Say you’re a state. For years, you’ve witnessed the rise of cloud computing services, which are being sold to citizens and businesses within your borders. Naturally, you’d begin to see these sales as an additional, untapped source of tax revenue. And so alongside the rise in cloud computing and other remotely rendered services come corresponding tax laws, which now require businesses to examine their potential sales tax exposure across states as well as the impact that exposure may have on their financials and margins.

In the past 15 years, many states have either enacted or amended statutes to bring computer programming within the definition of tangible goods, regardless of the form in which the program is delivered to a customer. Most states are now in the process of further broadening their definitions of goods and services to capture additional tax revenue related to cloud computing, software as a service (SaaS), and remote services.

This small, nonrepresentative sample of state laws highlights the varied approaches states are taking to address this issue:

• Connecticut taxes certain electronically delivered software as “computer and data processing services.”
• The District of Columbia taxes data processing, which is broadly defined to include two categories. The first is providing direct access to computer equipment to process, examine, or acquire information that is stored in or accessible to the computer equipment. The second is computer programming or software provided in conjunction with and to support the sale, lease, operation, or application of computer equipment or systems as well as any system or application programming or software.
• In New York, a taxable sale of prewritten computer software includes a license for its use. Therefore, a purchaser of remotely accessed software gains constructive possession of the software through the license to use or control it, which makes it taxable. 
• Texas has concluded that various cloud services are taxable as data processing. For example, businesses that provide remote SaaS or applications are considered data-processing service providers even if their customers don’t host a copy of the software on their computers. 
• Kentucky has determined that the sale of digital property and electronically delivered software is subject to sales and use tax, but it appears that cloud delivered software isn’t. There’s no guidance directly on this point.
• Ohio changed its laws effective January 1, 2014, to state that the sale of digital property is subject to sales and use tax. The taxation of electronically delivered software is factually dependent.

What Should You Do to Manage State Exposure?

This issue is best approached systematically. States are becoming more aggressive in their audits and are contacting companies more frequently than ever. Furthermore, if you’re considering a transaction now or in the future, the issue of your state tax exposure will come up—and it could impact your transaction. (See our March Alert for more on this topic.)

Technology companies should address this issue before they’re contacted by states and before working with a potential acquirer. To organize your efforts, it’s helpful to begin with a three-step approach: first, evaluate whether your business has a taxable presence in a particular state; second, determine the taxability of your service revenue; and third, assess whether there’s tax exposure and how you should go about managing the corresponding liability.

Step 1: Determine where you have taxable presence or nexus.

When an out-of-state business has sufficient connection with a state to cause a sales and use tax collection and remittance obligation, it’s called having nexus or taxable presence.

State taxing authorities have been broadening their definition of what’s considered nexus in their states by implementing the click-through and affiliate nexus standards. These new laws aim to impose sales-tax collection obligations on out-of-state companies whose only connection to the state is a virtual one.

Step 2: Look at what you’re selling.

States have widely varied definitions concerning cloud-based technologies and products. In the event a state hasn’t defined or classified your product, we suggest looking at the following characteristics to get a sense of how your offerings could and should be classified and what changes could sway the classification:

• The functionality. For example, does the software provide customers with a place to store data? Does it provide data for customers to research? Or does it enable customers to process transactions? Note that it may do more than one of these things.
• The nature and pricing. Are you granting customers a license to copy and use the software, or are your customers actually subscribers with limited rights to use of the software?
• The delivery method. Are your customers downloading the product? Do they log into a Web-based portal to access it? If so, where are they accessing the product? Is there an in-state intermediary, agent, or affiliate involved? If an electronic download is involved, the software may be classified as an intangible. However, if a security key, token, or other piece of hardware is delivered to your customer to allow the use of the software, the classification can change to a tangible item.

Though the tax implications of these three characteristics will vary from state to state, they’re often used as a baseline for determining whether an offering creates a sales tax liability.

Step 3: Look at financial impact to determine registration and reporting requirements.

By narrowing your attention to states where your business is considered to have taxable presence and where its service is taxed, you can determine where you have a sales and use tax compliance obligation. From there, you can better assess what your sales and use tax exposure is and decide how to best tackle the corresponding reporting issues, such as:

• Registering with a state
• Integrating sales tax rates into your current billing system
• Tracking the sales tax collected
• Generating sales tax reports
• Preparing sales tax returns and remitting collected sales taxes

We're Here to Help

Moss Adams LLP continuously reviews the regulatory and tax landscape for technology companies. For more information about any of the issues discussed above, or for insight on how they may impact your business, contact your Moss Adams professional.