Cloud Computing: The Answer Is Still No

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Cloud Computing:

The Answer Is Still ‘No’

by Arthur R. Rosen, Leah Robinson, and Hayes R. Holderness

This article serves as a follow-up to a prior article that analyzed the laws of Arizona, Colorado, Indi- ana, New York, Pennsylvania, and Utah on the taxation of cloud computing services.¹ In that article, we demonstrated why the various state departments of revenue — and one state court — have incorrectly treated online services as taxable licenses of tangible personal property. That treatment does not withstand statutory scrutiny, primarily because users never ‘‘possess’’ the underlying software. This article extends the analysis of that prior article to two additional states.

The state revenue departments of Massachusetts and Michigan have determined that obtaining a service from the cloud is obtaining constructive possession of pre-written (or canned) software that resides on the service provider’s server and is used there by the service provider itself. Since pre- written software is considered tangible personal property (through statutes or case law), the central question is whether the purchaser of such a service really has the degree of control over the software so as to constitute possession as intended by the relevant sales and use tax statute. Massachusetts’s and Michigan’s state revenue departments have taken the position that the purchasers do obtain the control necessary to constitute possession. However, the laws of each state simply do not support that position, as this article demonstrates, and thus,

receipts from the provision of services from the cloud should not now be taxable in either state.

As explained in our prior article, it is now com- mon for application service providers (ASPs) to provide services through computer networks. Those services are often referred to as ‘‘software as a service’’ (SaaS). Generally speaking, SaaS involves an ASP’s use of its own hardware infrastructure and its own software (usually proprietary) to provide some service to customers that access the ASP’s front-end portal (a Web page) using the customers’

own computer hardware and software. In most cases, an ASP’s customers have absolutely no ability to access, alter, copy, or delete the software used by the ASP. Typically, an ASP’s customers merely re- quest that the ASP use the ASP’s own software to perform a service for the customer.

Although Massachusetts and Michigan do not have identical sales and use tax statutes, they share a similar basic goal — to tax receipts from transfers of

possession or ownership of tangible personal property.

With that limited operational framework in mind, we now turn to the positions of Massachusetts and Michigan. Although Massachusetts and Michigan do not have identical sales and use tax statutes, they share a similar basic goal — to tax receipts from transfers of possession or ownership of tangible personal property.

Massachusetts Use and Control

In a series of recent letter rulings, the Massachu- setts Department of Revenue has taken the position that receipts from the provision of SaaS by ASPs are

1Arthur R. Rosen, Leah Robinson, and Hayes R. Holder- ness, ‘‘Cloud Computing: The Answer Is ‘No,’’’ State Tax Notes, Oct. 8, 2012, p. 101, Doc 2012-18232, or 2012 STT 195-1.

Arthur R. Rosen and Leah Robinson are partners at McDermott Will & Emery LLP, New York. Hayes R.

Holderness is an associate at the firm’s New York office.

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receipts from taxable licenses to use the underlying software.²In fairness to the Massachusetts department, it has applied a ‘‘real object of the transaction’’

test to determine the ultimate taxability of receipts from the provision of SaaS by ASPs, discussed below.

Nonetheless, the Massachusetts department’s position that taxable licenses to use the underlying software are created when a customer subscribes to an ASP’s services is unsustainable in the face of Massachusetts law.

Massachusetts imposes sales tax on sales of tangible personal property and defines sale to include

‘‘any transfer of title or possession, or both, ex- change, barter, lease, rental, conditional or other- wise, of tangible personal property.’’³ Possession is not defined in either the sales tax statute or accom- panying regulations.

The Massachusetts courts, however, have addressed the meaning of the term ‘‘possession’’ and have determined that control over property is necessary to generate a taxable sale or lease of that property.⁴The Massachusetts Appellate Tax Board, in New York Times Co. v. Comm’r of Rev.,⁵ offered one of the more complete analyses of the type of possession necessary to effectuate a taxable sale when it addressed whether a lease of an airplane was taxable:

Possession shall be deemed to have passed to the [transferee] whenever the property is under his control or direction whether or not an operator is furnished by the [transferor]. The Board’s decisions distinguishing sales or leases of property from sales of transportation services have likewise focused on control of the subject property in the circumstances of the particular case to determine whether there is a transfer of possession. Accordingly, control over property, as a matter of fact, will determine

whether a transfer of possession took place so as to constitute a ‘‘sale.’’⁶

Having determined that control over the property is necessary to create a taxable transfer of possession, the board then analyzed the many aspects of control particular to that case. In determining that the taxpayer had not leased the airplane, but rather had purchased services from the other party, the board focused on the exclusivity of the use of the airplane for the taxpayer only, the taxpayer’s sole ability to control when and where the airplane was used, and the taxpayer’s sole ability to control where the airplane was based to determine that the taxpayer had not relinquished control of the airplane.

