Is tax revenue lost in the cloud?
August 29, 2011
State sales tax systems created to generate revenue from face-to-face exchanges of tangible goods are struggling to keep up with the rapid shift of business transactions into the so-called cloud of the Internet.
As more companies use cloud-based servers and software, which are remote networks of computing resources often shared by multiple customers, the 20th-century rules of taxation no longer apply. Instead, accountants, lawyers, state tax officials and companies such as Google Inc., Apple Inc. and NetSuite Inc. are working to develop new guidelines for taxing the use of these emerging technologies…
"The thing that is being called cloud computing, while we’ve been doing pieces of it for some years, is now looking to be a new business model in a large way, and it affects every tax type you’ve got," said Verenda Smith, director of administration and policy at the Federation of Tax Administrators, a Washington group that represents state revenue departments.
The tussles over taxation of cloud computing extend beyond the familiar e-commerce dispute about whether states can require out-of-state companies to collect taxes on sales to in-state consumers. Tax authorities and companies are debating whether companies that sell software and data accessed through the cloud are peddling a taxable good or a nontaxable service.
Companies including International Business Machines Corp., Amazon.com Inc., and Google are trying to capitalize on a global market for cloud computing that is expected to increase to $241 billion in 2020 from $40.7 billion this year, according to Forrester Research Inc., which analyzes trends in technology.
Doubling Cloud Revenue
Mark Loughridge, the chief financial officer of IBM, said in an earnings conference call in July that the company is on track to double its revenue from cloud services for the year compared with 2010, and forecasts $7 billion in revenue from these services by 2015.
In the absence of clear rules on taxing cloud computing, dozens of skirmishes between businesses and governments over individual transactions are taking place across the country. The precedents set may help shape states’ ability to maintain their tax bases.
Technology companies, backed by lawmakers including Sen. Ron Wyden , D-Ore., and House Judiciary Committee Chairman Lamar Smith, R-Texas, are backing federal legislation that would regulate and limit states’ taxing authority of digital goods and services. Amazon, Apple , Time Warner Cable Inc., and Verizon Communications Inc. are part of the Download Fairness Coalition formed to lobby on the issue, which encompasses state taxation of downloaded music and movies.
"It is an enormous burden on businesses trying to figure this all out," said Jim McGeever, chief operating officer of NetSuite, a cloud-based financial management service provider with its headquarters in San Mateo, California.
McGeever said when his company considers potential acquisitions of smaller companies it will have to spend between $500,000 and $1.5 million to clean up the other companies’ sales- tax disputes.
"Just the third-party consulting costs and advisers, costs of filing all the back returns and negotiating with each agency, it’s a very substantial process that can take a year and a half," he said. "So it’s expensive in terms of time, it’s expensive in terms of money, it’s just a very difficult part of the process."
Smith, of the state tax group, said the proposed federal law wouldn’t mesh well with states’ different taxation systems and would lock in rules that wouldn’t be easy to change without going back to Congress.
Borders Disappear
States rely on reaping revenue from economic activity within their borders. As those borders disappear online, state officials worry that they won’t be able to collect taxes.
For example, states have long taxed off-the-shelf software purchases, and they often see purchasing cloud-based services as analogous to shopping at an office-supply store, said Kendall Houghton, an attorney at Alston & Bird LLP in Washington. Companies may challenge that analysis and contend that the shift of software out of a physical location transformed what was once a tangible item into a service.
"The departments of revenue have pretty old definitions of tax base items for sales tax purposes," she said. "What we see is a tendency to try and shoehorn cloud computing services and products into existing definitions, so that you can say yea or nay on the taxability."
The changing nature of business transactions creates confusing situations for state tax administrators.
For example, a New York-based company may purchase server space and cloud-based software from a Texas-based company.
That’s relatively straightforward, except that the Texas company may have servers in North Carolina and California, while the New York company may have satellite offices in Illinois, Florida and Kentucky that use the server space.
Furthermore, some of the New York company’s employees may be able to gain access to the same data and programs from their smart phones while they’re traveling out of their home state.
In some cases, the property transfer that typically signals a taxable event doesn’t occur, said Todd Harke, senior manager of state and local tax at the accounting firm CBIZ MHM LLC.
"If you’ve taxed software when it’s been transferred from a seller to a buyer, now you may not have that transaction anymore," he said.
The new transactions are fundamentally different from conventional purchases, said Reid Okimoto, a senior manager at KPMG LLP.
It’s akin to the difference, he said, between renting a bus and paying for a ride on one.
So far, most states haven’t rewritten sales tax laws to address these concerns or issued regulations, Houghton said.
"It’s not just a new thing out there," Smith said. "It’s looking to have the potential to be a game-changer in the way all companies do several pieces of their business. There’s just a lot at stake."