Cloud Computing: Taxing the Cloud*
By Jonathan S. Marashlian and Allison D. Rule
*article originally published April 2013 in TechNet Magazine
There are myriad state and local tax implications surrounding cloud communications services.
Whether for cost savings or more efficient administration, businesses are increasingly turning to cloud computing to address their technology needs. Despite the increasing interest in cloud computing solutions, though, many people would be hard-pressed to come up with a single definition or description of cloud computing services.
Many aspects of cloud computing have rapidly become fixtures in the marketplace. One particularly prevalent aspect of cloud computing is the provision of communications services through a cloud-based platform. There are many taxation issues and consequences applicable to these types of cloud-based solutions. Of particular importance are the nexus implications of adding a cloud communications component to a Software as a Service (SaaS) or cloud computing environment.
Cloud taxation is happening now
In light of continuing economic stagnation, states and local governments are facing large budget shortfalls. Pressure is mounting for them to “plug the holes” in their budgets with new tax revenue. While state taxing statutes have traditionally failed to keep pace with technological developments, a number of states have their eyes on potential revenue that can be tapped by taxing cloud-based services.
Cloud-based providers need to recognize the paradigm is shifting—and they also need to be prepared. Simply put, in the not-so-distant future, a majority of states will attempt to extract tax revenue from cloud-based services. This will happen either through rulemakings involving the current statutory scheme or through legislation specifically targeting cloud-based services.
Cloud-based providers can’t hope to avoid taxation because of the notion that they lack a “physical” platform linked to a particular state. This is especially true for providers of cloud-based communications solutions. While the tax and nexus complications associated with cloud computing are being addressed in the market, there’s an information vacuum when it comes to tax and nexus implications for SaaS providers that also offer communications services.
In the context of taxation, the term “nexus” describes the amount of business activity a company must reach before a state can impose taxes on its income or revenue. Nexus determinations involve an intensely fact-driven inquiry. This process can often lead to potential tax liability uncertainties, as well as opportunities for revenue protection.
The fact-driven nature of nexus determinations means seemingly similar business models can create dramatically different tax obligations even within the same taxing jurisdiction. For this reason, businesses should be careful when choosing business and distribution models. They need to ensure their decisions maximize opportunities for revenue protection while ensuring sustainable and profitable business operations.
As compared to nexus determinations for income tax purposes, nexus determinations for sales and use taxes are more fluid. States have taken advantage of this to make rather aggressive nexus determinations in the context of sales and use taxes. As expressed in the Supreme Court’s decision in Quill v. North Dakota, nexus determinations consider both the Due Process and Commerce Clauses of the U.S. Constitution. Each clause presents two different and distinct requirements that must be met in order to establish nexus for taxation purposes.
Due Process requires that businesses have “minimum contacts” with a jurisdiction to establish nexus. The Commerce Clause requires a “substantial nexus” with the taxing jurisdiction in terms of a physical presence.
Within the Due Process nexus, a business’s physical presence in a state is all but assumed to establish minimum contacts. An out-of-state business can also establish minimal contacts with a state by purposefully availing itself of the state’s economic benefits, as in the case of Quill. In other words, if a business purposefully directs its commercial activity toward the citizens of a state, that establishes nexus.
The substantial nexus required by the Commerce Clause refers to a business’s physical presence within a state. This arises when a business engages in regular, continuous and substantial activity directed at a particular tax jurisdiction. Generally, a business is considered physically present in a state where it maintains offices, equipment, employees or independent contractors, and when it delivers products to states other than by common carrier or mail.
However, there’s no one-size-fits-all rule when it comes to determining physical presence. In the years since Quill, vendors and tax authorities alike have been struggling to determine how much and what kind of physical presence equates to substantial nexus. This is significant for cloud providers.
Under the traditional notion of physical presence, Web-based hosted software or SaaS providers will only have substantial nexus for sales and use tax with a state where they have a physical presence—not in states where their services are accessed by customers or end users. These providers will only have substantial nexus with those states where the provider has some physical presence like a datacenter or server.
For example, if your organization maintains servers in a datacenter in California, you may only be required to collect and remit sales and use tax for customers located in California. You would not have the same tax obligations to collect from customers who access your services from other states via Web connections.
Because of this lack of physical presence for remote cloud-based companies, states have sought to expand their definition of nexus through concepts like “affiliate nexus” and “economic nexus.” Neither of those definitions necessarily requires an element of physicality.
