Most professional services aren’t subject to state sales tax. But some states are now casting their nets to tax online services that use computing to deliver their otherwise nontaxable service. As a result, CFOs of online service businesses need to be wary that some states might say their services are taxable as a cloud-based or data processing service.
The rapid advance of technology is colliding with states’ need to replace tax revenues lost because of e-commerce sales. A new strategy is thus emerging whereby services that have never been subject to sales tax become taxable if they’re provided through a computing platform. Proponents of the strategy argue that the use of a computing platform is tantamount to buying taxable software or data processing tools. In doing so, state tax agencies are – ironically– using the advance of cloud technology to make up for lost sales tax revenue that have resulted from the rise of e-commerce.
This trend should concern companies that provide services through the cloud because these vendors would be primarily liable for the tax. But the CFOs of such companies should also be worried about their customers, who would be liable if their online service vendors don’t collect the tax from them. Finance chiefs should review such online service arrangements to find out if their companies might have exposure and, if so, what steps might be taken to limit the risk.
The issue is whether services provided through a cloud platform are subject to sales tax as a software sale, data processing service, or information service. Not all states impose their sales tax on cloud computing, data processing, or information services. But many do tax one or more of these services. Recent sales tax developments in New York and Texas illustrate the trend.
The New York Department of Taxation released an advisory opinion dated March 15, 2016 that said that monthly fees paid for a home-based medical monitoring system are subject to the state’s tax on cloud computing. The company provided a tablet-based medical monitoring service that takes certain daily metabolic readings –blood glucose level measurements, for example – and transmits them wirelessly to the company’s Web portal. The company then transmits the readings to the patient’s caregiver as a text message, alerting the caregiver if the readings are abnormal and require medical attention.
Although health-care services aren’t subject to sales tax in New York, the Department of Taxation and Finance ruled that the monthly fee paid by customers for access to the company’s Web portal constitutes the sale of software that’s accessed electronically. That’s New York’s way of saying that this is a cloud computing service subject to its sales tax. If a traditional home-health company sent a nurse to the home of the patient to administer the test, that clearly would not be taxable. But adding cloud-based technology to the business model transformed it into a taxable software service in the Department’s opinion.
Further, a recent Texas appellate case reveals the state’s aggressiveness in asserting its tax on data processing, even though the case resulted in a victory for the online service vendor. The case involved CheckFreeServices, a B2B that sold its bill-paying platform service to banks, enabling the bank’s customers to pay their bills online. The Texas comptroller claimed that CheckFree’s service was taxable under the state’s tax on data processing services because the customer inputs data (concerning which bills to pay), and the service processes this information in order to execute the payment instructions.
The court found that the essence of the transaction between CheckFree and the banks was to provide a non-taxable financial service, not a taxable data processing service – a victory for CheckFree. But there’s one major catch in the decision that could result in further enforcement efforts by Texas against other companies providing services through a computing platform.
The court made a major point of the fact that CheckFree employed over 3,000 employees to facilitate the bill-payment service at multiple stages of the process. These professionals were the “secret sauce” of CheckFree’s platform, thereby causing its service to be classified as a tax-free financial service, rather than a taxable data processing service. Consequently, Texas might look to other service companies that use a computing platform that do not employ large numbers of workers as part of their business model for another test case.
Many other types of service-oriented businesses that use a computing platform could find themselves subject to sales tax claims from the tax agencies of states that tax cloud computing, data processing, or information services. For example, in 2013, New Jersey announced that a service that generates sales leads for automobile dealers using a Web- based platform is a taxable information service, even though advertising services are not taxable.
The potential exposure is huge, since many service oriented businesses are now delivered on a computing platform. And the businesses that buy these services also need to be aware of this risk, because even if the service business does not collect sales tax, the tax agency could go after the businesses that utilize these service providers for use tax.
Companies that provide a service through a computing platform should review the position of the states where their customers are located to determine if there might be exposure. If there is exposure in a particular state, they might want to revise their agreements to limit exposure by clarifying that the object of the arrangement is to obtain the service provided – not to buy cloud computing or data processing services. They might also separately itemize the costs of various components of the contract, so that even if the state says that a portion of the services provided are subject to sales tax, the tax would only be due on the cloud-computing component.
Finally, the service company could limit its exposure by taking steps to ensure that it doesn’t have any presence in a state. That would enable the company to avoid nexus there, which the Supreme Court says must be present in order for a state to be able to compel a business to collect its sales tax.
Even if a business is based in a nontaxable state, it might be required to collect sales tax in another state where it sells its service if the company has an adequate presence to establish nexus. Many companies might have nexus without realizing it, either through sales reps who make visits to a state or through independent affiliates who refer business to them. So companies providing online services based in states that don’t otherwise tax cloud computing or data processing should review potential sales tax exposure in other states as a result of having nexus there.
Marvin Kirsner, a tax attorney and shareholder with Greenberg Traurig, focuses his practice on state and local tax issues that impact businesses. This article is presented for informational purposes only and it is not intended to be construed or used as general legal advice nor as a solicitation of any type.