The taxman cometh for cloud services

If you build it, they will come. And hot on their heels will be the tax collectors.

The progress through Congress of the Marketplace Fairness Act, aimed at ending the tax-free status of retailers’ online sales, has garnered plenty of consumer and media attention. But there’s also been a steady march by economically strapped states to squeeze tax dollars from a venue where consumers are less likely to notice or protest: business-to-business computing and cloud-based services.

Massachusetts is the latest to join this trend: Governor Deval Patrick’s proposed budget for fiscal 2014 includes a line item that would expand the state’s sales taxes to include “canned software.” According to a Forbes report, “at least 14 other states have enacted similar taxes, and as many as 28 have at least some components of what’s being proposed in Massachusetts.”

CRN, citing a document from the Massachusetts Department of Revenue, says Massachusett’s broadly worded “canned software” actually targets custom-designed software and services hosted on the Internet and “would likely include services around code development, modification or testing of existing programs, feasibility studies, the design and installation of computer systems that integrate computer hardware, software and communication technologies, disaster recovery, and similar functions.”

In that same article, Momchil “Memo” Michailov, co-founder and CEO of Waltham, Mass.-based data management and protection software vendor Sanbolic, called the new tax an obvious play by the state to tax businesses while not taxing individual consumers. “If they charged taxes on everything, users would be up in arms,” he said. “The state is not taxing users for Internet service, even though most bandwidth is used for users’ pictures and videos. … Our customers and partners are staring at the computer screen wondering what will happen. The advantage of the cloud is, people can run a lot of applications efficiently, but it’s hard to know where the data and services are.”

The Digital Goods and Services Tax Fairness Act, introduced in 2011, would have limited the states’ ability to tax “digital goods and services.” The bill died in committee, but at least two states, Vermont and Idaho, have passed rules to explicitly exempt cloud-based services from state sales tax.

With laws like these, some states aim to attract businesses seeking to flee the imposition of new taxes — a point raised by Allen Falcon, CEO of Cumulus Global, a Westborough, Mass.-based cloud services company. In the CRN article, Falcon warned, “Massachusetts has been very aggressive in attracting startups and innovative companies. Certainly, we want to hold onto the talent that we develop at MIT and at other institutions. But this proposed tax would set up a situation that encourages them to drive an hour north into New Hampshire, and hours south into Rhode Island, and over to New York to retain greater profitability. I also think it will chill venture capital.”

Increased taxation can also remove the costs savings of transitioning to the cloud, since your business could get a surprise tax bill or tax-based price increase. A PricewaterhouseCoopers report notes, “IaaS and PaaS are enjoying unprecedented growth. Unfortunately, tax benefits and detriments are often overlooked or not given sufficient consideration until after a cloud infrastructure strategy has been implemented. As a result, a company can be blindsided by unintended tax assessments and a surprisingly expanded state tax footprint.”

These new laws also sow confusion, since definitions of what services will be taxed vary state by state, and the location of the cloud is by nature nebulous. As InfoWorld’s David Linthicum observes, “a New York-based company may purchase server space and cloud-based software from a Texas-based company. That’s relatively straightforward, except that the Texas company may have servers in North Carolina and California, while the New York company may have satellite offices in Illinois, Florida, and Kentucky that use the server space. Who gets the tax bill, and who gets the revenue? Good luck with that one.”

Stephen P. Kranz, a partner at D.C. law firm McDermott Will & Emery concurs, saying that “understanding what portions of the cloud are taxable and where to source these transactions is complex and requires a deep understanding of state tax law. Vendors and purchasers of cloud-based services are equally burdened by the lack of clarity and potential financial exposure that stems from failure to comply with the law.”

The Massachusetts Taxpayers Foundation has issued a strong statement against the governor’s tax proposal, calling it a “Pandora’s box” that will create “numerous problems” and seriously undercut the state’s competitiveness.

As Wired magazine observes on the taxing trend: “This is great for the lawyers, and possibly an application developer or two, but it’s terrible for IT.”

This article, “The taxman cometh for cloud services,” was originally published at InfoWorld.com. Get the first word on what the important tech news really means with the InfoWorld Tech Watch blog. For the latest business technology news, follow InfoWorld.com on Twitter.