The board also suggested that the responsibility for the safe maintenance and operation of the airplane was an indicator of control.

A customer of an ASP is simply not granted the control necessary to effectuate a taxable transfer of possession. The ASP’s customer has no exclusive right over the use of the ASP’s software.

In TRM Copy Centers (USA) Corp. v. Comm’r of Rev.,⁷the Massachusetts board considered whether a taxable lease of copiers had occurred or whether the taxpayer was merely providing nontaxable copying services. After first defining possession as ‘‘having control over a thing with the intent to have and to exercise such control,’’ the board determined that the transaction was not pursuant to a taxable lease because the taxpayer had not transferred possession of its copying equipment to its customer (even though the equipment was located at the customer’s facility and the customer did have custody). In so determining, the board noted that the customer did not have ‘‘the right to use [the] property for its own purposes, separate and distinct from the purposes of the would-be lessor.’’ Of critical importance was that the customer could not use the copying equipment for any purpose outside those approved by the taxpayer without incurring additional costs. Also, the customer could do nothing to physically move the copying equipment or to customize the appearance of the equipment.⁸

2Massachusetts Letter Ruling 12-13 (Nov. 9, 2012); Mas- sachusetts Letter Ruling 12-11 (Sept. 25, 2012); Massachu- setts Letter Ruling 12-10 (Sept. 25, 2012); Massachusetts Letter Ruling 12-8 (July 16, 2012); Massachusetts Letter Ruling 12-5 (May 7, 2012). Mass. Regs. Code 64H.1.3(3)(a) also provides that ‘‘taxable transfers of prewritten software include sales effected in any of the following ways regardless of the method of delivery, including electronic delivery or load and leave: licenses and leases, transfers of rights to use software installed on a remote server, upgrades, and license upgrades.’’

3Mass. Gen. L. ch. 64H section 1.

4See, e.g., Browning-Ferris Industries, Inc. v. State Tax Comm’n, 376 N.E.2d 568 (May 24, 1978); New York Times Co.

v. Comm’r of Rev., No. F214442 (Mass. Tax. App. Bd. July 8, 1997), aff’d 693 N.E.2d 682 (Mass. 1998); TRM Copy Centers (USA) Corp. v. Comm’r of Rev., Nos. F246124, F251053 (Mass.

Tax. App. Bd. Feb. 1, 2001); Lawrence-Lynch Corp. v. Comm’r of Rev., No. 195193 (Mass. Tax. App. Bd. Sept. 30 1997).

5New York Times Co. v. Comm’r of Rev.

6Id. (internal citations omitted).

7TRM Copy Centers (USA) Corp. v. Comm’r of Rev.

8For a similar ruling by the Federal Court of Claims, see Xerox Corp. v. United States, 656 F.2d 659 (Cl. Ct. 1981). In Xerox, the court first noted that ‘‘the following factors relative to the possessory interest retained by the taxpayer in the property were deemed relevant by IRS to a determination that a service arrangement existed: (1) retention of property (Footnote continued on next page.)

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The provision of remote access services by an ASP is strikingly similar to both of the services in New York Times and TRM Copy Centers. A customer of an ASP is simply not granted the control necessary to effectuate a taxable transfer of possession. The ASP’s customer has no exclusive right over the use of the ASP’s software, it cannot control when and where the software is run and housed, it does not bear responsibility for the maintenance and operation of the software, and — of critical importance — it has no right to cause the software to be used outside the purposes for which the ASP uses the software. The software is used by the ASP itself to provide the ASP’s services. Therefore, insufficient control — and thus possession — is transferred and the Massachusetts department’s treatment of the provision of remote access services as taxable licenses to use the underlying software is not correct.

