Is It Raining In Pennsylvania: Sales Tax on Cloud Computing Services?

I recently wrote a blog post on the new Vermont law on sales tax on cloud computing services, in which the state placed a moratorium on taxation of software as a service (“SaaS”). Pennsylvania, however, has decided to take a different approach to cloud computing. In Legal Letter Ruling No. SUT-12-001 (May 31, 2012), the Pennsylvania Department of Revenue announced a change in the existing law in Pennsylvania. In particular, the Department’s new approach is that SaaS is taxable in Pennsylvania to the extent that the users of the services are located in Pennsylvania. The Department took the position that the charge for electronically accessing taxable software is taxable because computer software is tangible personal property, and the user “is exercising a license to use the software” within the meaning of 72 P.S. § 7201(o)(1). That section of the statute provides that the exercise or right or power incidental to the ownership of tangible personal property constitutes a taxable “use.”

But this recent ruling, and basis therefor, is inconsistent with the prior ruling of the Pennsylvania Department of Revenue, Legal Letter Ruling No. SUT-10-005, in which the Department held that access to software solely through the internet from a data center located outside of Pennsylvania is not taxable because there is not a taxable transfer in Pennsylvania. Nowhere does the Department of Revenue in its 2012 ruling explain the basis for its ruling that a taxable transfer of the tangible personal property has occurred in Pennsylvania, other than the reference to “recent case law and technological advances.” In the case the Department identifies, Dechart, LLP v. Commonwealth, 998 A.2d 575 (Pa. 2010), the court found that electronically transmitted software downloaded to a computer in Pennsylvania constitutes the sale of tangible personal property in Pennsylvania.

However, there is no tangible personal property that is present in Pennsylvania for software that is accessed remotely from a data center located outside of Pennsylvania. Thus, as I wrote in my article on cloud computing, Let the Sunshine In: The Age of Cloud Computing, State Tax Notes November 28, 2011, and as other states (such as Kansas, Utah and Arizona) have ruled, SaaS should not be taxable in Pennsylvania because the tangible personal property is not transferred in Pennsylvania.

Pennsylvania DOR Puts Constitutionally-Suspect Affiliate Nexus Interpretation on Hold

On January 27, 2012, the Pennsylvania Department of Revenue delayed until September 1, 2012 the enforcement of its recently announced (and legally questionable) position regarding affiliate nexus.

We have written frequently about state affiliate nexus statutes and proposed legislation, as well as the challenge brought by our client, the Performance Marketing Association (“PMA”), against the Illinois affiliate nexus statute which took effect in July 2011. All of these affiliate nexus laws are of doubtful constitutionality. Indeed, Brann & Isaacson has argued on behalf of the PMA that the Illinois law impermissibly targets Internet performance marketing as a basis for asserting a use tax collection obligation on out-of-state retailers, in violation of both the Commerce Clause of the United States Constitution and the federal Internet Tax Freedom Act (“ITFA”). In an area of law where the authority of the states to expand their taxing power is very much in doubt, every state that has adopted an affiliate nexus law has done so through the legislative process by enacting a statute that purports to require reporting of use tax by remote sellers with no physical presence in the state.

On December 1, however, the Pennsylvania Department of Revenue determined that it did not require a new affiliate nexus statute in order to require use tax collection by Internet sellers advertising online through websites located in Pennsylvania. Instead, the Department issued Sales and Use Tax Bulletin 2011-01, regarding Remote Seller Nexus. The Department asserts in the Bulletin that a variety of activities, if conducted in the state by, or on behalf of, an out-of-state company, already constitute sufficient nexus under the Commerce Clause and state law to require the remote seller to collect Pennsylvania use tax. Some of the activities cited by the Department have been the basis for a finding of nexus for an out-of-state company in prior court decisions around the country (and, presumably, have long been reflected in the Department’s enforcement practice). The Department, however, also included “affiliate nexus” on the list. The Department will now make a finding of nexus for an out-of-state company even if the company’s only activity is merely having a contractual relationship with a person located in Pennsylvania whose website has a link to the remote seller’s website, if the in-state affiliate receives “consideration” for the contractual relationship with the retailer.

Is Amnesty Really Amnesty?

States frequently announce amnesty programs. In return for settlement of back taxes, taxpayers obtain waiver of penalties and sometimes a reduction of interest. It has now become increasingly common, however, that states provide a stick to go along with the carrot of penalty waiver. Thus, Pennsylvania completed an amnesty period on June 18 in which it provided for waiver of penalties for payment of back taxes. The Governor of the Commonwealth, Ed Rendell, has announced that in the future, an additional 5% penalty will apply to all tax delinquencies that remained after June 18. In addition, he pointed out that the DOR will begin to seek to hold corporate officers personally accountable for taxes businesses owe and take other aggressive means to enforce the taxes.

Back in 2005, California announced a similar program, by which it increased the accuracy penalty from 20% to 40% and assessed an additional 50% “interest penalty” for all those taxpayers who did not apply for amnesty. Other states have followed a similar approach.

