The Struggle to Tax the Cloud

As the economy shifts from one that relies on goods to one that relies on services, states are finding it hard to capture revenue from constantly evolving technologies like cloud computing.
by | June 2015

Two years ago, Massachusetts took a bold step. The legislature passed a bill to tax the cloud. But they didn’t stop there. Lawmakers also levied taxes on other tech activities. While the cloud may be where the fastest growth is taking place, technology overall is an increasingly large part of a state’s economy. Massachusetts didn’t want to lose out on a chance to include it in its revenue base. Legislative analysts projected that the taxes would bring in $160 million a year.

But just two months after passing the “tech tax,” as it had become known, Massachusetts repealed it. Opposition from the state’s business forces rained down pressure on lawmakers. The new law, they claimed, was putting them out of business. “It got very bruising,” says Andrew Bagley, research and public affairs director of the antitax Massachusetts Taxpayers Foundation.

Meanwhile, the Department of Revenue struggled to provide guidance to business owners on whether the service they were providing was subject to the tax. Amy Pitter, director of the department at the time, admits the complexities and confusion surrounding the law were a burden. So the legislature voted to repeal it and then-Gov. Deval Patrick, who had proposed the law in the first place, signed its retraction.

Massachusetts is not alone in trying to expand its sales tax to include tech services. Like many states, the commonwealth was already taxing some parts of the technology sector. But unlike most states, Massachusetts tried to capture a larger and growing part of that sector’s economic activity. The law’s resounding failure illustrates the many difficulties states have faced in recent years when it comes to taxing technology and computer services.

Part of the problem harks back to a general issue that has been bedeviling sales-tax states for more than half a century: As the economy has shifted from one that primarily produced goods (which are taxable at point of sale) to one that provides services, states have struggled to find a way to add services to their sales tax base. The other challenge is more specific to the technology industry: Its products and services are so complex, changing so rapidly and constantly overlapping each other, that it is hard to get a handle on what it is that should be taxed. The recent emergence of cloud computing -- computer services that consumers and businesses use and pay for but don’t necessarily own -- adds an extra layer of difficulty.

What has resulted from the attempts by Massachusetts and other states to harness the high-tech service economy is a hodgepodge of approaches that lack consistency and are frustrating for both the states that write the bills and the businesses affected by those laws.

But states must do something to keep up with the goods-to-services change in the economy. Indiana University’s John Mikesell has calculated that, between 1970 and 2010, the mean state sales tax base narrowed from 55 percent of personal income to 37 percent. While the sales tax remains an important revenue stream for states that levy the tax -- it accounts for about one-third of revenues on average -- states are capturing a smaller and smaller piece of the commerce pie.

Nearly 30 years ago, Florida infamously tried to add services to its tax base, passing an expanded sales tax on services including advertising, legal, accounting and construction. The backlash was immediate -- major corporations like Coca-Cola and Procter & Gamble revoked or reduced their advertising in the state to protest the tax, while business groups canceled at least 60 conventions there. The tax lasted just six months before it was repealed. A similar Massachusetts law in 1990 extended its then 5 percent sales tax to nearly 600 additional services, but that lasted less than a year before it was repealed.

A number of states over the years have added a service tax here and there -- on things like dry cleaning, landscaping and pet grooming. But the bigger, more powerful service providers have, for the most part, managed to convince their legislators that their services should not be taxed.

In the 1980s and 1990s, the emergence of the technology sector began to blur the line between goods and services even further. Software, for example, performed a service for the consumer but was, at that time, purchased as a product in stores. State taxation departments concluded that the sale of prewritten software programs that reside on a tangible storage medium, like a CD-ROM, should be considered taxable. Today, every jurisdiction imposing a sales tax subjects the sale of prewritten software to taxation. But when it comes to software in other forms, state approaches are far less uniform. A little more than half of the states now tax software that is downloaded onto a computer. A handful of states tax all writing or updating of software.

