services will not be subject to multiple and discriminatory levels of taxation. Failure to establish a national framework will invariably lead to costly and wasteful litigation. Congress has a clear role to act in tax matters impacting interstate and international commerce – digital commerce is sold over global networks crossing numerous state boundaries.
©2012 Sutherland Asbill & Brennan LLP 38 Federal Legislation What the measure does Ensures digital goods are taxed only once, precluding multiple states from claiming the right to tax same transaction or multiple taxation in the course of production. Ensures only generally applicable taxes can be imposed (i.e., general sales taxes) and that it must be done legislatively. Precludes discriminatory telecom/utility taxes from applying to digital commerce solely because these goods and services are riding over broadband/communication networks. Ensures that digital commerce is subject to same rules as comparable tangible goods. Provides certainty in how segments of the new economy can be taxed for state and local tax purposes.
©2012 Sutherland Asbill & Brennan LLP 39 Questions? Eric S. Tresh Phone: (404) 853-8579 Email: firstname.lastname@example.org@sutherland.com Jonathan A. Feldman Phone: (404) 853-8189 Email: email@example.com@sutherland.com
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