Classifying Cloud Computing Taxes
Cloud computing is the delivery of computing as a service rather than a product, whereby shared resources, software, and information are provided to computers and other devices as a metered service over the Internet. From a state income tax perspective, how should these services be classified?
States generally follow federal treatment of income and expenses. As such, cloud computing transactions could be classified as a:
- Service
- License or lease of tangible personal property, OR
- License or lease of intangible property
There most likely will be differing views on how to treat cloud computing transactions on a state by state basis. However, due to the large number of California based companies we’ll focus on how to treat such transactions from a California income tax perspective. For California, cloud computing would most likely be deemed to be a service. If for some reason it’s deemed to be a license or lease of intangible property, the result is the same from a sales sourcing perspective. It’s unlikely that it would be deemed to be a license or lease of tangible personal property. As of now, only canned software (i.e. software that you can go to the store and buy off of the shelf) is deemed to be tangible personal property.
In determining their taxable income attributable to California, businesses can look to the percentage of sales attributable to California (the Single Sales Factor formula) or they can use a three factor formula based on the percentage of property, payroll, and sales attributable to California. If the company elects to use the Single Sales Factor (SSF) method of apportionment, the sales would be sourced to the state where the purchaser receives the benefit (market based sourcing). In the case of cloud computing the benefit received could be considered wherever the customer accessed the information, which could be where the customer lives or elsewhere. For instance, a college student accesses information from the cloud in his/her dorm room in Arizona, but actually resides in California. How would you source that particular transaction? Most likely, it should be sourced to Arizona and not California. But based on the availability of information, you may only have the billing address for the customer, which in this case could be his/her permanent address in California. Thus, the billing address, while imperfect at determining where the benefit was received, may be the only available alternative.
If the company chooses the traditional three factor formula, the sales are sourced to the state where the greater amount of costs are incurred in generating the revenue. So if more than 50 percent of the costs are incurred in California, then all of the sales from the income stream would be sourced to California. This would often be the case for a company whose main operations are in California.
It’s important to choose the correct method given your financial situation. Generally, California based loss companies would not elect to use the SSF method since it can apportion more losses to California than using the traditional three factor formula and increase its net operating loss carryforwards to offset future taxable income. The opposite is true for companies in a taxable position, whereas the SSF method may yield a lower apportionment and income tax. This is a yearly election, so it provides flexibility depending on the position of the company.
If you have any questions, please contact the team at Mohler, Nixon & Williams, or your accounting professional.
Blake Larum is a Tax Manager at Mohler, Nixon & Williams.
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Business Taxation | Blake Larum | 
February 23, 2012 3:24 pm
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