Tax Management. Tax Base

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Reproduced with permission from Tax Management Weekly State Tax Report, Volume: 20 Issue: 43, 10/25/2013. Copyright姝 2013 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

Ta x B a s e

In providing cloud computing, Application Service Providers use their own hardware, op- erating systems and software to provide services that customers can access over the inter- net. Typically referred to as Software as a Service (SaaS), these transactions have been treated as taxable by many state revenue departments, based on the customer obtaining constructive possession of prewritten software, deemed to be tangible personal property. In this final installment, authors Arthur Rosen, Leah Robinson and Hayes Holderness, of McDermott Will & Emery LLP continue to highlight the inconsistencies posed by this tax- ing model but note also the different approach taken by New Jersey and Idaho.

Cloud Computing: Revenue Departments’ Cloudy Minds Lead to Inappropriate Assessments—Part 3

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hether a sale of cloud computing services is subject to sales and use tax has been hotly disputed.

With prewritten software now defined as tangible personal property in most states, this article ar- gues that the taxability of cloud computing services should be determined by the degree of control a purchaser has over the software and whether it is sufficient to constitute possession as intended by the relevant sales and use tax statutes.

As discussed in Parts I and II of this series, many state tax departments have taken the position that sales

of cloud computing services amount to taxable licenses to use the service provider’s software. The New York State Department of Taxation and Finance (‘‘New York Department’’) is one of these state tax departments.¹ However, as will be discussed, the New York Depart- ment has exposed the inherent flaws of this approach when it attempts to source the ‘‘licenses to use’’ it deems taxable at the location where the customer receives the benefit of the license. Without taking this approach, the New York Department would not be able to subject a number of these ‘‘licenses to use’’ to tax, but this sourcing approach is the approach for taxable ser- vices, not taxable tangible personal property.

Despite the approaches of many state tax departments that are inconsistent with their underlying state statutes, not all news in this area is bad news. There have been positive developments in a number of states, including New Jersey and Idaho, both of which will be examined prior to concluding the article.

1See, e.g., N.Y. Dept. of Taxn. and Fin., TSB-A-11(17)S (June 1, 2011); TSB-A-10(44)S (Sept. 22, 2010); TSB-A-10(2)S (Jan. 20, 2010); TSB-A-09(19)S (May 21, 2009).

Arthur R. Rosen and Leah Robinson are part- ners in the law firm of McDermott Will &

Emery LLP, with practices focusing on tax planning and litigation relating to state and local tax matters for corporations, partner- ships and individuals. Hayes R. Holderness is an associate with the firm, practicing in state and local taxation.

Weekly State Tax Report ^™

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I. Sourcing

Though this article is concerned primarily with the interpretations of various state tax authorities regard- ing the taxability of cloud computing transactions under their state sales tax statutes, a quick observation on the sourcing of these transactions in New York sheds light on the inherent incorrectness of the tax authorities’ positions.

The New York Department’s approach to sourcing is, at best, schizophrenic. On the one hand, the New York Department takes the position that a customer is

‘‘using’’ software that actually resides on and is used only by the Application Service Provider’s (the ASP’s) server—which very well may be located outside of New York; but on the other hand, the New York Department takes the position that the software is being used by the customer at the customer’s location in New York. This sourcing approach is internally inconsistent and ex- poses the fundamental flaw in New York’s position with respect to the taxability of cloud computing transactions.

According to the New York Department:

The location of the code embodying the software is irrelevant, because the software can be used just as effectively by the customer, even though the customer never receives the code on a tangible medium or by download. The accessing of [an ASP’s] software by [its customer] constitutes a transfer of possession of the software, because [the customer] gains constructive possession of the software and gains the ‘‘right to use, or control or direct the use of’’ the software. Therefore, [the ASP] should collect tax from [its customer] where the software is being used.²

If, as the New York Department contends, the customer has constructive possession of software residing on an ASP’s server, then the software, taxed as tangible personal property, is located at the same place as the server. The New York Department asserts, however, that the software (i.e., the tangible personal property) is transferred at the location from which the customer re- motely accesses the software. The New York Depart- ment seems to be taking the position that the correct

‘‘sourcing’’ for the transaction is where the benefit is re- ceived. However, that is a concept applicable to sales of services, not sales of tangible personal property.

So where does one remotely use tangible personal property? Consider the example of a U.S. military drone flying in Afghanistan. A drone is remotely controlled tangible personal property, just as the New York De- partment claims an ASP’s software is. Suppose the drone is operated from the military base in Rome, N.Y.

while the drone is in Afghanistan. Where is the drone being used? The New York Department’s position would lead to the conclusion that the drone is being used in New York because that is where the operator is located. This conclusion makes no sense—the drone is being used in Afghanistan.