Real Object Test

The Massachusetts tax law requires the use of a real object test to determine the taxability of a transaction that might include both nontaxable services and taxable property.⁹Under that test, a transaction is not subject to sales tax when:

(1) The real object of the transaction is the service itself, and no transfer of tangible personal property occurs; or (2) [t]he real object of the transaction is the service itself, and an inconsequential transfer of tangible personal property occurs, and the service enterprise does not separately state the purchase price of the property on the bill to the customer.¹⁰

As mentioned, the Massachusetts department is applying that test to transactions for the provision of ASPs’ services and has even determined that some of those transactions are not taxable because the real object of a transaction was to acquire nontaxable services rather than taxable pre-written software.¹¹The success of a real object of the transaction argument will depend on the facts and circumstances of a transaction, but it seems likely that many ASPs should be able to demonstrate that they provide services, not the underlying software. Still, ASPs should also include the ‘‘use and control’’

arguments above when dealing with the Massachu- setts department on this matter.

Working Draft Directive 13-XX

On February 7 the Massachusetts department released a working draft of a directive intended to provide guidance to taxpayers regarding the application of the Massachusetts sales tax to remote access services.¹² The draft directive provides in- sight into the ‘‘criteria the Commissioner considers when determining whether a transaction [is] a taxable sale or other transfer of the right to use pre- written software or, instead, involves a product that is a non-taxable personal or professional service’’

and explains that ‘‘no one factor is determinative of taxability.’’

Noticeably lacking from the criteria provided in the draft directive is the concept of control as required by Massachusetts law (and as discussed above). Indeed, the Massachusetts department simply follows its prior approach for determining whether the provision of remote access services constitutes a license to use the underlying software.

For example, a transaction may be considered a taxable transfer of pre-written software if ‘‘the seller refers to itself as an Application Service Provider (ASP) or its product as Software as a Service (SaaS) or in a similar manner’’ or ‘‘the seller provides access to software, including operating system software or application software, even if no software is transferred to the customer.’’ Under Massachusetts law, however, those should not be criteria used to determine whether a transaction is a taxable transfer of pre-written software, as neither provides any indi- cation of a transfer of control necessary to create a taxable transfer.

Furthermore, the Massachusetts department’s criteria for finding that a transaction actually is for the performance of a nontaxable service also sub- stantially fail to focus on whether there is a transfer ownership by the taxpayer; (2) retention of possession and

control of the property by the taxpayer; (3) retention of risk of loss by the taxpayer; [and] (4) reservation of the right to remove the property, and replace it with comparable prop- erty.’’ Id. at 674 (internal citations omitted). The court then determined that Xerox was providing copying services rather than entering into leases of copiers in part because ‘‘the rental agreements contained provisions which insured that the customer would be able to obtain the desired copies. Plaintiff was required to keep the machines in good working order and make necessary inspections, adjustments, repairs and re- placement of machines and machine parts without charge to the customer. . . . Plaintiff’s like-for-like exchanges indicate that machines were viewed as interchangeable, with the emphasis on insuring that the customer had the use of a working machine rather than on keeping the machine as- signed to a customer in working order.’’ Id. at 677.

9See Houghton Mifflin Co. v. State Tax Comm’n, 370 N.E.2d 441 (Mass. 1977) (‘‘The test is the object of the transaction. If the buyer’s fundamental object is to obtain the item of personal property transferred to it, the sale of that property cannot reasonably be considered ‘inconsequential’

and the transaction cannot reasonably be considered one for personal service.’’); Mass. Regs. Code 64H.1.1(2)(a).

10Mass. Regs. Code 64H.1.1(2)(a). In general, ‘‘inconsequential’’ means a value of less than 10 percent of the total charge. Mass. Regs. Code 64H.1.1(1).

11See Massachusetts Letter Ruling 12-5 (May 7, 2012).

12Massachusetts Department of Revenue, Working Draft Directive 13-XX: Criteria for Determining Whether a Trans- action Is a Taxable Sale of Pre-Written Software or a Non- Taxable Service (Feb. 7, 2013).

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of control of the underlying software. Only one criterion listed comes close to recognizing the effect of a lack of a transfer of control: ‘‘the customer does not interface with the pre-written software either on its own or on seller’s or third-party servers or enter information that will be further manipulated by the software.’’ That criterion, although accurate, does not go far enough by again failing to recognize the type of control necessary to effectuate a taxable transfer of pre-written software.

