Taxing the Cloud: Tax Implications of Adding Cloud Communications on Providers of Cloud Computing

Cloud Compliance

Taxing the Cloud: Tax Implications of Adding Cloud Communications on Providers of Cloud Computing

By TMCnet Special Guest
Jonathan S. Marashlian, Marashlian & Donahue
  |  January 25, 2013

This article originally appeared in the Q1 -2013 edition of Cloud Computing Magazine.

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.

Despite the increasing interest in cloud computing solutions, most would be 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 the taxation consequences of one particular aspect of cloud computing – the provision of communications services through a cloud-based platform. Of particular importance, are the nexus implications of adding a cloud communications component to a SaaS (News - Alert) or cloud computing offering.

In light of the continuing economic stagnation, states face budget shortfalls and pressure is mounting for them to “plug the holes” with tax revenue from new sources. As a result, a number of states have latched onto the 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.

Under the traditional notion of physical presence, a Web-based hosted software or SaaS provider establishes substantial nexus, for sales and use tax purposes, where it has a physical presence. In general, substantial nexus exists in jurisdictions where the provider has data center or server located. This is not necessarily the same locations where services are accessed by consumers. Because many remote, cloud-based companies lack physical presence, many states have sought to expand their definition of nexus through the 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.

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 jurisdictions merely because their activity within a particular state lacks a traditional physical presence. Which brings us to the key point of this article: What are the tax implications of adding cloud-based communications services to a cloud computing service? The consequences might surprise you.

As it pertains to state and local communications taxes, substantial nexus exists between the service provider and any state where calls originate, provided the customer is billed for the call at a billing address in the state. Generally speaking, therefore, communications service providers are found to have nexus with states where their customers are located and originate calls. Further, under most state communications sales, use and excise 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 (in other words, the rules are “protocol agnostic” and apply to communications by any means or medium).

Whereas 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. The same may not be said for certain IP-based providers whose services ride over the Internet access facilities of an unaffiliated ISP. 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 significant 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 with state and local governments across the country. 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 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.

Tax risks and exposures are increasingly becoming a significant issue for cloud computing providers, particularly because many are adding cloud communications as a complimentary feature. But providers must be aware of the implications and consequences of adding voice communications because next to alcohol and tobacco, there is no product or service taxed more than telecommunications. And as Internet-based communications continue to chip away at traditional services, you can be certain the Tax Man is lurking in the shadows, waiting to pounce.

Jonathan S. Marashlian is the managing partner at Marashlian & Donahue, LLC, a Washington, D.C.-area law firm specializing in telecom and technology matters. Allison D. Rule, co-chair of the firm’s Communications Taxes and Fees Practice, assisted in the preparation of this article.

Edited by Brooke Neuman
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