Cloudbusters, The Forecast

Taxing the Cloud Part Two: Questions Without Answers

A few weeks ago I posted a blog about whether cloud services should be taxed as products or services, in which I asserted that cloud services should be considered nontaxable services.  Something of a debate erupted over that blog.  And when I say debate, I mean that people disagreed with me. 

Here’s my over-simplified summary of some of the debate, in which all the involved parties will remain anonymous:

Someone pointed out that just as managed services are remote or hosted services, cloud services are remote or hosted versions of products, and they should be subject to sales taxes like other goods. Then someone else chimed in with the “are you adding value” distinction – if a “thing” is simply resold, it’s a product.  If that “thing” is packaged up along with additional value, then it can become a nontaxable service. But then couldn’t the “remote or hosted” packaging be considered a “value add” in and of itself? 

Is it just the difference between the “thing” or product that is sold and the administration or management service of that “thing?” In some cases the “thing” is managed by the cloud provider and in some cases it’s managed by the user, and in some cases a little of both. Does the way that it’s used make the difference between product and service? Some “cloud services” would be products while others would be services. 

It was a thought-provoking discussion with (and about) some very smart, informed people in our industry, but it didn’t leave me with any real answers.

While this was still fresh in my mind, I spoke with Charles Weaver of The MSP Alliance. He was involved in said debate, and he told me an interesting story. A story about an MSP in Florida. At first I didn’t understand how the cloud taxation issue and this story were related, but it quickly became crystal clear.

This MSP has been in business for a healthy number of years, delivering flat rate IT services to small business clients. This MSP underwent a tax audit. In that audit, the Managed Services revenue caught the auditor’s attention. “Looks like a warranty to me,” the auditor said, and determined that the MSP should have charged sales tax on all that revenue. Then of course the MSP received the judgment and the massive back-tax bill…and disputed it because, of course, Managed IT Services are very different from hardware warranty services, and really shouldn’t be subject to sales tax. Right? 

So how did the Florida tax auditor come to that conclusion? That’s not a question with an easy answer…but I’ll try to break out two key ideas that relate to it. 

First, in simplest terms, our tax code is just not designed to deal with this stuff. Distinctions between warranty work on hardware and Managed IT Services to support information workers and businesses are often lost on folks outside the IT industry, especially folks like policy makers, tax auditors and accountants. And that doesn’t even begin to touch on the complexities of how sales taxes should be imposed (or if they should be imposed at all) on cloud services. 

This is the problem. We’ve reached a point where the existing tax code just doesn’t fit very well anymore with the kinds of services we deliver, but the folks who should recognize that can’t.  Probably because technology is complicated – some of our clients have a hard time understanding the nuances of the delivery models. 

Second, states are hungry. Economic recession has left many states trying to recoup lost tax revenues any way they can. They’re looking harder for ways to capture more tax dollars than maybe ever before. So if there’s a gray area in the code, states are going to “err” on the side of whatever generates more tax revenue.

This sounds like a very, very painful and expensive combination of factors for us if left unchecked. Think about it – how much is 8% (average sales tax) of the total amount of managed services revenue collected in the history of a healthy MSP business? Potentially a WHOLE lot of money.  Good for state, bad for MSP. 

That poor MSP in Florida fighting his judgment is just one of many. We’ve also heard about similar things happening in Connecticut, Ohio, Wyoming, and a few other states. It’s becoming obvious that, when it comes to the kinds of services we deliver to our clients today, the rules about what is subject to sales tax aren’t clear, and the folks who make and enforce those rules are in desperate need of tax revenue from anywhere they can get it. Yikes.

The term “conflict of interest” comes immediately to mind. And it’s not just about Managed Services revenue – cloud services are an even bigger gray area. 

Even if we uniformly assume that cloud services are products subject to sales tax (as many suggest we should), there are still issues. The issues with the current tax code can basically be boiled down to one word: Where? Where is a cloud computing service located? What state has the right to tax it—the one in which it’s used? What if the service can be used in more than one state? Does the state in which the servers that run the service are located have the right to tax it? Or the state in which the offices of the cloud provider are located? Does any state have the right, or do they ALL have the right? There are so many different variations of cloud services, and so much complexity.  So many questions and so few answers.  And with states so hungry, they’re more likely to try to take a piece. 

Whether you think cloud services should be taxed as products or considered nontaxable services, the rules are vague and don’t provide practical guidance for us today.  But we and our businesses are liable either way.  If tax auditors are struggling under existing code to differentiate between a hardware warranty and Managed IT Services, they may need a little help in navigating the complexities of cloud services and how to tax them. 

The MSP Alliance and Charles Weaver are dealing with these issues first hand, every day. Stay tuned to Looks Cloudy for our upcoming multi-part podcast series with Mr. Weaver in which we’ll break down the complexities of these issues, as well what is being done about them from a public policy perspective, and a offer few tips for MSPs to help protect themselves amid the uncertainty. 

One more important closing note: I want to make it clear that I am not a tax attorney, nor am I an accountant.  If there are actual experts on these matters out there reading this, I’d love for you to add your perspective. 

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>