With respect to cloud computing, the New York De- partment seems to be focusing on where the benefit of the use of the remotely controlled tangible personal

property (i.e., the underlying software) is enjoyed. This test applies to certain taxable services, but has never been used for the sale or license of tangible personal property. The New York Department’s approach to sourcing reveals the precise reality that the New York Department is trying to ignore—that an ASP provides a service.

Thus, if the New York Department continues to insist that ASPs are in the business of licensing prewritten software, and also was forced to use a consistent approach to sourcing, then the New York Department seems to be inadvertently laying the groundwork for unsound tax policy. If the use of software to deliver a service is deemed a taxable sale of tangible personal property, then savvy taxpayers can simply defeat the tax by moving their servers outside of New York because, as noted, the location of the server is at all times the location of the software, and sales of tangible personal property are sourced to the location of the transfer.³ As the software is always at the location of the ASP’s servers, any transfer of possession must be at that location.

If the New York Department were to abandon its schizophrenic approach to sourcing, its position that ASPs sell tangible personal property would have little effect. There is no question that absolutely no physical software is delivered to ASP customers in the normal ASP scenario (the New York Department concedes this point) and so, if an ASP’s servers are located outside of New York, none of the software would be ‘‘used’’ by the customer in New York. Thus, no sales tax would be due from ASPs whose servers are outside of New York.

Only by disregarding that reality and conflating tangible personal property sourcing with services sourcing does the New York Department actually raise a mean- ingful amount of revenue from its new position.

In other words, if it is appropriate to treat a customer’s use of an ASP’s software as a license to use, then the New York Department, if it wishes to be intellectu- ally consistent, needs to concede that the software is being used on the ASP’s server and that the receipts from the sale should be sourced to wherever the server is located (even if outside of New York).

II. Positive Developments New Jersey and Idaho

This article has offered criticism of the approaches used by a number of state revenue departments in their taxation of cloud computing services. However, the recent approaches of New Jersey and Idaho deserve positive attention – not because the states have determined that cloud computing services are not taxable, but rather due to their thoughtful and legally consistent approaches towards these determinations.

The New Jersey Division of Taxation (‘‘New Jersey Division’’), joining the revenue departments of states such as Iowa,⁴ Kansas,⁵ Missouri,⁶ Tennessee,⁷ Vir-

2N.Y. Dept. of Taxn. and Fin., TSB-A-10(28)S (July 2, 2010).

3N.Y. Comp. R. & Regs. tit. 20, § 525.2(a)(3).

4Iowa Dept. of Rev., Policy Letter No. 12300002 (Jan. 11, 2012).

5Kansas Dept. of Rev., Opinion Letter No. O-2012-001 (Feb.

6, 2012).

6Mo. Dept. of Rev., Letter Ruling No. LR 6991 (Jan. 27, 2012).

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ginia⁸and Wisconsin,⁹has applied thoughtful analysis to conclude that obtaining a service from the ‘‘cloud’’

does not involve the transfer of tangible personal property and therefore is not subject to sales tax.¹⁰This conclusion is consistent with a thorough analysis of New Jersey’s laws.

In addition, Idaho has recently passed legislation specifically providing that cloud computing services are generally not subject to sales tax.¹¹

a. New Jersey

i. New Jersey Technical Bulletin No. TAM 4-2103. The New Jersey Division’s new guidance provides that SaaS (and PaaS) is not subject to sales and use tax in New Jersey because it is not the sale of tangible personal property or an enumerated service.¹²The New Jersey Division correctly observes that ‘‘SaaS providers do not transfer software to their customers. Rather, SaaS providers only allow customers to access software through remote means. . . . SaaS providers fully retain and oper- ate the software applications to which they sell access. . . . SaaS customers do not receive title or take possession of the software. The SaaS provider uses the software it owns or licenses to provide the service and does not transfer the software to its customers.’’ These observations lead to the New Jersey Division’s conclusion that ‘‘[b]ecause SaaS only provides the customer with access to the software and the software is not ‘delivered electronically,’ it is not the sale of tangible personal property.’’

ii. Use and Control.New Jersey imposes sales tax on sales of tangible personal property and defines ‘‘sale’’

as ‘‘any transfer of title or possession or both, exchange or barter, rental, lease or license to use or consume, conditional or otherwise, in any manner or by any

means whatsoever for a consideration . . . .’’¹³‘‘Posses- sion’’ is not defined in the sales tax statute, accompany- ing regulations or case law.

The New Jersey courts, however, have addressed the type of power or control over property necessary to constitute a taxable ‘‘use’’ under the complementary use tax. The seminal case addressing this power or con- trol is Hoffman-LaRoche Inc. v. New Jersey Taxn. Div.

