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miller nash llp | Fall 2011

NW Tax Wire™

(continued on page 4)

inside this issue2 The Tax Man Cometh . . .

3 Is the Fox Guarding the Henhouse? . . .

Cloudy With a Chance of Tax

by Valerie H. [email protected]

503.205.2510

It is a truth universally acknowl-edged, that an emerging business model in a lucrative area must be in want of a new taxing model.1 Business-es are increasingly outsourcing their information technology requirements to the “cloud.” State legislatures and policymakers are struggling to adopt taxing mechanisms to capture the new model of business activity. This article discusses common questions about state taxation of cloud computing activity and concludes with an analysis of the current status of state tax laws surrounding cloud taxation.

Query: What is cloud computing?

In order for us to determine tax-ability of cloud transactions, we need to be able to identify them. Broadly stated, cloud computing is a model for “enabling ubiquitous, convenient, on-demand network access to a shared pool of computing resources.”2 The National Institute of Standards and Technology (“NIST”), a division of the Commerce Department, has identified five essential characteristics of the cloud model:

•On-demand self-service: The user can use computer resources (e.g., server time and network storage) as needed without requiring human interaction with the service’s provider.

•Broad network access: The computer resources may be accessed over the user’s network in a variety of different ways, including in ways (cell phones and laptops) that promote use by a mix of thin (depending heavily on some other server) and thick (stand-alone) client platforms.

•Resource pooling: The cloud provid-er’s computer resources are pooled to serve many consumers using a multi-tenant model, with different physical and virtual resources dynamically as-signed and reassigned based on variable consumer demand. These resources may include storage, memory, process-ing, network bandwidth, and virtual machines. Location independence is increased in this model. This is the idea that the consumer has no control or knowledge over the exact location of the provided resources. Information tech-nology outsourcing agreements may or may not specify that the location may be a particular data center or located in a particular state.

•Rapid elasticity: Computer re-sources can be rapidly and elastically reallocated between consumers. This

allows the resource provider to scale a particular consumer’s computer resources in and out to the consumer’s computer usage. From the consumer’s perspective, the resources appear to be unlimited and can be purchased in any quantity at any time.

•Measured service: As noted above, one of the advantages of the cloud model is the scalability of resources to usage. Providers and consumers have greater visibility to the consumer’s actual usage of the resources. Thus, the resources can be monitored, controlled, and reported in methods appropriate to the type of resource. This lends itself to a “metered” model, typically pay-per-use.

These characteristics are typi-cal of cloud systems that our clients have adopted in industries as diverse as healthcare, manufacturing, and electronic retailing. As computer re-sources increase in cost and complexity,

1 Apologies to Jane Austen.

2 Peter Mell and Timothy Grance, “The NIST Definition of Cloud Computing (Draft): Recommendations of the National Institutes of Standards and Technology,” Special Publication 800-145 (Draft) (Jan. 2011).

2 | miller nash llp | NW Tax Wire

The Tax Man Cometh, and He’s Got His Eyes on Your Investment

“. . . each partner will be treated as having investment income equal to his or her share of the partnership’s investment income.”

It’s not news that the current Social Security and Medicare programs are not sustainable. In fact, with the first wave of baby boomers already eligible for So-cial Security and first becoming eligible for Medicare in 2011, the outlook is bleak for each program unless significant re-forms are made. In an attempt to bolster the Medicare program, as part of the over-1,000-page and much-publicized “Health Care and Education Reconciliation Act of 2010,” Internal Revenue Code Section 1411 was enacted. This provision will cause investment income of many individuals to be subject to a 3.8 percent Medicare tax beginning in the year 2013 (the new Medicare tax also applies to trusts and estates, but this article focuses on the application to individuals).

Traditionally, Medicare has ap-plied only to an individual’s wages or self-employment income earned in the operation of a trade or business. Cur-rently, and in general terms, Medicare tax is a payroll tax equal to 2.9 percent of wages paid, and the cost of the tax is shared equally by employers and em-ployees (each paying 1.45 percent of the tax). Individuals who are self-employed pay both the employer and the employee portions of the Medicare tax.

Beginning on January 1, 2013, the new Medicare tax will apply at a rate of 3.8 percent on the investment income of individuals with a modified adjusted gross income of $200,000 ($250,000 for couples filing jointly) or more. The tax applies to the lesser of (1) the total investment income for the year, and

(2) the amount by which the individual’s total income exceeds the threshold. For example, a single individual taxpayer who has $150,000 of investment income and $125,000 of other income will pay the new Medicare tax on $75,000 (the amount by which the individual’s in-come exceeds the $200,000 threshold). Because the threshold amounts for the new Medicare tax are not indexed for inf lation, more taxpayers will be subject to the new Medicare tax over time.

