The term “cloud computing” is broad enough to cover a vast array of transactions, all of which use the Internet in some fashion. Two of the most prevalent forms of cloud computing are “software as a service” (SaaS) and “infrastructure as a service” (IaaS). SaaS refers to transactions where software is accessed by a customer remotely over the Internet. The customer does not receive a copy of the software, and the software does not reside on the customer’s hardware. Rather, the customer gains access to the software typically by using its own Internet browser. IaaS refers to transactions where a customer remotely accesses hardware over the Internet. The customer never takes physical possession of the hardware. Rather, the customer accesses the service provider's hardware instead of purchasing and maintaining its own hardware.
In 2008, the New York State Department of Taxation and Finance (Tax Department) announced that SaaS transactions are taxable under the state’s sales and use tax law. Under New York’s Tax Law, software is considered to be “tangible personal property.” The Tax Law essentially creates the legal fiction that something that has virtually no physical properties qualifies as tangible property. According to the Tax Department, remotely accessed software constitutes a license to use tangible personal property because the customer obtains constructive possession of the software Licenses to use tangible personal property are taxable under New York’s sales and use tax.
Given this history, it was somewhat shocking to read that the Tax Department recently concluded that IaaS transactions are not subject to the state’s sales tax. Yet such is the Tax Department’s conclusion in an advisory opinion that was issued in April. According to the Tax Department, remotely accessed hardware (which clearly qualifies as tangible personal property) is not taxable, while remotely accessed software (which for all intents and purposes has no tangible properties and only qualifies as tangible personal property because of a legal fiction written into the law) is subject to tax. These counterintuitive results simply make no sense. Under the law, both the hardware of the IaaS transactions and the software of the SaaS transactions qualify as “tangible personal property.” In other words, in the eyes of the law, these two transactions are identical. They both deal with tangible personal property that is remotely accessed via the Internet. Because the transactions are identical under New York’s State’s sales and use tax law, either both IaaS and SaaS transactions should be taxable or both should be nontaxable. So what’s the right approach?
Ironically, the Tax Department itself provides a clue to the answer in its recent advisory opinion. The most striking aspect of this opinion is actually what it's missing. The opinion never analyzes the IaaS transaction as a license to use hardware (i.e., tangible personal property). Rather, the opinion baldly concludes that “[b]ecause providing a customer with computing power is not one of the services made taxable by the Tax Law, [the vendor] need not collect sales tax on its Cloud Computing product.” The Tax Department’s lack of analysis and conclusory statements speak volumes. Had the Tax Department analyzed the IaaS transaction as a traditional “license to use” hardware, it would have had to reference various authority that would contradict its holding that SaaS transactions are taxable. For example, one of the regulations construing taxable licenses contains the following example:
Example 14: A corporation contracts with a computer center for access time on the computer center's equipment through the use of a terminal located in the corporation's office. The terminal is connected to the computer by telephone. The corporation's access to the computer through the terminal is not deemed to be a transfer of possession of the computer subject to tax...
There is no way that the Tax Department could have analyzed the IaaS transaction as a license to use tangible personal property yet not cited this regulation and example. But if this example makes clear that IaaS transactions are not taxable under the Tax Law because possession is not transferred, why should SaaS transactions be any different? After all, both transactions represent the remote use of tangible personal property. And customers engage in the exact same activity in both situations – customers sit at their computers typing on keyboards and clicking their mouses to get either the software or the hardware to perform some function. Since 2008, the Tax Department has issued numerous advisory opinions that conclude that SaaS transactions are subject to tax, yet none of them have cited or otherwise addressed this example. Moreover, the Tax Department has also ignored, seemingly purposefully, the numerous cases that demonstrate that a customer must have an exclusive right to control property in order for a taxable license to exist. These cases all deal with traditional tangible property (jukeboxes, lockers, airport luggage carts, etc.). And they would seemingly be applicable to an analysis of hardware licenses. Yet they are omitted from the discussion and replaced with a conclusory statement that “computing power is not one of the services made taxable by the Tax Law.” As if computing power is somehow distinct from the constituent hardware items that create it.
Simply put, the Tax Department could never tax IaaS under the existing statutory and regulatory provisions. Example 14 from the sales tax regulation discussed above clearly demonstrates that remotely accessed hardware is not taxable. So, the Tax Department got at least half of the “cloud computing” story right. Since it can’t tax IaaS transactions, the Tax Department decided to simply omit a detailed discussion of tangible personal property licenses because such a discussion would invalidate its position regarding the taxability of SaaS transactions. But this inconsistency can’t last forever. Sooner or later, the Tax Department is either going to have to face the authority it has thus far ignored or lobby to amend the Tax Law/redraft its regulations.