Is an offer of relief from liability coupled with a penalty for failure to take the offer really amnesty? Webster’s defines amnesty as a pardon from an authority. The consideration by the taxpayer for such pardon is the payment of back taxes. The sort of punitive measures, however, that some states impose for failure to acknowledge liability is not a pardon. Serious questions of taxpayer fairness are raised. Why should there be an additional penalty and in some cases threat of personal liability when a taxpayer has a legitimate dispute and chooses not to seek “amnesty”? The Due Process Clause of the U.S. Constitution is designed to provide every citizen their “day in court.” Imposing a penalty for the exercise of this due process right seems to be inconsistent with the basic principle of fair dealing that should be the very foundation of our tax system.

NEXUS: Quill Physical Presence Test Should Apply to Gross Receipts Taxes

Since National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967), was decided in 1967, states have attempted to avoid the physical presence test of nexus that the National Bellas Hess case established.  Thus, in the 1980’s, the Pennsylvania Department of Revenue argued that that our client, L. L. Bean, Inc., was required to collect Pennsylvania sales and use tax on all of its sales into the state because the mail order industry had changed since National Bellas Hess was decided.  The Pennsylvania Commonwealth Court squarely rejected this challenge to National Bellas Hess.  L. L. Bean, Inc. v. Department of Revenue, 516 A.2d 820 (Pa. Cmwlth. 1986).

Similarly, the State of California threatened assessment of 300 direct marketers on the ground that they had nexus with California because of their use of 1-800 numbers and acceptance of credit cards.  On behalf of the Direct Marketing Association, Brann & Isaacson sued in federal court, and the Ninth Circuit issued a judgment in favor of the DMA, on behalf of its members, declaring that in the absence of a physical presence in a state, a company is not liable for sales and use tax in that state.  DMA v. Bennett, 916 F.2d 1451 (9th Cir. 1990), cert. denied, 500 U.S. 905 (1991).

The states’ next test case, Quill v. North Dakota, 504 U.S. 298 (1992) (Brann & Isaacson filed an amicus curiae brief on behalf of the DMA in Quill), was yet another unsuccessful effort by the states to overrule and/or limit the physical presence test.

The states’ latest efforts to limit the nexus test under the Commerce Clause by adoption of an economic presence test to measure nexus for gross receipts tax should also be rejected.

New York Threatens to Discontinue Long-Standing Promotional Material Exemption

As a result of the U.S. Supreme Court’s decision in D. H. Holmes Co., Ltd. v. McNamara (486 U.S. 24 (1988)), a number of states began taxing promotional materials printed outside of the state and distributed within the state.  New York was one of those states until March 1, 1997.  At that time, New York enacted an amendment to New York Tax Law Section 1115(n) to exempt promotional materials distributed in the State.  The exemption has been broadly interpreted to include the finished product as well as mechanicals, layouts, artwork, photographs, and other pre-press services and materials, and also includes services relating to mailing lists.  In a search for revenue, New York now threatens to remove this exemption.  If passed, New York Assembly Bill - A.9710-B Budget Article VII – Part R would eliminate the exemption provided in Section 1115(n).

It is also reported that Pennsylvania is thinking of eliminating its exemption, too.  Other states, such as California, Michigan and Ohio, provide exemptions for promotional materials distributed in the state, and thus far have not sought to eliminate the exemptions.  In fact, I recently argued and won a case against the Board of Equalization at the California Court of Appeal, PeoplePC v. California BOE, in which the Court ruled that California’s printed sales message exemption applies not only to promotions printed on paper, but also to promotions printed on CDs.

As Matt Schaefer wrote in this blog last month, states have begun putting pressure on companies to collect use tax on promotional materials, even on sales to clients with no physical presence in such states.  Let’s hope that there is not also a trend to eliminate the exemption for printed sales messages where direct marketers are still protected.

What’s Next For Sales Tax (a/k/a Use Tax) On Direct Mail?

Direct marketers know that successful eCommerce strategies often depend upon reaching customers offline as well as online. Direct mail, including the distribution of catalogs, remains one of the most effective ways of driving traffic to a website. Indeed, given the reluctance of some consumers to give out their e-mail addresses, and the protections afforded consumers from unwanted solicitation under anti-SPAM, Do-Not-Call and other consumer privacy laws, traditional “snail mail” marketing techniques remain an important way for Internet sellers to communicate directly with customers.

Although several larger states (including California, New York, and Pennsylvania) provide exemptions from tax for certain types of direct mail, the vast majority of jurisdictions treat direct mail as taxable. And in all states, including those that provide exemptions, there are myriad other complex legal issues affecting taxability, including sourcing rules, taxability of postage, “direct mail” certificates, and nexus considerations, each of which make determining the proper sales tax treatment of direct mail transactions challenging. Add the fact that mailings go to recipients in many, if not all 50 states (and countless localities), each of which has its own tax law, and the difficulty of properly applying tax to any particular direct mail transaction multiplies exponentially.