The result has been a flurry of affiliate or click-through nexus state laws, commonly referred to as the “Amazon laws.” Several states—including California, Colorado, Illinois and New York—have passed laws establishing nexus for out-of-state product or services providers who receive business referrals through links hosted from the Web sites of in-state residents. Colorado and Illinois courts have since overturned such laws, finding no substantial nexus, while New York courts have upheld the so-called Amazon laws.
Even with certain states rejecting the Amazon laws, not all out-of-state hosted software providers are in the clear from taxation by remote jurisdictions merely because their activity within a particular state lacks a traditional physical presence. For cloud providers whose customers purchase services solely over the Internet, the tax implications of adding hosted voice or Communications as a Service (CaaS) are potentially staggering.
In terms of state telecommunications taxes, there’s a substantial nexus between a communications services provider and a state where a call originates or terminates if the customer is charged for the call to a billing address within the respective state. Simply put, communications providers generally have nexus with states where their customers are located.
Under most state telecommunications excise tax and sales and use tax statutes, the definition of taxable telecommunications services is broad enough to cover a variety of services. This includes one-way and two-way communications facilitated by almost any technological means. Any provider of cloud-based CaaS, therefore, could be potentially subject to state telecommunications service taxes should the state consider its CaaS offering as taxable telecommunications. This is in addition to sales and use taxes.
While the standard for asserting jurisdiction over more traditional telecommunications providers has been extensively vetted and litigated in favor of the states’ position regarding non-physical nexus, the same has not happened with advanced and IP-based communications services. For traditional, wireline telecommunications services providers, state tax authorities generally establish nexus over out-of-state providers. The theory is that such providers must avail themselves of network infrastructure located within the taxing jurisdictions in order to originate and terminate telecommunications traffic. The providers either maintain facilities within the taxing jurisdiction or lease or resell such facilities.
For many IP-based providers, the services merely ride over an unaffiliated ISP’s Internet-access facilities. For this reason, there could be an argument that such providers aren’t availing themselves of infrastructure in the taxing jurisdiction in the same manner as a traditional provider.
This theory hasn’t been tested in the courts yet, and taking this approach is not without its risks. This approach could face the prospect of being rejected by state taxing authorities seeking to expand the assessable tax base. This would place the onus on the services provider to resolve the dispute through litigation, which has befallen at least one, well-known Voice over IP (VoIP) provider.
Furthermore, this approach is only defensible insofar as the CaaS provider has no other physical presence within the taxing jurisdiction. For example, provisioning equipment to customers as well as the CaaS service would likely create sufficient nexus for tax purposes, regardless of how the communications service is provided.
Providers should also keep in mind that any non-communications services offerings that may have otherwise escaped taxation due to nexus considerations—including lack of a physical presence—may face taxation by virtue of the existence of a CaaS offering and the nexus it creates. In other words, once nexus is established for one service offering, a state can then extend its reach to other service offerings, even if those services would be non-taxable by themselves.
The reality of the situation
Cloud computing providers must be absolutely aware of the extent of their tax exposure. When structuring their businesses, they should think carefully about potential tax exposure, as well as opportunities for revenue protection. The price of non-compliance can be steep.
Besides penalties and future tax remittance, companies can find themselves sold at a significantly diminished price to an acquiring entity because of hidden tax liabilities. Thus, the complexity of cloud communications taxation can have ramifications far beyond past and current fiscal years.
About the Authors
Jonathan Marashlian is the Managing Partner of Marashlian & Donahue, LLC, The CommLaw Group (www.CommLawGroup.com). Mr. Marashlian is the winner of multiple Lexology / International Law Office (“ILO”) Client Choice Awards, named overall winner in the Telecom Law-U.S. category. The CommLaw Group has been honored as the Leading Customer Service Law Firm of the Year and Best Communications Law Firm in the U.S. by ACQ Global Awards for three consecutive years. Allison D. Rule, co-chair of The CommLaw Group’s Communications Taxes & Fees and USAC Audits practice groups, co-authored this article. Mr. Marashlian may be reached at (703) 714-1313 or jsm@CommLawGroup.com.
Disclaimer: This article is intended for informational purposes only and is not for the purpose of providing legal advice. You should not act upon the information in this article without seeking professional counsel.