For purposes of the new Medicare tax, net investment income will include interest, dividends, annuities, royalties,

rents, income from passive activities, and gain from the sale of assets. But in-vestment income that is not recognized for federal income tax purposes will not be subject to the new Medicare tax, in-cluding income from tax-exempt bonds, tax-free distributions from qualified re-tirement accounts, gain from the sale of a principal residence to the extent that Section 121 applies, gain from the sale of property to the extent that Section 1031 applies, increases in the value of a life insurance policy, and gain in a quali-fied IRA or other retirement account. Additionally, taxable distributions from qualified retirement accounts, income from a trade or business (other than a passive trade or business or trading in financial instruments or commodities), and income subject to self-employment taxes are exempt from the new Medi-care tax, but any such amounts will be included in the individual’s modified adjusted gross income and could push the taxpayer over the threshold, causing other investment income of the indi-

vidual to be subject to the new Medicare tax.

Although the new Medicare tax applies to individuals, for investment income earned by a partnership (includ-ing a limited liability company that is taxed as a partnership rather than a cor-poration), each partner will be treated as having investment income equal to his or her share of the partnership’s invest-ment income. Additionally, although a corporation won’t be subject to the new Medicare, any dividends paid to an in-dividual shareholder will be investment income to the shareholder. This means

that creating an entity to hold investment-income-producing assets for a taxpayer is unlikely to effectively avoid the new Medicare tax.

Individuals who anticipate being subject to the new

3.8 percent Medicare tax may want to engage in some advance tax planning before the tax becomes effective. For example, if an individual desires to sell an industrial rental property in the next few years and expects to have $1 million of taxable gain as a result of the sale, the taxpayer could avoid $38,000 of Medicare tax if he or she sold the prop-erty before January 1, 2013. Addition-ally, a taxpayer might consider selling investment-income-producing assets before 2013 and investing the proceeds in tax-exempt bonds or a whole-life in-surance policy, thereby avoiding the new Medicare tax on any gain generated by the sale of the asset and avoiding the new Medicare tax on the income produced by the investment. A taxpayer might also consider transferring investment-income-producing assets to a qualified retirement account, or, after 2013, sell-ing assets on an installment-sale basis, if doing so could help keep the taxpayer under the new Medicare tax threshold.

by Jeneé [email protected]

503.205.2505

| 3

Is the Fox Guarding the Henhouse? State of Washington’s DOR Takes Over Business Licensing

“It is not going to end well for the hens.” That is the appropriate response when one finds out that the fox has been charged with guarding the henhouse. Business taxpayers in Washington may soon find the truth of this aphorism out firsthand. Effective July 1, 2011, all functions of what was known as Wash-ington’s Master License Service have been transferred from the Washington Department of Licensing to the Wash-ington Department of Revenue, with the program now called the Business Licensing Service.

This change, the result of Substi-tute House Bill 2017 passed by the 2011 Legislature, gives the Department of Revenue oversight of the multijuris-dictional licensing program, through which over 100 state licenses are granted and over 200 state endorsements and 70 city licenses are applied for. In ad-dition, the Business Licensing Service serves as the vehicle for registering for workers’ compensation insurance, for unemployment insurance, and with the Department of Revenue.

The stated reasons for this change of jurisdiction were to integrate and streamline the licensing program. While raising tax revenue and bring-ing nonfilers into compliance may not have been the primary motivations behind SHB 2017, those may very well be an unintended benefit to the state. It has been our experience that not all licensees are registered with the Department of Revenue—sometimes for a valid reason and sometimes not. The role of the Department of Revenue in administering the Business Licens-ing Service will give it direct access to the identity of and information about all businesses holding or applying for the hundreds of state and local licenses and endorsements covered by the Busi-ness Licensing Service, even if those companies have not registered with the Department of Revenue.

In other states, taxing agencies are known to use state registration and licensing information to identify and track down companies suspected of not being in full compliance with tax laws, even when such taxing agencies do not administer the state licensing systems. Now that the Washington Department of Revenue administers the Business Licensing Service, this sort of data matching is all the more likely. Any

company with taxable nexus in Wash-ington that is not registered with the Department or is not fully paying its B&O or sales and use tax obligations should take note that the Department of Revenue now has a large new cache of information at its disposal. It re-mains to be seen how the Department will use that information.