As released on February 7, the draft directive simply does not reflect the transfer of control required by Massachusetts law to effectuate a taxable transfer to render the provision of remote access services subject to sales tax.

Michigan Use and Control

The Michigan Department of Treasury has begun taking the position that transactions for the provision of SaaS by ASPs create taxable licenses to use the underlying software.¹³ However, a mere two years before taking that position the Michigan department determined that receipts from transactions for SaaS were not taxable because they en- tailed the provision of services.¹⁴Interestingly, there was no relevant change of law between the time those two conflicting positions were taken. As we will discuss, the Michigan department’s first position — that receipts from transactions for SaaS are not taxable — is the correct position under Michigan law.

Michigan imposes sales and use tax on the pro- ceeds of transfers of ownership of tangible personal property.¹⁵The lease or rental of tangible personal property is included in the definition of transactions subject to tax,¹⁶ and ‘‘lease or rental’’ means ‘‘any transfer of possession or control of tangible personal property for a fixed or indeterminate term for con- sideration.’’¹⁷

The Court of Appeals of Michigan has on numer- ous occasions considered the amount of control necessary to effectuate a taxable use under the Michi- gan use tax.¹⁸In WPGP1, Inc. v. Dep’t of Treasury, the Court of Appeals considered the many indicators

of control over an airplane that the taxpayer leased to a third party. In concluding that the taxpayer did not engage in a taxable use of the airplane in Michigan because it had ceded control of the airplane to the third party, the court focused on the fact that the third party completely controlled the flight schedules and the routine maintenance of the air- planes and that the third party was responsible for ensuring that the aircraft remained duly registered with the Federal Aviation Administration.¹⁹ Fur- thermore, in Bailey v. Muskegon County Bd. of Comm’rs, the court, considering whether a taxable use of motel beds had occurred, said that ‘‘under no stretch of the imagination, or the language, can the use of a bed in a motel be defined as a transfer of ownership in a tangible property.’’ Therefore, Michi- gan law requires more than simple tangential uses of property for a taxable sale or use to have occurred.

Instead, control incident to ownership rights in the property must be transferred to create a taxable transaction. Indeed, the Michigan use tax statute defines the type of use necessary to create a taxable transaction to mean ‘‘the exercise of a right or power over tangible personal property incident to the ownership of that property including transfer of the property in a transaction where possession is given.’’²⁰

As an illustration of what are considered ownership rights under Michigan law, consider the Michi- gan Tax Tribunal’s discussion in Kelly Properties, Inc. and Kelly Services, Inc. v. Michigan Dep’t of Treasury,²¹ involving the transfer of the ability to use certain intangible properties held by the taxpayer:

The Tribunal is unconvinced by [the] argument that [the taxpayer] transferred possession of the ‘‘property.’’ [The taxpayer] retains ownership of the trademarks and trade names at all times. Regardless of how many times Kelly Services was allowed to use those trademarks and trade names, Kelly Services did not control the use of the trademarks or trade names beyond so as to impact in any way the property rights of [the taxpayer]. [The taxpayer] remained the owner of that property and could further allow the use or not, at its discretion.

[The taxpayer] gave up no property rights by allowing Kelly Services to use the trademarks and trade names. And further, if Kelly Services was allowed to sublicense the trademarks and

13Michigan Department of Treasury, Technical Services Division, Letter Ruling (Apr. 20, 2009) (on file with authors).

14Michigan Department of Treasury, Technical Services Division, Letter Ruling (Jan. 31, 2007) (on file with authors).

15Mich. Comp. Laws Ann. section 205.52(1).

16Mich. Comp. Laws Ann. section 205.51(1)(b); Mich.

Comp. Laws Ann. section 205.93(1).

17Mich. Comp. Laws Ann. section 205.51a(l); Mich. Comp.

Laws Ann. section 205.92b(l).

18See, e.g., NACG Leasing f/k/a Celtic Leasing, LLC v.

Dep’t of Treasury, Dkt. No. 306773 (Mich. Ct. App. Oct. 16, 2012); WPGP1, Inc. v. Dep’t of Treasury, 612 N.W.2d 432

(Mich. Ct. App. 2000); Bailey v. Muskegon County Bd. of Comm’rs, 333 N.W.2d 144 (Mich. Ct. App. 1983).

