Seeking new revenues, states are starting to consider taxation of cloud-based services. For example, Washington enacted a statute which specifically taxes Software as a Service (SaaS) providers. Other states have issued letter rulings addressing specific fact scenarios. Missouri ruled that SaaS 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 to a state’s sales and use tax regime.

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.

But, in 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 state. Other states now impose tax on certain services provided within their state. Still others have adapted their statutes to now tax downloads of digital products or web-based software. Cloud computing is a further evolution that will stretch traditional state tax principles.

Impact on Cloud Service Providers and Users of Cloud Services

One of the biggest challenges the industry will face is how to define what providers and buyers of those services are actually buying or selling. SaaS models apply to distinct user groups, but all are predicated on borderless global networks. Will 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 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 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 create income tax nexus for the user of cloud-based services. This could mean that a business that licensed, for example, SaaS products in another state, unwittingly expanded its income tax footprint, subjecting it to filing income tax returns in that state.

Service providers should act now to anticipate upcoming tax issues for their particular business model. Since states are adopting taxation laws with very different philosophies, and the laws evolve continually, your strategy will need to be revised frequently. Due to the nuances of how the laws are evolving, your entire corporate strategy may evolve.

States will continue to find ways to tax cloud-based services. Businesses, both providers and users of cloud-based services, need to understand this evolution. For help navigating the rapidly evolving cloud services taxation issues, please contact Brendan Lund, Esq. at: (650) 342-9600 or blund@carr-mcclellan.com.