There can often be significant ben-efits for a taxpayer to voluntarily come forward before being discovered by the Department of Revenue as being in noncompliance with its tax obliga-tions. The most notable program in Washington is the Department of Rev-enue’s Voluntary Disclosure Program. Under this program, a taxpayer that has previously failed to register with the Department and pay taxes can, if it otherwise comes into compliance and meets certain requirements, enter into an agreement with the Department under which the period of assessment will be reduced to the current year plus the prior four years and have some or all of the associated penalties waived. It has been our experience that par-ticipation in Washington’s voluntary disclosure program can result in thou-sands of dollars of savings over what would be owed if the Department of Revenue were to initiate an audit.

Of course, the key requirement to participate in the Voluntary Disclosure Program is that the company must not have been contacted by the Depart-ment of Revenue about its noncompli-ance before it requests a voluntary disclosure agreement. Additionally, in most cases a company can contact and work out its agreement with the Department on an anonymous basis, using a law firm as the intermediary.

The fox has the keys to the hen-house; it remains to be seen how he’ll use them. In the meantime, vulnerable hens . . . er companies, should look to get their house in order.

by Ryan R. [email protected]

503.205.2521

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businesses look to cloud solutions for low-cost approaches to internal infor-mation technology functions as well as outward-facing customer interaction tools.

Query: What does cloud computing look like?

One of the initial challenges for the state-tax professional is to identify when consumers are utilizing a cloud process. NIST has also identified three major models of cloud computing:

•Software as a service (“SaaS”): This is the most commonly discussed form of cloud computing in the tax press. With SaaS, a cloud vendor provides consumers with the capability of using the vendor’s applications running on a cloud infrastructure. The consumer ac-cesses these applications through a thin client interface. One of the most easily recognized examples of SaaS is Web-based e-mail, which the user accesses through a browser. The consumer does not have the ability to manage or control the underlying infrastructure or program other than some limited consumer-specific application settings.

•Platform as a service (“PaaS”): With the PaaS cloud model, the consumer develops applications and the cloud ven-dor provides the capability to deploy the application onto cloud infrastructure. The consumer may develop the applica-tion using the provider’s programming languages and tools. The consumer does not have the ability to manage or control the cloud infrastructure, but has control over the deployed applica-tion and may have limited control over hosting environment configurations. Two of the most commonly discussed models of PaaS are Amazon Web Ser-vices and Google’s App Engine.

•Infrastructure as a service (“IaaS”): With IaaS, the cloud vendor rents pro-

cessing, storage, networks, and other similar computing resources in which the consumer may deploy and run software, including operating systems and applications. The consumer doesn’t manage or control the cloud infrastruc-ture, but has control over operating systems, storage, and deployed applica-tions, and may have some control over networking components (e.g., host firewalls).

As one might expect, each of these broad models has several subcategories and different manifestations that industry professionals have identified. State revenue authorities (and most commenters) have primarily addressed the sales-tax treatment of SaaS. But the varying degrees of service and control associated with PaaS and IaaS may lead to different nexus, sourcing, and tax-ability concerns.

Query: How do states tax cloud computing services?

Currently, very few states have even begun to address the different economic model that cloud computing presents. The earliest state-tax models were developed to tax the activity of

traveling salesmen (“drummers”) in the late nineteenth and early twentieth centuries. To this end, these models are still largely based on the jurisdiction where an activity takes place or where a service is provided.

Nexus: The threshold question of state taxation is whether there is nexus. A business must have physical-presence nexus with a state for it to be constitu-tionally subject to that state’s sales-tax collection regime. Historically, sales-tax nexus may be created with a state by the presence of in-state employees or tangible personal property. Income-tax nexus has a broader standard that has recently expanded to include economic activity directed at the residents of a state. Oregon has adopted an economic-nexus standard for its corporate excise tax.

Cloud computing models create a problem particularly for sales-tax-dependent jurisdictions. There is complexity in determining whether cloud vendors or consumers have tax-able presence. In the vendor’s case, the physical computer systems that provide services are not physically located in

5 | miller nash llp | NW Tax Wire

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the state taxing jurisdiction, may be located in a nontax jurisdiction (such as Oregon), and may be located over sev-eral jurisdictions. The elasticity that is a hallmark of cloud computing may cre-ate situations in which computer infra-structure in one or more jurisdictions is actually providing the computing services. Similarly, end users working for a single consumer may ultimately access the cloud services from various different physical locations that may not be readily visible to the consumer and may complicate nexus determina-tions. Does the presence of a traveling executive checking and responding to Web-based e-mail in the Denver airport create sales-tax nexus for her employer in Colorado?