Dir..¹⁴There the New Jersey Tax Court held a New Jer- sey pharmaceutical company exercised a right or power over advertising and promotional materials which it had purchased out-of-state and had delivered to inde- pendent contractors (direct mailing houses) in New Jer- sey. The court relied on the taxpayer’s right of approval over distribution of the materials by the direct mailing houses to find the requisite control over the materials.

In Quest Diagnostics Inc. v. New Jersey Div. of Taxn.,¹⁵the taxpayer operated a laboratory in which it performed testing of human blood and other body flu- ids. Once a physician agreed to use the taxpayer’s services, the taxpayer would provide the physician a sup- ply of vacutainers free of charge for collecting the samples to be tested. The New Jersey Tax Court, rely- ing on Hoffman-LaRoche, determined that the taxpay- er’s ‘‘exercise of power and control over the vacutainers in selecting the physicians to whom they were sent and determining the quantities sent and time and the method of delivery’’ created a taxable use. As developed in Hoffman-LaRoche and Quest Diagnostics, the key to the type of ‘‘power and control’’ over property that must be transferred in order to create a taxable sale is the ability of the transferee to determine the use of the property, to the exclusion of others.

The role of the customers in the provision of remote access services by an ASP is similar to the role of phy- sicians in Quest Diagnostics. The ASP controls who is able to access its services and how they are delivered—it has the exclusive ability to determine the use of the underlying software. The ASP’s customer has no exclusive right over the use of the ASP’s software and it cannot control when, where or how the software is run and housed. The software is used by the ASP it- self to provide the ASP’s services. Thus, insufficient control—and, therefore, insufficient possession, has been transferred to subject the transaction to tax, as the New Jersey Division correctly recognizes.

iii. New Jersey’s Departure From the New York Approach.

The New Jersey Division’s position is particularly inter- esting in light of the fact that New Jersey sales tax law is based upon the New York sales tax law (the New York Department has taken the opposite position, see above).¹⁶ New Jersey courts consistently look to New York authority for guidance in the application of New

7Tenn. Dept. of Rev., Revenue Rulings Nos. 13-03 (Jan. 14, 2013) and 11-22 (June 10, 2011).

8Va. Dept. of Taxn., Ruling of the Commissioner No. 12- 191 (Nov. 29, 2012).

9Wis. Dept. of Rev., FAQs - Sales and Use Tax Treatment Computer Hardware, Software, Services (Aug. 15, 2013).

10N.J. Div. of Taxn., Technical Bulletin No. TAM 4-2013 (July 3, 2013).

11Idaho House Bill No. 243 (signed April 4, 2013). Minne- sota has also recently changed its law defining ‘‘transferred electronically.’’ Minnesota House Bill 677, signed May 23, 2013, amended Minnesota Statutes 2012, § 297A.61 by adding subdivision 56, which provides that ‘‘[a] product will be con- sidered to have been transferred electronically to a purchaser if the purchaser has access to the product.’’ The governor of Minnesota has made clear his desire to submit remote access services to taxation, see Minn. Governor’s Budget 2012-2013, State Taxes and Local Aids and Credits, p. 29, and the amend- ment found in Minnesota House Bill 677 may be used to achieve that end.

12However, as the New Jersey Division notes, where the true object of the sale is the providing of information services, sales tax is applicable. N.J. Rev. Stat. § 54:32B-3(b)(12). There- fore, transactions for cloud computing services which meet the definition of information services are subject to sales tax. ‘‘In- formation services’’ means ‘‘the furnishing of information of any kind, which has been collected, compiled, or analyzed by the seller, and provided through any means or method, other than personal or individual information which is not incorpo- rated into reports furnished to other people.’’ Id., § 54:32B- 2(yy).

13N.J. Rev. Stat. § 54:32B-2(f).

14Hoffman-LaRoche Inc. v. New Jersey Taxn. Div. Dir., 5 N.J. Tax 154 (N.J. Tax Ct. 1983), modified, 192 N.J. Super. 552 (N.J. Super. Ct., App. Div. 1983).

15Quest Diagnostics Inc. v. New Jersey Div. of Taxn., 21 N.J. Tax 484 (N.J. Tax Ct. 2004), aff’d, 387 N.J. Super. 104 (N.J. Super., App. Div. 2006).

16See, e.g., L & L Oil Service Inc. v. New Jersey Dir., Div. of Taxn., 773 A.2d 1220 (N.J. Super., App. Div. 2001); Urso &

Brown Inc. v. New Jersey Dir., Div. of Taxn., 19 N.J. Tax 246 (N.J. Tax Ct. 2001).