19See also NACG Leasing f/k/a Celtic Leasing, LLC v.

Dep’t of Treasury (involving a similar finding on similar facts).

20Mich. Comp. Laws Ann. section 205.92(b).

21Kelly Properties, Inc. and Kelly Services, Inc. v. Michigan Dep’t of Treasury, Dkt. Nos. 319360 and 319361 (Mich. Tax Trib. Aug. 26, 2010).

(Footnote continued in next column.)

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trade names, [the taxpayer] still retained full ownership rights to that property.²²

Clearly, ownership rights concern the ability to control the use of the property — to exclude others and to determine how others may use the property.

The provision of SaaS simply does not involve the transfer of ownership necessary to effectuate a taxable transaction under the Michigan sales and use taxes. The customer does not have any sort of exclusive rights over the underlying software, cannot alter or manipulate the software in any way, and has no responsibility for the maintenance or other burdens associated with the software. Furthermore, the ASP retains those rights and controls how the software is accessed during the provision of its services. Even if it could be said that the customer exercises control over the software by accessing it remotely, that control is not the type of control the Michigan authorities have considered relevant when determining whether a taxable transaction has occurred. Therefore, the Michigan department’s position that receipts from the provision of SaaS are taxable under the Michigan use tax is fatally flawed.

Incidental to Service Test

The Michigan Supreme Court has adopted an

‘‘incidental to service’’ test for determining whether sales or use tax applies to a particular transaction that might include both nontaxable services and taxable tangible personal property.²³ According to the court:

Under this test, ‘‘sales tax will not apply to transactions where the rendering of a service is the object of the transaction, even though tangible personal property is exchanged inciden- tally.’’ The ‘‘incidental to service’’ test looks objectively at the entire transaction to determine whether the transaction is principally a transfer of tangible personal property or a provision of a service.

* * *

In determining whether the transfer of tangible property was incidental to the rendering of personal or professional services, a court should examine what the buyer sought as the object of the transaction, what the seller or service provider is in the business of doing, whether the goods were provided as a retail enterprise with a profit-making motive, whether the tangible goods were available for sale without the service, the extent to which intangible services have contributed to the

value of the physical item that is transferred, and any other factors relevant to the particular transaction.²⁴

In most transactions for SaaS, the customer seeks out a service, not software. Furthermore, ASPs are in the business of providing services, not selling or licensing software. ASPs and their customers would both likely be surprised to learn that they had contracted for the sale of software as opposed to the provision of the ASPs’ services. Indeed, the underlying software used to provide an ASP’s services is generally unavailable to consumers without the service, and the value of that software would be minis- cule without the ASP’s services offered alongside it.

Thus, under Michigan’s incidental to service test, it is clear that even if it could be said that software were transferred along with the services, any such transfer of software would be merely incidental to the services, not causing the overall transaction to be taxable.

Conclusion

We have now examined the troubling approaches taken by the taxing authorities of Arizona, Colorado, Indiana, Massachusetts, Michigan, New York, Penn- sylvania, and Utah toward the classification of cloud computing for sales and use tax purposes. Those taxing authorities, through administrative rulings, have disregarded the relevant legal authorities in their states and are inappropriately subjecting cloud computing transactions to their sales taxes under the guise that the transactions are the transfers of taxable tangible personal property rather than the provision of nontaxable services.

This article passes no judgment on whether cloud computing transactions should, as a policy matter, be taxable, and that is the point of the article. Those types of judgments are for state legislatures to make, not tax administrators or us.²⁵ When state legislatures have not expressed an intent to tax ASP services, state taxing authorities should not ignore the facts of the transactions in order to fit them into the definition of other taxable transactions merely because the taxing authorities believe that those transactions should, as a policy matter, be taxable.

When those tax authorities do so, they have over- stepped their bounds. Taxpayers affected by those rulings should challenge them as invalid exercises of administrative power, and state courts should cancel assessments based on the approaches reflected in

those rulings. ✰

22Id.

23Catalina Marketing Sales Corp. v. Dep’t of Treasury, 678 N.W.2d 619 (Mich. 2004).

24Id. (internal citations omitted).

25See Mark W. Eidman and Arthur R. Rosen, ‘‘Non- Legislated Tax Legislation,’’ State Tax Notes, Jan. 24, 2011, p.

301, Doc 2010-27224, or 2011 STT 15-3.