This blog was last updated on June 26, 2021
*This is part 3 of a four part blog series addressing the nexus and sourcing issues associated with sales tax and cloud computing. In part 1, we addressed what the cloud is and in part 2 we discussed why businesses should concern themselves with cloud based transactions. The following discussion will address sourcing issues and rules for cloud based transactions.
Nexus and Sourcing Issues Associated with Cloud Based Transactions
Once a cloud based transaction has been identified and classified (SaaS, IaaS, Paas), depending on the taxability of such transactions, the next most important challenge is determining whether or not you have nexus within a particular taxing jurisdiction. In addition, you must determine which taxing jurisdiction or jurisdictions (with which you have nexus) to source the use of such services to. Determining nexus allows an out-of-state cloud service provider to pinpoint whether they are subject to the tax laws of a given state. Sourcing rules allow cloud service providers to determine where and sometimes how much tax should be paid to a particular taxing jurisdiction. Nexus When discussing sales and use taxes, no discussion would be complete without addressing the issue of nexus. Simply stated, nexus is the determining factor of whether an out-of-state business selling products into a state is liable for collecting the tax on sales within that jurisdiction. Unlike most laws relating to sales tax, the standard of substantial nexus is articulated by the U.S. Supreme Court. In two historical decisions, Quill Corp. v. North Dakota and National Bella Hass, Inc. v. Illinois, the court created a bright-line rule which sated that unless an out-of-state business has physical presence in a state, the state may not compel the business to collect sales and use tax on the business’s sales into the state. Nexus rules can vary by jurisdiction but all must meet the constitutional standard laid out in Quill and Bella Hess. Depending on the taxing jurisdiction, what amounts to “physical presence” can differ. Businesses can have nexus if they have a physical location in the jurisdiction, own property in a jurisdiction, have a sales force in the jurisdiction, participate in trade shows or provide services in a jurisdiction. A newer concept, known as affiliate or click through nexus, gives a business nexus when affiliates funnel business to their partners through the use of website links within a jurisdiction. When looking at the issue of nexus as it would apply to cloud based transactions it seems clear that the location of the users of that cloud based service will play no role in determining where potential liability lies. For a small to midsize cloud provider with its headquarters, servers, and a sales force operating in a single state, it seems simple – the cloud providers would only have obligations in those states where they operate. However, the reality is that as more business is conducted in the cloud and cloud providers increase in size, so does the nexus exposure. For instance, a midsize SaaS provider with headquarters and servers located in Massachusetts could potentially be compelled to collect sales and use tax in any and all U.S. taxing jurisdictions depending on the size of its outside sales force (which could potentially include sales persons in all 50 states). Even in the event that the SaaS provider with headquarters and servers located in Massachusetts only maintained an in-state sales force, there is a potential for nexus in several states depending on the business affiliate agreements the business engages in. There is good news for cloud service consumers; the mere use of cloud services should not create physical presence in a state for any cloud users. Accessing the cloud (SaaS, IaaS, Paas) does not establish physical presence for users in the location of the servers or equipment which host the users data. Sourcing Once a business has determined nexus and the taxability of cloud services in those states where nexus exists, the business must then look to the sourcing rules in order to determine the correct location or locations to remit the tax. Sales and use tax on service transactions are generally sourced to either the location of service performance or the location where the benefit of the service is received (this of course depends on the rules of the taxing jurisdiction). It is extremely difficult to apply such generic sourcing logic to cloud based transactions. Taxing jurisdictions (state & local) can potentially view the sourcing of cloud based transactions in a variety of ways including location of servers, location of software, location of user or location where the original data or information was created. Like sourcing rules relating to the sale of software, the trend in cloud based service sourcing is towards the location of use (where the benefit is received). However, this is by no means the only way to source such transactions and there are several states that use different methods. In the event a cloud based transaction is sourced to the location of the user, complications relating to multiple users can and do occur. Multiple users can most likely mean remitting taxes to multiple taxing authorities depending on a business’s nexus footprint. When sourcing sales and use tax transactions to multiple locations it will be necessary to apportion the receipts generated (many states require this). The method of apportionment will depend on the taxing jurisdictions involved and there may be overlap. Subscribe to the Taxware Blog to Read the entire series on this topic. In Part 4 we will take a more in-depth review of state tax schemes being applied to cloud based transactions, specifically focusing on key states such as New York and Illinois. Be sure to subscribe to the blog so you don’t miss any of this great information
