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TAXING THE CLOUD
11 Jan, 2013
State and Local Tax Issues and Implications of Cloud Communications Services on Cloud Computing Jonathan S. Marashlian, Allison D. Rule The media buzz surrounding cloud computing and industry talk regarding the boundless benefits cloud-based solutions offer companies of all sizes has been unavoidable in recent months. Whether for cost savings or the reduction of administrative burdens, businesses are increasingly turning to cloud computing to address their technology needs. Many facets of cloud computing have rapidly become fixtures in the marketplace. For instance, Software as a Service (“SaaS”), which allows for remote online access to software, has become especially popular. Despite the increasing interest in cloud computing solutions, many people would be hard pressed to come up with a single definition or description of what a cloud computing service is. At its core, the “cloud” refers to the Internet. The “computing” aspect of the phrase is what opens up the concept to a virtually unlimited scope of services and solutions. In this article, we focus on one particular aspect of cloud computing (although quite broad in and of itself) – the provision of communications services through a cloud-based platform. But, many of the taxation issues and consequences addressed herein are applicable to other cloud-based solutions. Of particular importance, as explained in this article, are the nexus implications of adding a cloud communications component to a SaaS or cloud computing offering. What Every Provider of Cloud-Based Solutions Should Know: The Future of Cloud Taxation is Happening Now In light of the continuing economic stagnation, states and local governments are facing large budge shortfalls, and pressure is mounting for them to “plug the holes” in their budgets with new tax revenue. While state taxing statutes have traditionally failed to keep pace with technological developments, a number of states have their eyes on potential revenue that can be tapped by taxing cloud-based services. Cloud-based providers need to not only recognize that the paradigm is shifting; they need to prepare for it. Put simply, in the not so distant future, a majority of states will attempt to extract tax revenue from cloud-based services, either through rulemakings involving the current statutory scheme or through the implementation of legislation specifically targeting cloud-based services. Similarly, cloud-based providers cannot hope to avoid taxation on the notion that they lack a “physical” platform that can be linked to a particular state. This is especially true for providers of cloud-based communications solutions. While there have been a number of articles written that address the tax and nexus complications associated with cloud computing, there is an information vacuum when it comes to tax and nexus implications for SaaS providers that also offer communications services. In this article, we attempt to fill that void by identifying unique nexus issues affecting providers of cloud-based communications and associated managed software solutions. General Nexus Considerations In the context of taxation, the term “nexus” describes the amount or degree of business activity that must be reached before a state can impose taxes on a business’s income or revenue. Nexus determinations involve an intensely fact-driven inquiry, which can lead to uncertainties as to potential tax liability, as well as opportunities for revenue protection. In particular, the fact-driven nature of nexus determinations means that seemingly similar business models can create dramatically different tax obligations even within the same taxing jurisdiction. For this reason, businesses should be careful when choosing business and distribution models to ensure that the ultimate decisions maximize opportunities for revenue protection while ensuring sustainable and profitable business operations. As compared to nexus determinations for income tax purposes, nexus determinations for sales and use taxes are more fluid, and states have taken advantage of this to make rather aggressive nexus determinations in the context of sales and use taxes. As expressed in the Supreme Court’s decision in Quill v. North Dakota, nexus determinations involve consideration of both the Due Process and Commerce Clauses of the U.S. Constitution, and each clause presents two different and distinct requirements that must be met in order to establish nexus for taxation purposes. Due process requires that businesses have “minimum contacts” with a jurisdiction to establish nexus, while the Commerce Clause requires a “substantial nexus” with the taxing jurisdiction in terms of a physical presence. Pursuant to Due Process nexus, a business’s physical presence in a state is all but assumed to establish minimum contacts. In addition, pursuant to Quill, an out-of-state business can also establish minimal contacts with a state by purposefully availing itself of the economic benefits of that state. In other words, if a business purposefully directs its commercial activity towards citizens of a state, nexus can be established. The substantial nexus required by the Commerce Clause refers to a business’s physical presence in a state and arises when a business engages in regular, continuous, and substantial activity directed at a particular taxing jurisdiction. Generally, a business is physically present in a state where it maintains offices, equipment, employees, or independent contractors and when it delivers products to states other than by common carrier or mail. However, there is no one-size-fits-all rule when it comes to determining physical presence. And, in the years since Quill, vendors and tax authorities alike have been struggling to determine how much and what kind of physical presence equates to substantial nexus. Impact of Traditional and Expanded Notions of Physical Presence on Cloud-Based Providers Under the traditional notion of physical presence, Web-based hosted software or SaaS providers will only have substantial nexus for sales and use tax with a state where it has a physical