A new ruling by the City of Chicago, the Personal Property Lease Transaction Tax Ruling #12 (June 9, 2015), takes a broad view of how its whopping 9 percent tax applies to cloud-based services. Providers of information services, software as a service (SaaS), platform as a service (PaaS), and some forms of infrastructure as a service (IaaS) that have nexus with the City must carefully consider whether they should be collecting tax on sales to Chicago customers or challenging the applicability of the tax. Companies with locations in the City are liable for the tax if their providers do not collect it and should begin self-assessing tax in those instances unless they plan to challenge the tax.
Background: Chicago Expansively Interprets the Lease Transaction Tax
The Chicago Lease Transaction Tax—a home rule municipal tax on the leasing of tangible personal property in the City or the use of leased property in the City—is an artifact of the unusual way that the Illinois state sales and use tax system treats leases. Where most states treat a lessee as the end-user subject to tax on lease payments, the Illinois sales and use tax system treats the lessor as the end-user subject to tax on the purchase price. The lease stream is not subject to state-level tax, but the City has imposed a municipal-level 9 percent tax on the lease payments. Property leased in Chicago is thus first subjected to the 6.25 percent-or-more state level tax on the lessor’s purchase price, and then the 9 percent City tax on the lease payments.
As a home rule tax, Chicago administers and enforces the lease transaction tax, and the City has taken an extremely broad view of what can be considered the leasing of tangible personal property in an obvious attempt to increase its coffers. The City has proclaimed that everything from mail box services to advertising in taxis is actually a lease of tangible personal property that is subject to the tax. In terms of computer and online services, the lease transaction tax originally was applied to “time-sharing” on computers and has since been stretched to encompass a use of one’s own personal computer to access sites with search engines. See Personal Property Lease Transaction Tax Amended Ruling #5 (rev. August 6, 2013, original eff. February 1, 1987); see also Personal Property Lease Transaction Tax #9 (June 1, 2004, original eff. September 28, 1992). The tax ordinance itself now specifies the taxation of “nonpossessory computer leases” and requires sourcing of such transactions to the location of the user’s own computer or access terminal rather than the location of the actual computer and software that is deemed to be leased. See Chi. Mun. Code § 3-32-020.I.
Ruling #12 Classifies Most Cloud-Based Services as Taxable
The new ruling includes the City’s interpretation of a critical exemption from this lease transaction tax where the transaction meets two requirements. First, “the customer’s use or control of the provider’s computer” must be “de minimis.” Second, the “the related charge” must be “predominantly for information transferred to the customer rather than for the customer’s use or control of the computer.” See Chi. Mun. Code § 3-32-050.A.11. The exemption provisions also include as an example, “the nonpossessory lease of a computer to receive either current price quotations or other information having a fleeting or transitory character.”
Communications from personal computers to computers, servers, and other remote devices (collectively, “computers”) can be considered leases under the City’s definition of a “nonpossessory computer lease” as the use of “the computer and its software to input, modify or retrieve data or information” without any human intervention. See Chi. Mun. Code § 3-32-020.I. However, information services and software services, particularly when accessed through a web browser interface, are typically used for the information transferred, and generally do not give the end-user significant control over the remote computer being accessed. The plain language of the ordinance supports treating these types of transactions as exempt. Taxpayers have been claiming the benefit of this exemption, but the City has seen things differently and has continued to assess the tax.
The City’s new ruling, unfortunately, hamstrings the exemption by taking a broad interpretation of what constitutes “control” and a narrow view of when the object of a transaction is “information.” As a result, “[a]s a general rule, a subscription to an interactive web site will be subject to the lease tax, and will not be exempt....”
With respect to control, the City’s focus is on the ability to conduct searches. It contrasts a one-way, non-searchable stock market ticker feed with a searchable legal database and concludes that website or service that allows users to search and interact with information will generally be treated as offering a user more than de minimis control, thereby not qualifying for the exemption.
With respect to the object of the transaction being information, the City’s ruling looks to whether the transaction involves proprietary information. Proprietary information, particularly if similar to tangible antecedents (books, newspapers, etc.), can qualify for the exemption, even if there is a search component. On the other hand, public information (e.g., legal cases), is not deemed to have value, thus making databases of public information more likely to be subject to tax. This distinction is nonsensical because the charge for the customer’s use may still be predominantly for the information transferred in those instances. The search is simply a means of finding the right information, which may not be easy to acquire even if it is public, and the costs associated with search functionality are typically minimal in relation to the company’s costs of compiling the information.
The City categorically excludes “entertainment materials” (copyrighted books, music and films) from the lease transaction tax in the ruling. Instead it is imposing the City’s amusement tax, which is also imposed at 9 percent. See Amusement Tax Ruling #5 (June 9, 2015). There is no apparent technical basis for distinguishing the access of computers hosting entertainment information from the access of computers holding information for purposes other than entertainment.
Ruling #12 also provides guidance about sourcing the lease transaction tax. While the City has been very aggressive about taxability, it generally has been more reasonable on sourcing issues. Ruling #12 provides that the City is going to apply the principles for mobile telecom sourcing, generally applying the tax to Chicago residents and companies with primary business addresses in the City. Customers can provide evidence of complete or partial out-of-city use. If a provider has no information indicating Chicago use, it has no duty to collect tax.
While much of the City’s audit attention has focused on providers of services that it believes are subject to tax, users are also liable for lease transaction tax and must self-assess and remit if not collected by the provider. See Chi. Mun. Code § 3-32-080.B. Many providers do not have nexus and thus have no obligation to collect tax. As Chicago-based businesses increasingly rely on cloud-based services, they need to evaluate whether their purchases are subject to lease transaction tax even if not collected by providers.
Ruling #12 is effective July 1, 2015, although it provides that the effect of the ruling is to begin September 1, 2015. Unfortunately, the delayed effective date “does not release or otherwise affect the liability of any business that failed to comply with existing law before the effective date of the ruling.” As much of Ruling #12 appears to be the publication of the City’s preexisting interpretations of the lease transaction tax, the prospective date likely will be of little assistance to companies facing audits.
The City’s extension of the lease transaction tax to the deemed use of out-of-state computer hardware and software is troubling and vulnerable to attack. Much like state departments of revenue that have taken similar positions under their sales taxes, it is questionable whether Chicago can impose tax on the deemed use of hardware and software physically located outside of its jurisdiction, particularly when the control over the hardware and software is so attenuated. Moreover, the tax can be challenged on the grounds that such an imposition of tax exceeds the City’s home rule powers, violates the Uniformity Clause of the Illinois Constitution, the Internet Tax Freedom Act, and the Commerce Clause of the United States Constitution. The only published case involving a challenge to the lease transaction tax on computers access, Meites v. City of Chicago, 540 N.E. 2d 973 (Ill. App. 1989), was a putative class action that did not survive a motion to dismiss and thus was not fully litigated. The Meites case also does not reflect the technology changes of the past 30 years. It dates back to when central terminals and computer sharing were the norm and the internet barely existed.
As cloud-based services become increasingly important to the modern economy, the 9 percent lease transaction tax will be a considerable burden on Chicago businesses. The City’s aggressive enforcement of the tax means that a challenge to the tax by a taxpayer or a coalition of taxpayers is imminent.