Cloud computing has not only transformed how businesses and people conduct their daily activities, it has also clouded the landscape for taxing such technological advancements.
In 1998, the same year Google was founded, the Internal Revenue Service finalized the regulations governing the taxation of cloud computing transactions. With a reboot so clearly overdue, the IRS on Aug. 9, 2019, released its new proposed regulations on the classification of cloud transactions. But the proposed regulations may raise a number of questions, according to Alston & Bird federal & international tax partner Edward Tanenbaum.
One glaring omission is that the proposed regs provide no sourcing rules for cloud transactions, he said: “As it stands now the proposed regulations classify cloud transactions as either a lease or a service, but then fail to provide guidance on how to determine the source of income generated by such transactions.”
Although viewed by many practitioners as the Treasury Department’s effort to block the tax avoidance activities of large U.S. tech-multinationals, the proposed regulations have major implications for all cloud computing service vendors, according to Joyce Beebe, a fellow at the Center for Public Finance at Rice University’s Baker Institute for Public Policy.
“First, the proposed regulation formally defines cloud transactions as ‘a transaction through which a person obtains non-de minimis, on-demand network access to computer software, digital content, or other similar resources,’” Beebe observed. “It specifically points out that the definition applies to streaming and access to books, music or movies in digital format.”
“Second, it clearly states that a cloud transaction is is either a lease of property or provision of services, and not a sale or license of a property,” she continued. “By not classifying cloud transactions as licenses, it alleviates concerns of many vendors, as royalty payments might be subject to high withholding taxes.”
“Finally, the guidance specifies that the location of a cloud transaction is where the consumer downloads or installs the digital item. If vendors cannot be sure, the consumer’s residential address would be used,” she said. “As a result, a foreign vendor who sells to U.S. consumers may have previously avoided U.S. taxes by designating in legal contracts a certain low tax location as the place where transactions happen. The proposed regulation would void many of these arrangements.”
“Although the IRS still needs to clarify many details, the proposed regulations are the first guidance issued since 1998, when the Treasury addressed transactions involving computer software programs primarily sold in preloaded CDs,” Beebe said. “Treasury’s recent action highlights that it recognizes the importance of modernizing tax rules regarding technological advancements, and provides certainty for vendors — a good starting point.”
“The applicability of state sales tax on cloud computing is murkier for vendors, primarily due to the lack of clear and consistent sales tax rules across states,” she said. “As of mid-2019, 30 states and Washington, D.C., taxed digital products such as music, video and books, 22 states taxed streaming services, and 17 states and Washington, D.C. taxed cloud computing,” she said. “Each state may define what constitutes digital products, streaming or cloud services differently.”
The absence of clear and consistent rules has led to lawsuits across the nation, according to Beebe. She cited suits brought by ADP, Netflix and Apple. The ADP lawsuit, against the Arizona Department of Revenue,contested the state’s position that ADP’s cloud-based software was tangible personal property. Separate lawsuits by Netflix and Apple against Chicago argued that the city should not treat streaming products differently from non-internet based products.
On Oct. 1, 2019, an Illinois appellate court upheld a lower court ruling in favor of Chicago, legitimizing the city’s “Netflix tax” on streaming services.
The state sales tax issue is further complicated by the fact that state officials and federal legislators do not necessarily agree on who is the most appropriate authority to address the taxability of digital products or services, according to Beebe.
“Congress’s version of the solution, the Digital Goods and Services Tax Fairness Act, has been introduced four times since 2011,” she observed. “On the other hand, the Multistate Tax Commission believes that a model statute generated by state-led efforts would be superior to a federal preemption, which typically takes a long time to accomplish and even longer to revise.”
“Unless any decisive simplification measure appears, taxpayers will have to rely on sales tax automation software, reference or request state private letter rulings, or resort to litigation as an alternative. As the digital economy continues to encompass a larger share of economic activities and more consumers are streaming or downloading digital products, states are sure to expand their taxing power on cloud computing and digital products,” she said. “A better path forward would be for states to address issues related to the taxability of digital goods through legislative actions, instead of simply fitting new products and services into outdated rules.”