Complexity also exists in states that impose a corporate income tax. It is unclear whether providing cloud services to a consumer that may or may not access the services in a jurisdiction crosses the constitutional threshold of the purposeful availment of a state’s economic environment. Even the recent bright-line MTC nexus standards (un-der which a certain amount of sales in a state creates nexus) may be difficult to evaluate given sourcing complexity, discussed below.

Sourcing: Even if a state jurisdic-tion can determine that a particular cloud vendor or consumer has taxable presence in the jurisdiction, it may be difficult to source a particular transac-tion or revenue stream to a state.

For sales-tax purposes, sales are typically sourced to a state taxing juris-diction where delivery of the tangible personal property or specifically enu-merated service occurs. For cloud trans-actions, there is no delivery because physical possession of the computer systems remains with the cloud vendor. Additionally, the utilization of resource

pooling may mean that an ever-variable selection of computer systems in differ-ent jurisdictions are involved in provid-ing the services. In a 2009 private letter ruling, Utah ruled that the location of the servers in Utah required the sourc-ing of an SaaS transaction to Utah. So the service may not occur in a particular jurisdiction. Sourcing the sale to the lo-cation of the consumer, as several states are contemplating, might not solve this particular problem because consumers may utilize the service in a variety of different locations. New York takes this approach.

For income-tax purposes, most states still employ a greater cost-of-performance model to source service revenue. This means that the revenue will be sourced to wherever there is the greater cost to perform the service. This may be complicated to evaluate, since the resources utilized to provide particular services may implicate various different taxing jurisdictions at any given time. One of the strongest trends in state tax has been a shift to market-based sourcing. That is, the sale is sourced, for income-tax purposes, to the location of the consumer. This im-plicates all the concerns outlined above in the sales-tax context. Additionally, the decision tree that many states uti-

lize to source sales ultimately resorts to using the customer’s billing address as the transaction location. As cloud trans-actions increase, this seems to create a planning opportunity for multistate taxpayers that states will undoubtedly seek to address.

Taxability: Assuming that the vendor and consumer have taxable nexus and the sale is determined to occur in a state, there is still an evolv-ing understanding about whether a particular transaction is taxable. State sales taxation of computer software is largely based on the delivery of tan-gible personal property to customers. California, for example, has historically imposed its sales and use tax on pre-written computer software products if tangible media was used to convey the software program. Custom software is not typically subject to state sales and use tax, since the “true object” of the transaction was the programming ser-vice that the programmer was supply-ing to the customer. Other specifically enumerated services, such as manda-tory maintenance agreements, may also be subject to state sales and use tax.

Very few states have addressed the taxability of cloud services. Mas-sachusetts and Texas have informally determined that SaaS transactions


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are taxable. New York has also issued technical service determinations find-ing that SaaS transactions are subject to sales tax.

As of July 26, 2009, Washington began imposing its sales and use tax on digital automated services (“DASs”). A DAS is defined as an electronic service that utilizes one or more software applications. The Washington Depart-ment of Revenue has issued guidance that specifically includes photo-sharing services, car-history report services, and search engines as digital automated services subject to tax. Washington also imposes its sales tax on remote-access

software (“RAS”). An RAS sale involves prewritten software that resides on the cloud vendor’s server and that the consumer pays for the right to access. These statutes indicate that Washing-ton intends to subject SaaS transactions to its sales and use tax.

Conclusion

Although cloud transactions pose very interesting puzzles for state-tax professionals, there is not a great deal of published guidance that a taxpayer can hang her metaphorical hat on. Washington’s 2009 Digital Products Bills provided the clearest expression of statutory direction currently available.

In the absence of the adoption of specific statutes addressing cloud taxa-tion, it is our expectation that state rev-enue authorities will rely on standard analytical tools to determine whether a particular taxpayer has nexus with the taxing jurisdiction, whether the trans-action can be sourced to that taxing jurisdiction, and finally whether the transaction itself is taxable. The leading edge of the battle appears to be develop-ing in the sales-tax context, but we an-ticipate that these types of transactions will also be carefully scrutinized by jurisdictions, such as Oregon, that are solely reliant on their corporate income tax.


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