How Sales Tax Applies to Cloud Based Software Service Offerings
Once widely considered to be a niche segment of the market, cloud-based software services are now the norm, not the exception. Virtually everyone, whether personal or business related, uses some sort of cloud-based service on a consistent basis, potentially without even realizing it.
With respect to sales and use tax compliance, keeping up with changes in the law and the correct application of tax within this industry has been challenging. Most business owners consider online software applications to be exempt from tax due to their intangible nature. In reality, however, there are a number of states that treat cloud-based software offerings as taxable licenses to use pre-written software. Other states have deemed cloud-based software to be a nontaxable service, based on the fact that no tangible software is transferred. Finally, other states take the approach that taxability depends on whether the true object of the transaction is the use of software or some other purpose.
In addition to the inconsistent treatment among states, there is significant confusion regarding the various types of broad software categories and acronyms associated with cloud-based software and related service offerings. While it can be difficult to find commonality among the states, most states use the following general definitions for cloud-based software service offerings:
- SaaS: software-as-a-service. Under a SaaS offering, a consumer purchases access to a software application that is owned, operated, and maintained by the SaaS provider e.g. Microsoft Office 365. The consumer accesses the application over the Internet and the customer does not have the right to permanently download, copy, or modify the software. SaaS is generally offered for free or on a per transaction or subscription basis.
- Ohio: SaaS offerings are taxable in Ohio when they are sold for use in a business if the true object of the transaction is the receipt of automatic data processing services rather personal or professional services to which automatic data processing are incidental. Non-business use of SaaS is generally not subject to tax. (Ohio Rev. Code Ann. §5739.01(B)(3)(e))
- Missouri: In Missouri, the sale of SaaS is not subject to tax. The service provider must pay sales or use tax on any tangible personal property used to provide the service that is purchased or used in Missouri. Missouri defines software as a service as a model for enabling ubiquitous, convenient, and on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction. The term includes platform as a service model, infrastructure as a service model, and similar service models. It does not include any service model that gives the purchaser the right to use specifically identified tangible personal property. (Mo. Rev. Stat. §144.010)
- IaaS: infrastructure-as-a-service. IaaS providers sell access to storage, networks, equipment, and other computing resources that the provider operates and maintains e.g. Google Compute Engine (GCE). A consumer purchases the ability to store data or deploy and run software using the provider’s equipment. The consumer does not manage or control the cloud infrastructure but has control over its applications and data.
- Colorado: while the Colorado legislature has not directly addressed the topic of infrastructure as a service, Colorado generally imposes sales tax on sales of tangible personal property, but only certain specified services are subject to the tax. Because infrastructure as a service is not mentioned in the statute as being a taxable service, it is presumed to be excluded from taxation. (Sec. 39-26-104, C.R.S.1)
- California: California does not currently have any specific provisions regarding IaaS. If no tangible personal property is involved in the sale, however, then the transaction is likely exempt as services are generally exempt from tax in the state. (Cal. Code Regs., title 18, § 1502, subd. (g)(1))
- PaaS: platform-as-a-service. PaaS providers sell access to a platform and software development tools that a consumer uses to create its own applications e.g. OpenShift. A consumer deploys the application(s) it creates onto the provider’s infrastructure. The consumer has control over its deployed applications but does not control the underlying infrastructure.
- Massachusetts: PaaS offerings are taxable in the state unless the true object of the transaction is to obtain information or a service other than the use of software. (Mass. Regs. Code tit. 830, §64H.1.3(14)., Letter Ruling 11-2.)
- New Jersey: PaaS offerings are not considered by the state to be a sale of tangible personal property and they are also not listed as a taxable service within the statute. When use of the software is the true object of the sale, PaaS is not subject to sales tax. So long as the use and access to PaaS does not include the transfer of tangible personal property, the sale of PaaS is not subject to sales tax. This is true whether the software is located on a server in New Jersey or on a server outside New Jersey. (N.J. Technical Bulletin TB-72)
As the forgoing demonstrates, authority on these offerings and their taxability is everchanging and it varies by state. It is important to understand how cloud software products are categorized, so its taxability can be accurately established. Only after the product has been properly categorized, can its taxability be accurately established.
Failure by a business to recognize the taxability of one of its offerings that results in the failure to collect tax, can result in an expensive learning lesson that may significantly affect the bottom line. For this reason, we recommend being proactive and having a taxability study completed on your software service offerings to ensure that your business is in compliance and collecting tax where it is applicable.
*Note that the content of this article should not be treated as legal advice. The specific State examples are accurate as of December 2020, but they are subject to change.