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How the Tax Man Followed Amazon and Apple to the Cloud Computing Party

This article is more than 10 years old.

Tax (Photo credit: 401K)

Dan Dixon is certain that state revenue authorities will soon start up more ambitious efforts to tax online commerce.

How does he know this? Well, for starters he is a state tax attorney at Reed Smith LLP and hears about back room deliberations in various state government offices. Then there this this, he says: his mother has recently become aware that Apple offers cloud services. She saw it on TV. “When companies like Apple start promoting the cloud to every day consumers on television, that tends to get the attention of state tax officials.”

In short, whether they have said so publicly or not, collecting sales and use taxes from cloud computing customers via their providers has become a topic of interest for state tax officials. Many states have been studying the issue for at least a year and  it won’t be long before they start to collect.

By the end of this year or the beginning of next, how when and under which circumstances the cloud should be taxed will be an open topic of debate in state tax circles, predicts Reed Smith state tax attorney, Kelley Miller - much like 2011 was all about how to force online retailers to collect sales tax from their customers.

“In July of last year only four states were looking at the cloud for tax issues,” Miller says. “Today we have another six states considering it. I wouldn’t be surprised if half of the states will have something moving in this area by the end of the year.”

When it does, it wil impact both providers of software-as-a-service -- the Salesforce.com’s of the world -- and their customers. If tax officials take a relatively benign approach it will just mean higher prices for customers and more complex billing procedures for vendors.

“Companies will either have to build in the sales taxes they must collect in their pricing, or reserve for it in accounting,” Dixon says. “Either way, that will mean higher prices.” It will also mean comparing prices on a per seat, per month basis will be that much harder for customers, especially if vendors are not completely transparent about what is included in their pricing.

Not a Plug and Play Calculation

Nor will this be a plug-and-play type of calculation. Each state will be different in its approach--certainly that is how it is shaping up at the moment--with some states deciding that the provision of access to data in the cloud is an information service and others viewing it as a storage service. “There is no consistency and thus no single answer for cloud providers,” Dixon says.

If tax officials are out for blood--or perhaps more appropriately, as much revenue as they can rake in--they will apply the “cloud activities are taxable” approach retroactively  with the usual slew of accompanying penalties and fines.

Miller has a client in this quandary now, she says. She is attempting to negotiate a settlement in which the client only pays such taxes going forward.

Watching it Unfold in Vermont

A similar push is underway in Vermont right now. The Burlington Free Press has been reporting on the fallout over a little-noticed 2010 technical bulletin issued by the Department of Taxes that says the state’s sales and use tax should be assessed on “prewritten software  that is licensed for use and available from a remote server,” aka cloud computing.

Recently, the department began citing this provision in state tax audits to the astonishment of local businesspeople. Seven Days, a Burlington newspaper, told of the plight of Inntopia, a Stowe-based software company that provides online reservation tools for the hospitality industry. The company got hit with a six-figure bill for four years of back taxes.

Indeed, it is not the IBMs and Oracles et al that will feel the brunt of this next wave of online sales and use tax initiatives, although given the amount of software they provide through the cloud, the back taxes alone will surely be horrifying.

It is the smaller companies--and SaaS is an industry that has spawned both large companies such as Salesforce.com and a healthy number of smaller, best of breed companies like Inntopia--that will have to negotiate with state tax authorities without the resources of blue label accounting and legal team.

“The large companies have been watching this unfold,” Miller says. “They are aware of what is happening. It’s the smaller and mid sized firms that will be blindsided.”

Local Politics

How this will play out remains to be seen, of course, and much will depend on local politics. In Colorado, for instance, a U.S. district judge just knocked down a reporting and notification provision for online retailers--a law that was loathed by local Republicans. This isn’t exactly the same issue but it is roughly the same neighborhood--briefly, the law would have required online retailers to notify their Colorado customers of what they purchased for the year and the sales tax that they now owe the state as a result. That information would also have been furnished to the state tax department--hence the law’s moniker in some circles as the stool pigeon requirement.

So far in Vermont local politicians seem to be siding with businesses’ argument that the general assembly never meant to assess taxes on cloud computing.

Battleground States

Another emerging battleground is Utah, which ruled in February that if a company downloads an applet or piece of software that allows it to access data remotely, the state is able to tax all of the value of the data. That is a truly scary law, Miller says, especially if other states replicate it.

Other states clearly taxing the cloud, she says, include Arizona, New York, Washington DC, Washington, South Carolina and Texas--which in fact is among the most advanced of states in this area, having set up a committee to look at specifically at the issue of e-commerce and cloud computing. It was one of the first states to decide they as taxable as information services.

That list will surely grow as more states understand the level of revenues that are at stake. “I expect it won’t take longer than a year for states to develop explicit authority for themselves to apply sales and use tax to SaaS,” says Peter Stathopoulos, a CPA and attorney at Bennett Thrasher. It‘s not a foregone conclusion that state tax authorities will get their way, of course. “There are some thorny issues that need to be decided and the business community can be counted on for push back,” he says. Comforting words but then consider Amazon which pushed back hard on the online sales tax issue. It is now negotiating with states not if it should collect such taxes but when.