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Is Your Head In The Clouds? A Closer Look At The Taxability Of Software As A Service

25 May 2011

As companies continue to look for ways to minimise IT infrastructure costs and gain the benefits of increasing technological advantages, Software as a Service (SaaS), or cloud computing, will continue to grow. Most states impose sales tax on the sale or transfer of tangible personal property, but a growing number of states tax services, including SaaS. With states facing budget shortfalls, Taxand US investigates the possibility of taxing SaaS as a potential source of revenue.

What Is Software as a Service?
SaaS generally consists of software that is hosted at a central location and is provided to multiple users that remotely access the software and related data over the Internet. Customers pay for the right to access the software and for a license to use it. It is no surprise that SaaS has grown in popularity, because a customer can access it from anywhere they have an Internet connection. The software is also routinely upgraded by the provider so that the customer gets the benefit of the newest technology without the added cost. SaaS can be used for a variety of business applications, including accounting, collaboration, customer relationship management, invoicing, human resource management and security.

Question of Taxability
Generally, the taxability of SaaS will hinge on the specific facts of the provider and customer, the type of SaaS, and the location of use or benefit. When determining the taxability of SaaS, a company should consider the following three questions:

  • Where does the SaaS provider have nexus?
  • Where is the buyer located or benefit received?
  • Does the state in question tax SaaS?

For a SaaS provider, the first question should be whether it has nexus with the state where the customers use the service. Regardless of the product or service a company sells, the company must have a physical presence, or nexus, with the state. Nexus is generally created by maintaining property or employees or by sending a sales representative or agent into a state.

When determining the taxability of SaaS, it is also important to establish the buyer's location or where the benefit is received. Historically, electronically delivered software was delivered or downloaded to a fixed location, and the location of the buyer or receipt of benefit was relatively simple to ascertain. However, SaaS is different from the sourcing of electronically delivered software because SaaS customers remotely access the SaaS from anywhere the customer has Internet access, often making it difficult to identify where the benefit is received. If a provider cannot determine where the SaaS is used, it may not be able to determine if it has a sales tax collection responsibility or apply the appropriate tax.

Assuming the provider can identify where the benefit is received and if it has nexus in that state, then it must ascertain if SaaS is subject to tax in the state. However, even if a provider does not have nexus, a customer may nonetheless be responsible for accruing and remitting use tax if the state imposes tax on SaaS.

Taxand's Take

Currently, many US states are considering cloud computing to be a service exempt from tax. However, as states continue to expand their tax base to meet growing deficits, companies can expect SaaS to be a point of interest. As such, it is important for SaaS providers to understand their tax filing obligations and to monitor proposed state legislation. Customers should also understand the added costs (i.e., sales and/or use tax) that may be imposed on their purchases of SaaS. It is imperative that providers, as well as customers, become aware of these state tax rules to avoid any pitfalls along the way.

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Your Taxand contacts for further queries are:
Alejandro Joya
T. +1 305 704 6680

Taxand's Take Author