presence – not where its services are accessed by customers or end-users. Such providers will only have substantial nexus with those states where the provider has some physical presence in the form of a data center or server. For example, a provider with a server or data center in California could only be required to collect and remit sales and use tax for customers located in California but would not have the same tax obligations to collect from customers who access its services from Florida, presumably over the Internet. Because of this lack of physical presence for remote cloud-based companies, states have sought to expand their definition of nexus through use of concepts such as “affiliate nexus” and “economic nexus,” neither of which necessarily requires an element of physicality. The result has been a flurry of affiliate or click-thru nexus state laws, commonly referred to as “Amazon laws.” States including California, Colorado, Illinois, and New York passed laws establishing nexus for out-of-state sellers who have business referrals through links hosted from the web sites of in-state residents. Colorado and Illinois courts have since overturned such laws finding no substantial nexus, while New York courts have upheld that state’s Amazon law. Nexus Implications of Cloud-Based Communications Service Offerings Even with the rejection of “Amazon laws” by certain states, not all out-of-state hosted software providers are in the clear from taxation in remote jurisdiction merely because their activity within a particular state lacks a traditional physical presence. For cloud providers whose customers purchase services solely over the Internet, the tax implications of adding hosted voice or Communications as a Service (“CaaS”) as a feature are potentially staggering. In terms of state telecommunications taxes, substantial nexus exists between a communications service provider and a state where a call originates or terminates if the customer is charged for the call to a billing address within the respective state. Simply put, communications providers generally have nexus with states where their customers are located. Further, under most state telecommunications excise tax and sales and use tax statutes, the definition of taxable telecommunications services is broad enough to cover a variety of services, including one-way and two-way communications that are facilitated by almost any technological means. Any provider of cloud-based CaaS, therefore, can be potentially subject to state telecommunications service taxes in addition to sales and use taxes should its CaaS offering be considered taxable telecommunications by the state. However, while the standard for asserting jurisdiction over more traditional telecommunications providers has been extensively vetted and litigated in favor of the states’ position regarding non-physical nexus, the same cannot be said with regard to advanced and IP-based communications services. For providers of traditional, wireline telecommunications services, state tax authorities generally establish nexus over out-of-state providers under the theory that such providers must avail themselves of network infrastructure located in the taxing jurisdictions in order to originate and terminate telecommunications traffic, i.e., the providers either maintain facilities in the taxing jurisdiction or lease/resell such facilities. The same cannot be said for many IP-based providers, whose services merely ride over an unaffiliated Internet Service Provider’s Internet access facilities. For this reason, an argument can be made that such providers are not availing themselves of infrastructure in the taxing jurisdiction in the same manner that a traditional provider does. But, this theory has not been tested in the courts, and taking this approach is not without risks. In particular, this approach would face the prospect of being rejected by state taxing authorities seeking to expand the assessable tax base, thus placing the onus on the service provider to resolve the dispute through litigation (which is the scenario that has befallen at least one, well-known over-the-top VoIP provider). Moreover, this approach is only defensible insofar as the CaaS provider has no other physical presence in the taxing jurisdiction. For example, the provisioning of equipment to customers in addition to the CaaS service would likely create sufficient nexus for tax purposes regardless of how the communications service is provided. Providers should also keep in mind that non-communications service offerings that may have otherwise escaped taxation due to nexus considerations, including lack of a physical presence, may face taxation by virtue of the existence of a CaaS offering and the nexus created there from. In other words, once nexus is established for one service offering, a state can then extend its reach to other service offerings, even if those services would be non-taxable if sold in isolation. The Reality of the Situation Cloud computing providers must absolutely be aware of the extent of their tax exposure and should think carefully about potential tax exposure, as well as opportunities for revenue protection, when structuring their businesses. The price of non-compliance can be steep. In addition to penalties and future tax remittance, companies can find themselves sold at significantly diminished price to an acquiring entity because of hidden tax liabilities. Thus, the complexity of cloud communications taxation can have ramifications far beyond past and current fiscal years. Jonathan S. Marashlian is the Managing Partner at Marashlian & Donahue, LLC , a Washington, D.C.-area law firm specializing in telecom and technology matters, with concentrations in cloud computing and state and local taxation. Allison D. Rule, co-chair of the firm’s Communications Taxes and Fees Practice, assisted in the preparation of this article. Jonathan can be reached at email@example.com . Disclaimer: This article is intended for informational purposes only and is not for the purpose of providing legal advice. You should not act upon the information in this article without seeking professional counsel.