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Jersey’s sales and use taxes.¹⁷The New York Tax Law imposes tax on ‘‘[a]ny transfer of title or possession or both’’ of tangible personal property.¹⁸Under the New York sales tax regulations, a taxable transfer of possession occurs when ‘‘one of the following attributes of ownership has been transferred: (i) custody or possession of the tangible personal property, actual or constructive; (ii) the right to custody or possession of the tangible personal property; [or] (iii) the right to use or control or direct the use of tangible personal property.’’¹⁹

As discussed, the New York Department has taken the position that ASP sales of remote access services are taxable licenses to remotely use prewritten software. However, the New York Department’s advisory opinions noticeably do not address whether the ASP actually transfers to its customers the right to ‘‘use or control or direct the use of,’’ the ASP’s software. Rather, the opinions appear to assume that a customer’s use of an ASP’s services is the same thing as the customer using the ASP’s software, thus creating constructive possession of and sufficient control over the software for the transaction to be a taxable license to use prewritten software. However, as perhaps the New Jersey Division has realized, the relevant—and substantial—New York legal authority does not support the New York Depart- ment’s assumptions.²⁰ The New York Department should reconsider and follow the New Jersey Division’s approach to the taxability of remote access services under its similar sales and use tax laws.

b. Idaho

The main purpose behind this article has been to point out that many revenue departments have, through administrative rulings, overstepped their authority by disregarding the relevant statutory authority in their states in order to subject cloud computing transactions to sales taxes. The decision of whether cloud computing transactions should be taxable is for state legislatures to make, not tax administrators.²¹

Through recent legislation, Idaho joins Washington in statutorily addressing the taxability of remote access services. Idaho House Bill No. 243 amends the definition of tangible personal property under Idaho Code

§ 63-3616(b) to provide that ‘‘[t]he term . . . includes any computer software that is not a custom computer pro- gram and is not application software accessed over the internet or through wireless media.’’

The bill further provides that the term ‘‘application software accessed over the internet or through wireless media’’ means:

the right to use computer software where the software is accessed over the internet or through wireless media from a location owned or main- tained by the seller or an agent of the seller and is not loaded and left at the user’s location. The term does not include such remotely accessed computer software if the primary purpose of such computer software is for entertainment use, or if the vendor of that computer software offers for sale, in a storage media or by an electronic download, to the user’s computer or server, and either directly or through wholesale or retail channels, that same computer software or comparable computer software that performs the same functions.

Therefore, remotely accessed services are exempt from sales tax in Idaho unless they fall within particular taxable buckets (i.e., the services are for entertainment use or the software behind the services is available in storage media form or by an electronic download). The provision may leave some questions to be addressed, but Idaho has taken the important first step of addressing remote access services through this valuable legislation.

III. Conclusion

Earlier installments of this series have examined the troubling approach of a number of state revenue departments towards the classification of cloud computing for sales and use tax purposes. These revenue departments (and one state appellate court) have cava- lierly disregarded the relevant legal authorities in their attempts to subject cloud computing to sales tax using the guise that there has been a transfer of taxable tangible personal property rather than a provision of non- taxable services. However, as seen by the New Jersey example, not all state revenue departments take this approach.

This article passes no judgment on whether cloud computing transactions should—as a policy matter—be taxable or not; that is precisely the point: Those types of normative judgments are for state legislatures to make, as has been done in Washington and Idaho.²² The tax authorities in other states should not recast the transactions between ASPs and their customers in order to fit those transactions into the definition of a taxable transaction merely because they believe such transactions should be taxable. When they do, tax authorities overstep their bounds. State taxing authorities must consider the actual type of possession, use, or control of ASP software the customers receive before concluding the transaction is taxable. Merely asserting, without support or explanation, that the customers are granted sufficient possession, use, or control is not a sufficiently principled basis for the result. Simply rely- ing on the use of labels in contract language between ASP and customer, such as use of the term license, also will not suffice.

17E.g., Urso & Brown Inc. v. New Jersey Dir., Div. of Taxn., 19 N.J. Tax 246 (N.J. Tax Ct. 2001); Meadowlands Basketball Assocs. v. New Jersey Dir., Div. of Taxn., 19 N.J. Tax 85 (N.J.

Tax Ct. 2000); Cooperstein v. New Jersey Div. of Taxn., 13 N.J.

Tax 68 (N.J. Tax Ct. 1993).

18N.Y. Tax Law § 1105(a); N.Y. Tax Law § 1101(b)(5).

19N.Y. Comp. Codes R. & Regs. tit. 20 § 526.7(e)(4).

20See id.

21Arthur R. Rosen and Mark W. Eidman, ‘‘Non-Legislated Tax Legislation,’’ State Tax Notes, Jan. 24, 2011, p. 301, Doc.

2010-27224, or 2011 STT 15-3.

22Arthur R. Rosen and Mark W. Eidman, ‘‘Non-Legislated Tax Legislation,’’ State Tax Notes, Jan. 24, 2011, p. 301, Doc.