Finance

The Complexities of Taxing the Cloud

Cloud sales are expected to generate billions in revenue this year, but state and local governments are unsure whether they can (and how they would) tax them.
by | June 12, 2014
 

Some 50 years ago, states and localities missed the boat on keeping their sales taxes current. As the economy shifted from manufacturing to services, most governments failed to slap sales taxes on them. Now there's a new wrinkle confronting states and localities: The migration of commerce -- the sale of goods and services -- to the cloud.

The shift poses a number of challenges for tax departments. Namely, if software is provided virtually and hosted by a worldwide network, has real property changed hands and can states tax it? With software sales on the cloud expected to generate $17 billion in revenue worldwide this year, states and localities are in a hurry to sort out these kinds of questions.

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At a recent conference, Harley Duncan, managing director for state and local tax at KPMG and the former executive director of the Federation of Tax Administrators, laid out the issue for governments. His comments were edited for clarity and length.

Cloud commerce confuses sales tax laws.

Tax laws are lagging technological change and that is putting stress on state tax systems. Three changes in particular challenge the basic norms of the tax systems: the move to cloud computing, greater utilization of digital goods and remote retailing.

When sales and use taxes were designed in the 1930s and developed through the 1960s and 1970s, they were organized around the concept of whether there was a purchase of personal property. If so, you had a taxable transaction. In addition, you considered if something real was sold and what its state destination was. The services world is muddier. If it's a service, you consider where was the service performed and where its primary cost is -- that's where you would source it. With cloud computing, it changes the characterization of what you buy.

Can personal property exist in the cloud?

Now we are moving into the digital age. Instead of physically acquiring, taking delivery and installing an office package on your computer, you now interact with the same software in a hosted environment. It is not on your machine. You are not in control of it. You don't download it. It is hosted by someone else in a cloud environment. You get the same functionality as before, but you interact over the Internet. As a business, you pay for a service to provide the capacity you need.

What does that do to the sales tax question? Well, what do you have? What is it you are buying? What is the characterization? Where does it get sourced? Who gets to tax it? Think about cloud computing as compared to the acquisition of software or servers. The characterization question is, do you have software or a service? You didn't download anything, yet you have all the functionality. You didn't acquire a server, so is it tangible personal property which is taxable? If it's not -- if it's a service -- then it depends on individual state law where only enumerated services are taxable. A service a state could enumerate is to tax software as a service or data processing.

What is the retail side of Internet transactions?

Think of the migration of music over time. Some of us went from vinyl eight-track tapes that we played in our muscle cars, to cassette tapes, to CDs. Now, all of a sudden we're downloading or streaming. The same sales tax questions arise: I know what I have when I buy a vinyl record. I'll take delivery and there's a tax. What about streaming? Do I have a service? That's what a provider will tell you. But it's the functional equivalent of vinyl. Is it a product, service or something in between -- a digital good? Then there's the question of sourcing. If it's taxable, where? People use streaming walking down the street or in an international airport. How do you decide who gets to tax it when you're away from the tangible world of acquiring, owning and installing. It creates real issues.

As we migrate to the Internet world, we get lots of people coming up with different business models. One model says, "Rather than go to a dealer or retailer, I'm going to try to find a group of buyers that want to buy something. I'll put together a group of buyers and say, 'I can get you a great deal on a 42-inch TV. If you promise to pay $50 for it, I'll go to a manufacturer and deliver it.'" So who's the buyer? The middle person? Who's the seller? It turns taxes on their head. Another model says, "I will provide the infrastructure for buyers to interact with sellers." Who's the buyer? Who's the seller? My activities create a jurisdiction for someone else to sell to me or use me to help sell.

Our traditional sales tax models worked well from the 1930s to 1970s. They got tattered in the 1980s and 1990s and now they're struggling to accommodate new business models. The issue is, how can you best keep up with the change and accommodate that? It's a challenge for states and their departments of revenue.

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