Cloud Computing Taxes Up in the Air in States

A dozen states are debating whether they should and how they could tax cloud computing services.

Buying something is different from renting it. That distinction is at the heart of the debate in a dozen states about how -- or whether -- to tax cloud computing services.

In the old days (say, back in the 1990s) individuals or companies wanting to use software went to a store and bought a disk. That changed with the advent of downloadable software, but states ruled that downloads were still taxable purchases. The software may not have been sold as a physical item, but its code was still a tangible product consumers were taking possession of.

Nowadays, a lot of software is never controlled by the consumer. Instead, it’s accessed remotely, via the Web and distant servers (an arrangement now commonly called the cloud). The software that allows people at separate computers to meet in real time, for instance, isn’t downloaded. Instead, businesses may pay a monthly fee to access the meeting software. “What you’re doing is accessing the software as a service,” says Kelley Miller, a state tax expert with the law firm Reed Smith.

Some state officials have ruled that these different ways of using software all amount to basically the same thing, and therefore are subject to tax. “Our statute says anything that would have been taxable in tangible form is taxable in electronic form,” says Scott Smith of the Utah State Tax Commission.

Tax departments in several other states have taken a similar position over the past couple of years, ruling that many cloud-based services are akin to software sales. Needless to say, not everyone agrees. The line between services and sales is already blurry along Main Street; things get even trickier when you move to the cloud.

Some tax advisers argue that most of what happens in the cloud is purely a service and therefore not subject to sales tax in most jurisdictions. “Historically, only material which you take physical possession of is appropriate for taxation,” says Vermont state Sen. Vincent Illuzzi. “It’s only when you obtain a product, not just use a product that you never have control of.” Vermont legislators put a moratorium on taxing the cloud this year, pending further study. Meanwhile, the Streamlined Sales Tax Governing Board has been trying to define which cloud-based activities are sales and which ones are services. Given the amount of flux and the disagreements between legislators and tax departments, companies often don’t even know what their tax rate should be. “It’s impossible for a person like myself to give proper advice to companies about how to tax their service,” says Joel Waterfield of the accounting firm Grant Thornton.

Caroline Cournoyer is GOVERNING's senior web editor.