The big problem now is with cloud computing, where services and software are stored on a server that could be anywhere in the country. According to industry reports, total sales of cloud software in the U.S. were between $20 billion and $22 billion in 2012, but states have been able to capture little of the commerce. That’s largely due to the fact that the technology industry does not fit neatly into traditional state tax categories. Because businesses can access applications without installing software on each employee’s computer, companies can run their entire IT operation without an actual transfer of tangible personal property.

Some state taxation departments try to fit cloud computing into one of their existing tax components. But that has had mixed results. Texas, for example, issued a ruling in 2012 that concluded cloud computing products were taxable because they qualified as a data processing service. (Texas is one of a handful of states that taxes data processing.) But when Michigan started taxing remotely accessed software because it was being used within the state, a court in 2014 overturned that decision. The court held that software accessed remotely was neither tangible personal property nor “used” by the taxpayer as defined under Michigan statutes. Further, any prewritten computer software provided to the customer was only an incidental component of the various services purchased and did not subject the charges to tax. Pennsylvania similarly began taxing remotely accessed software; so far, the tax hasn’t been challenged.

The piecemeal approach is frustrating. Tech businesses don’t like the murkiness of the rulings. Many, for example, criticized Pennsylvania’s tax as being a contradiction to the department’s prior rulings on software. Nor do they like wading through a web of different rules for every state.

Taxation departments are equally perturbed. They are constantly being asked to clarify the state’s tax stance on any number of issues for a sector that is ever-changing. “The safer way to go about it is to have a statute,” says Gale Garriott, the Federation of Tax Administrators’ executive director. “Then you have a legislature dealing with it specifically, addressing the pros and cons, and you hold hearings. So when it’s signed into law, it is a very clear authority to tax.”

That’s what Massachusetts had hoped to do with its broad tax on technology services. But the law’s swift failure wasn’t just caused by the political pressure from the industry. The effort lacked organization from the start. The tech tax was initially included in the budget proposal without consulting the tax department. When news of it broke and businesses began making a fuss, legislators consulted the Department of Revenue and others and rewrote it to make it less cumbersome. Or so they thought.

“By the time the legislature was through with it, it didn’t really resemble any of the changes we’d discussed,” says Pitter, former director of the department. As passed, the law extended the commonwealth’s 6.25 percent sales tax to software services. But in practice, implementing the tax on an industry that was constantly evolving was confusing. Take, for example, third-party website design. Websites created with entirely original coding were not taxable, according to the law. But what if a designer turns around and sells that software to five other businesses? The department dealt with hundreds of questions along these lines.

As Pitter and her staff were churning out guidance for businesses on how to apply the new tax, the tech industry awoke from its slumber. This was, according to Bagley of the Massachusetts Taxpayers Foundation, an unexpected “rifle shot” from state lawmakers. “Much of the industry is made up of entrepreneurs,” he says, “and they just don’t pay attention regularly to Beacon Hill.”

In 2007, the Maryland tech industry had gotten a similar jolt when the General Assembly passed a computer services tax during a special session held to fix the budget deficit. Much as in Massachusetts, the approach to the tax was almost haphazard. In what would be a precursor to Massachusetts’ fate, lawmakers in 2008 repealed the Maryland tax before it could be implemented. “We never thought the term ‘computer services’ was well-defined in the first place,” says Brian Levine, lobbyist for the Tech Council of Maryland. “Confusion is one of the biggest detriments to things like this -- what are you taxing, who’s in, who’s out. It’s extremely confusing.”

Those who oppose these kinds of taxes also say they are unfair because they target one service or sector. For some, the solution is to expand the services tax as a whole in the state. But those efforts have failed just as spectacularly.

With the mobility of tech companies, particularly in East Coast states, there is talk of finding a solution at the federal level. But given the lack of political will in Congress to grant states the authority to collect taxes on Internet sales, action in greater matters seems unlikely for now.

That leaves states to operate in ever-murkier waters. Given the experience in Massachusetts and Maryland, and the long aftermath of Florida’s 1987 attempt to tax services, the prospect of more decisive legislation looks unlikely in the near future. But as cloud services continue to grow, states either have to keep trying or forgo millions in revenue.