Tennessee Ruling Provides Another Wrinkle for Cloud Computing Services

A recent ruling by the Tennessee Department of Revenue (Ruling #12-11) illustrates some of the anomalies and pitfalls in properly taxing cloud computing services. The request for ruling concerned a service that provided Tennessee users access to software maintained on remote servers located outside of Tennessee. This is otherwise known as an SaaS service. In addition, the charge for the service permitted users access to certain databases, including certain reference materials such as dictionaries and encyclopedias. It would appear that the users did not download the references to their computers.

One of the anomalies in the ruling is that the Department stated that the SaaS portion of the service was not taxable, but access to the databases was taxable because the Department deemed the access to include the right to license and use digital books. As of January 1, 2009, the right to license and use digital books is taxable pursuant to an amendment to the Tennessee sales and use tax statute adopting the Streamlined Sales and Use Tax Agreement (“SSUTA”).

The Department’s basis for this distinction in taxability appears to be that access to software is not taxable because “title, possession, and control” of the software always resides outside of Tennessee. On the other hand, the taxability of digital books is predicated on the following underscored clause from Tenn. Code Ann § 67-6-233(a), which provides for the taxation of digital books when there has been the “retail sale, lease, licensing, or use of specified digital products transferred to or accessed by subscribers or consumers in this state.” (emphasis added). Section 67-6-231(a), providing for the taxation of software, includes only “software transferred by tangible storage media or delivered electronically,” but does not include access to the software. The difference between the two statutory provisions is subtle. On the one hand, digital books are taxable if the consumer in Tennessee has “access” to the books, without being required to download them. On the other hand, computer software is not taxable, even if the consumer has access to the software, so long as the consumer does not download the software to his or her computer in Tennessee.

Another anomaly pointed out in the ruling is the distinction between information services and digital books. The Department conceded in its ruling that data processing and information services are not taxable in Tennessee, and defined such nontaxable services as allowing “data to be generated, acquired, stored, processed or retrieved or delivered by electronic transmission.” Because the service at issue in the ruling included access not only to information maintained in a database by the service provider, but also access to reference materials such as a dictionary or encyclopedia, the non-taxable information service was transformed into access to digital books.

Finally, the “pitfall” is, as the Department ruled, because the charge was for the combined service of access to the software as well as access to the databases and the digital books, the entire transaction was taxable. This was the case even though the transaction fit within the definition of a “bundled” transaction (i.e., the sale of two or more services for one price), and some of the services were not taxable.  The ruling is in line with the old New York “cheeseboard” rule* and the proverbial expression that “one rotten apple spoils the bunch.” The lesson for a cloud service provider is that it should itemize charges for separate services; otherwise it stands the risk of taxation of the entire transaction. This is so, even in the SSUTA states, which only provide for “unbundling” services (i.e., permitting the showing of the portion of a bundled transaction that is not taxable) where the services consist of a bundled transaction of “telecommunications services, ancillary services, Internet access services, or audio or video programming services.” Most cloud computer service providers do not provide such components as part of their service offerings and so itemizing the services they actually provide is a constructive way to limit the tax hit.

* Under 20 NYCRR § 527.1(b), “Taxable and exempt items sold as a single unit. When tangible personal property, composed of taxable and exempt items is sold as a single unit, the tax shall be collected on the total price.  Example: A vendor sells a package containing assorted cheeses, a cheese board and a knife for $15. He is required to collect tax on $15.”