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Taxing Digital Goods and Services: The What, Where, and How


 Confusing cloud tax issues.

When we hear the word ‘cloud’ today, it could just as easily be referencing an interconnected network of computers as cumulus, stratus, or cirrus.

Cloud computing has revolutionized the transfer of goods and services. Back when clouds were only made of water droplets, people typically purchased goods by going to a store. Eventually, goods could be purchased by mail or phone order, and later still, over the internet. The process was much the same for the purchase of a service, such as the use of an attorney’s advice, and accountant’s accounting, or a hair stylist’s talented hands.

Thanks to the world of cloud computing, we can collaborate on a Google Drive document with a colleague on the opposite coast. We can watch movies and television shows on demand, share photos with friends and family through Dropbox, and access more songs than we have time to hear. We can even create a virtual world and purchase virtual goods with virtual money like Bitcoins.

Increasingly, individuals and businesses are discovering the advantages of using cloud-based services, like software as a service (SaaS). Calculating sales tax rates in multiple jurisdictions, managing exemption certificates, and having updated customer records on mobile devices are just some of the digital services available.

If this has led some folks to wonder where all the vinyl has gone, it has also caused state taxing authorities to wonder where some of the sales tax revenue has gone. The taxation of physically goods and services is not without its complexities (consider how candy is defined and taxed), but at least physical goods and services are known entities. Digital goods and services, on the other hand… exactly what are they? How can something so nebulous be taxed?

Under construction

The taxation of cloud-based goods and services is a work in process, both in the United States and abroad. Many states have yet to decide if digital goods and services should be subject to sales tax. Other states tax some and exempt others. And then there’s Massachusetts, which enacted a sales tax on cloud computing services and then repealed it 6 weeks later.

Businesses that sell cloud computing services and digital products tend to be relatively young and may have yet to face a state tax audit. The more these businesses come under scrutiny, the more tax issues will arise. According to Bloomberg BNA, sales tax will attract the initial attention. Income tax will undoubtedly follow.

What is that?

Cloud computing and digital product providers face a unique sales tax audit issue: their transactions are sometimes characterized as taxable telecommunications, sometimes as data processing, and sometimes as information service. How they’re characterized impacts which taxes apply to what transactions.

Where is that?

Determining “where a service is ‘delivered,’ benefited from,’ or ‘used’ also impacts sales tax. Yet time-honored practices often don’t work in the cloud. Is it appropriate to source a sale based on the location of the server when the buyer is located in another state? It may be. Then again, it may not.

How do mobile devices fit in?

If applying sales tax to digital services purchased from a computer based at home or a business is complicated enough, applying sales tax to digital services purchased from a mobile device takes it to a whole new level. When sales tax is imposed, it is typically imposed “at the location of the customer”—a practice called the destination regime (Bloomberg BNA).

“The legislative destination regime that we have today doesn’t work in a mobile environment,” says Stephen Kranz of McDermott Will & Emory LLP. “For example, if a person makes a cloud purchase remotely in Denver, but the billing address that the cloud provider has for the purchaser is in Washington, D.C., the District may collect the tax on the purchase even if that’s not what the law says should happen.”

Double dipping

Reporting on results of a survey on the taxation of cloud computing, Bloomberg notes that “the method by which most cloud computing providers source sales of cloud computing services for sales tax purposes varies by state or by the type of service provided.” The survey suggests that “inconsistencies in state law, coupled with the nomadic nature of many cloud and digital product services, provides the potential for more than one state to tax the same transaction for sales tax purposes.”

For example, a cloud service that relies on a server located in Texas to perform a task for customer in New York could trigger sales tax in both Texas and New York. Which state has the right to tax what? Where should the seller appeal?

A federal solution

Kranz believes federal legislation will be necessary to sort out the complexities of taxing digital goods and services. The Digital Goods and Services Act (S. 1364 / H.R. 3724) currently being considered, addresses sourcing rules and the impact of such a tax on state budgets, among other issues.

Don’t let the where, what and how get you down. Learn more about the taxation of digital goods and services.

photo credit: Jason A. Samfield via photopin cc


Sales tax rates, rules, and regulations change frequently. Although we hope you'll find this information helpful, this blog is for informational purposes only and does not provide legal or tax advice.
Gail Cole
Avalara Author
Gail Cole
Gail Cole
Avalara Author Gail Cole
Gail began researching and writing about sales tax in 2012 and has been fascinated with it ever since. She has a penchant for uncovering unusual tax facts, and endeavors to make complex sales tax laws more digestible for both experts and laypeople.