ISSUES & INSIGHTS's's

State legislatures seeking new tax revenues in the down economy are again focusing on sales/use taxes. Much has been written about states’ desire to tax internet sales of tan-gible personal property (Amazon.com, etc.). However, less noticed has been the states’ increasing taxa-tion of Software as a Service (SaaS) and other “cloud-based” service providers. In the following article, Armanino McKenna Tax Partner Malcolm Ellerbe outlines consider-ations for SaaS companies seeking to avoid surprises from unexpected sales/use tax liabilities in this dy-namic environment.

As software delivery models moved from tangible media (e.g., CD ROM, disks) to downloads (elec-tronic transmission), states gradual-ly updated the taxation of software to include downloaded software. (All but 11 states with sales taxes impose tax on downloaded soft-ware.) Similarly, states are adapt-ing to the recent move to the cloud for software companies and other cloud-based services. Many cloud-based services companies feel they are providing nontaxable services and not sales of taxable software. Based on a recent study, at least 18 states currently tax or are seeking to tax hosted or cloud-based software, including what many consider to be Software as a Service.

Avoiding SurprisesCloud services companies should

seek to avoid surprises in potential liabilities related to state sales/use taxes, especially as these companies prepare for a public stock offering or other exit event. One prominent SaaS executive recently commented that his company spends between $500,000 and $1.5 million to “clean up” each acquisition target com-pany’s sales tax disputes:

“Third-party consulting costs and advisers, costs of filing all the back returns and negotiating with each agency is a very substantial process that can take a year and a half, so it’s expensive in terms of time and money. It’s just a very difficult part of the process.”

Avoiding surprises involves iden-

tifying whether a potential prior period exposure exists, resolving these potential liabilities, and effi-ciently complying on a prospective basis.

Identifying ExposureTwo critical issues in identifying potential sales/use tax exposure are product/service taxability and the obligation to collect the tax.

Issue 1 - Is What We are Selling Taxable?As discussed above, states are adapting to new software delivery models and cloud-based services. Many states tax hosted software, even if there is no software license (e.g., subscription models). These states may assert that the software

© 2011 Armanino McKenna LLP. All Rights Reserved.

Software as a Service (SaaS) and Other Cloud Service Providers Potentially Affected by Recent and Pending Rule Changes

ISSUES & INSIGHTS's's

is being used or accessed, notwith-standing the lack of physical pos-session by or transfer to the user.

Other states may not treat the transaction as software at all, but as a taxable “data process-ing service” (Texas), or a taxable “electronic information service” (Ohio). Washington even distin-guishes between taxable Remote Access Software (RAS) and taxable Digital Automated Services (DAS), which explicitly reach beyond pure software transactions into cloud services. It is important for cloud services companies to review their customer agreements and evaluate which states sales/use taxes may apply, especially given the states’ increasing adaptation to the changes in technology.

Issue 2 - Do We Have a Duty to Collect the Tax?Most cloud services companies are B2B (business to business) as op-posed to B2C (business to consum-er), exceptions being gaming and other consumer digital products. For most B2B businesses, sales are often generated by a sales team physically soliciting sales in each state (“footsteps on the ground”) where significant sales occur. This physical contact with the state, if not de minimis, generally will trigger a sufficient connection or “nexus” with the state to establish the company’s sales/use tax collec-tion duty. This is true even if the individuals are nonresident or inde-pendent representatives. An office

or permanent location in the state is not required to establish nexus.

Resolving ExposureThe decision to resolve prior period sales/use tax liabilities may have several drivers:

1. The company could be consid-ering a public stock offering and is “cleaning things up” in preparation for its S-1 filing or could be considering an exit through sale of the company and desires to minimize the risk of escrowed funds to cover a sales/use tax exposure,

2. The company’s financial state-ment auditors may have raised the issue of prior period expo-sure and the company is prepar-ing an accrual for contingent liabilities (FAS 5/ASC 450), or

3. The company is at the point in its lifecycle/growth stage where it is making investments in overall tax compliance, espe-cially if its larger customers insist it collect proper sales/use tax on its invoices.

Once the company identifies where it has nexus (collection duty), it should carefully evaluate its cus-tomer agreements and determine whether it is providing a taxable product/service in each state. A simple spreadsheet can then be prepared for management outlining potential tax, penalty and interest potentially due for prior periods, if any. Management can then decide, based on materiality, whether to

pursue negotiated settlement agree-ments in those states, reach out to customers to identify where they have self-assessed and paid the tax already, or simply decide to comply on prospective basis. Management may also wish to discuss the poten-tial impact of material prior period exposure on its financial statements with its advisors.

Efficient ComplianceOnce the company has decided to begin collecting tax in various states, it should make decisions about the efficient collection of tax and filing of returns in those states. The company may choose to file returns manually if only filing in a few states, or utilize various sales/use tax compliance software of-ferings which interface with the company’s ERP system and greatly simplify multistate sales/use tax filings.

Whether or not a cloud-based services or SaaS company chooses to collect and file sales/use taxes, it should at least be aware of the rapidly changing sales/use tax land-scape that may affect its business at some point and attempt to make informed tax compliance decisions while avoiding surprises.

Malcolm Ellerbe, CPA, is a Tax Part-ner at Armanino McKenna’s Silicon Valley office. His practice focuses on state and local tax, including sales and use taxes for technology companies. Contact Malcolm at malcolm.ellerbe@amllp.com.

© 2011 Armanino McKenna LLP. All Rights Reserved.