Current Tax Issues in the Cloud

Sales Tax Basics

As a preliminary matter, it is helpful to review five foundational sales tax concepts. First, sales of tangible personal property (generally speaking) are broadly taxable. Second, sales of services (generally speaking) are narrowly taxable, meaning services must be specifically enumerated by statute before they are subject to tax. Third, most states (generally speaking) define tangible personal property to include non-custom software, which would otherwise be considered an intangible. Fourth, for a transaction to constitute a sale, a transfer of title or possession for consideration is required. Fifth, some states in effect treat the sale of SaaS as the taxable transfer of possession of software, a tangible product, rather than as the sale of a nontaxable service.

Citrix v. Comm’r

In brief, Citrix sold three online software products (GoToMyPC, GoToAssist, and GoToMeeting), each of which enabled a screen-sharing connection between a host computer and a remote computer through the Internet. The screen sharing allows a user of a remote computer to see the screen output of the host computer and to share access to its input controls, such as the mouse and keyboard.

Citrix’s SaaS technology necessarily operates through proprietary software, but none of that software is downloaded or otherwise transmitted to the customer, other than certain “endpoint software,” which is required for functionality. There was no dispute that the products, in fact, constituted software. Rather, the parties did not agree 1) whether the transaction was properly viewed as the sale of a service or the sale of software and 2) if software, whether the right to use it (i.e., possession) was actually transferred to the customer. In examining SaaS transactions, these can be difficult lines to draw.

Central to this dispute was the party’s disagreement whether Massachusetts’s applicable statutes and regulations permitted taxation of SaaS transactions. In 2005, the Massachusetts legislature expanded the definition of tangible personal property to include “transfers of standardized computer software,” including electronic transfers. Subsequent to the 2005 amendment, the Massachusetts Department of Revenue then promulgated a regulation that treats “transfers of rights to use software installed on a remote server” as a taxable transfer of software.

Citrix argued that its software was not transferred to the customer, and that it was selling a remote connection service, not tangible property. Throughout the transaction, Citrix retained control over the software and hardware that it used to facilitate the remote access. In contrast, the Massachusetts Department of Revenue auditors argued that the “basic purpose” of Citrix’s customers in purchasing the online products was to gain access to them and that the online products themselves constituted taxable software. In other words, Citrix was selling the right to access its software.

After evaluating the arguments, ultimately the Massachusetts Supreme Judicial Court sided with the auditors, concluding that under the applicable regulations “it is apparent that Citrix’s subscription fees involved ‘transfers of rights to use software installed on a remote server.’” As part of its reasoning, the court analogized Citrix’s online products to the sale of online tax preparation software, which Massachusetts regulations treat as taxable. The court concluded, “It is the functionality of standardized software that customers seek and that enables them to complete specific tasks.”

Consequently, Citrix lost its court battle and owes tax on its sales of SaaS in Massachusetts. But this is hardly the final judgment, and future disputes over the proper taxability of SaaS transactions in other contexts and in other states still loom large.

Underlying Complexity

Technology is advancing faster and faster, and the law is generally slow to adapt. Often there is not an obvious answer regarding the proper classification and taxability of information technology and e-commerce transactions. Is the software custom (exempt) or canned (taxable)? Does the state have authority subjecting SaaS to tax? New York takes the position that SaaS is taxable [see, e.g., TB-ST-128, Computer Software (08/05/2014)], while New Jersey does not tax SaaS transactions [see, e.g., TB-72, Cloud Computing (07/03/2013)]. If not the sale of software, remote or otherwise, is the service at issue a taxable service? Can it be treated as a taxable information service, or as some nontaxable consulting service? Needless to say, CPAs will be expected to answer these questions for their clients.

Does the transaction actually involve software or something along the lines of platform-as-a-service (PaaS) or infrastructure-as-a-service (IaaS)? What is being transferred? Who is using the underlying software applications? Are the business inputs being resold or used? Is tax being paid on the purchase of those inputs? Can a resale certificate be issued? Each state has its own rules affecting the answers to these types of questions.

Furthermore, these disputes can take an exhaustively long time to resolve. The Citrix litigation involved sales tax periods dating back to April 2007, that were audited in 2011 and then assessed in 2012. For the next eight years, the parties studiously litigated the matter through the appropriate trial and appeals process that led to this decision, issued February 5, 2020. Business must keep in mind that interest continues to accrue on open balances.