How should we tax the cloud?

By Joyce Beebe, Ph.D.
Center for Public Finance


Many people use Dropbox to access and manage remotely stored files, and cloud computing-based services like Gmail and Google Calendar have become routine experiences. The profitability and growth of cloud computing is as remarkable as the convenience generated by these applications: Amazon’s cloud computing segment, Amazon Web Services, boasted close to 50% annual growth in revenue over the last three years, which doubled from $12 billion in 2016 to $26 billion in 2018. Microsoft’s Intelligent Cloud segment demonstrated equally impressive revenue growth from $27 billion to $39 billion over three years. 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.

Recently, the IRS issued proposed regulations about income tax treatments for cloud computing transactions. Although many practitioners view this guidance as Treasury’s attempt to block large U.S. tech-multinationals’ tax avoidance activities associated with cloud computing services, it has three major implications for all cloud computing service vendors.

First, the proposed regulation formally defines cloud transaction as “a transaction through which a person obtains non-de minimis, on-demand network access to computer software, digital content, or other similar resources.” It specifically points out that the definition applies to streaming and access to books, music or movies in digital format. Second, it clearly states a cloud transaction is either a lease of property or provision of services, and not a sale or license of a property. Not classifying cloud transactions as licenses 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. 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 regulation is the first guidance issued since 1998, when the Treasury addressed transactions involving computer software programs primarily sold in preloaded CDs. 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.

Turning to the state and local level, the applicability of state sales tax on cloud computing is even cloudier for vendors, primarily due to the lack of clear and consistent sales tax rules across states. As of mid-2019, 30 states and Washington, D.C., tax digital products (e.g., music, video, books), 22 states tax streaming services, and 17 states and Washington, D.C., tax cloud computing, and each state may define what constitutes digital products, streaming or cloud services differently.

Software as a Service (SaaS) is the most commonly discussed cloud computing delivery models (e.g., web-based emails and calendars), potentially due to its popularity and ease of use. Even so, the tax treatments vary across states. For example, Texas views SaaS as taxable data processing service but allows 20% of revenue to be exempted from tax; New York sees SaaS transactions equivalent to sales of off-the-shelf, boxed software and is therefore taxable; and Wisconsin generally does not consider SaaS as a taxable data processing services.

The absence of clear and consistent rules leads to mounting lawsuits across the nation: Automatic Data Processing (ADP) disagreed with Arizona Department of Revenue where the state considered ADP’s cloud-based software a tangible personal property. ADP contested there is nothing “tangible.” Netflix and Apple filed separate lawsuits against the city of Chicago, arguing the city should not treat steaming products differently from non-internet based products.

Further complicating the state sales tax issue is that state officials and federal legislators do not necessarily agree who is the most appropriate authority to address the taxability of digital products or services. Congress’ version of the solution, the Digital Goods and Services Tax Fairness Act (S.765/H.R. 1725), has been introduced four times since 2011. On the other hand, the Multistate Tax Commission (MTC) 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.

Before any decisive simplification measure appears, taxpayers would have to rely on sales tax automation software, reference or request state private letter rulings, or resort to litigation as the “second best” alternatives. However, as digital economy continues to encompass a larger share of economic activities and more consumers are streaming or downloading digital products as opposed to purchasing them through tangible means, states are sure to expand their taxing power on cloud computing and digital products. 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.