Taxing the internet of things (IoT)
IoT to transform whole industries and raise big tax questions
The growth of the Internet of Things (IoT) is staggering. According to industry estimates, $6 trillion will be spent to connect 24 billion IoT devices to the internet by 2020. IoT is predicted to be the largest device market in the world by 2019 — more than double the size of the smartphone, PC, tablet, connected healthcare, and wearable markets combined.
Far from a consumer-only technology revolution, IoT stands to transform the very nature of numerous industries ranging from agriculture to manufacturing to transportation to oil and gas ... to name just a few. Farmers are using connected devices to meet food demands, manufacturers to unlock operational efficiency, and fleet managers to monitor everything from carbon emissions to driver fatigue. There are smart homes, smart buildings, smart cars, smart factories, smart surgical equipment, and smart energy grids. Every day seems to bring a new IoT innovation; each month another provider promises to help change the world by tying more things to the internet.
But as more “dumb” objects become “smart” by way of the internet, the question of taxation stands as a roadblock threatening to halt the progress of unprepared providers. The reason: IoT is opening another door — the one that has lawmakers and regulators evaluating when new services, software solutions, and hardware models become subject to communications taxes and federal regulations. Yet many companies investing in IoT solutions remain unaware that creating those connections can completely change the taxes they’re liable for and regulations they’re subject to. Such oversights have the potential to turn profitable revenue streams into costly headaches due to increased risks of penalties, fees, and audits.
In this whitepaper, we address core components of the communications tax implications of IoT, including the need-to-know basics of:
- The definition and breadth of the IoT industry
- How IoT fits into current tax legislation
- Determining IoT taxability — a quick potential test
- Managing growing complexity through automation
Tax authorities are taking note of IoT growth
With so many companies entering the IoT market, America’s governing bodies are starting to take note. When internet connectivity comes built into a device, the possibility that services, software, or hardware (or all three) will trigger communications tax liabilities increases exponentially. These types of taxes are among America’s most complex, yet many manufacturers and retailers remain unaware that selling IoT devices means they may be obligated to understand and comply with them.
The problem is magnified by the fact that so many governing and regulatory bodies are struggling to catch up with IoT technology as it advances at a rapid pace. As a result, communications tax laws change frequently — meaning a product or service that had never before been subject to communications taxes may suddenly fall within the realm of federal and state regulations.
This can make for major challenges as growing companies attempt to master communications tax compliance. The big question on everyone’s mind is: When does an IoT offering become subject to communications taxes and regulatory oversight? In many ways, the answer could depend on the very definition of IoT.
Defining the Internet of Things impacts taxation
Webopedia defines the Internet of Things as “The ever- growing network of physical objects that feature an IP address for internet connectivity, and the communication that occurs between these objects and other internet- enabled devices and systems.”
If that sounds familiar, it’s because the concept of IoT has been a part of the communications industry for a while in the form of “machine-to-machine” communications. While there’s been some debate on the differences between M2M and IoT, the two models share many similarities.
At its core, IoT is about transforming traditional products into devices that connect their users to the world around them. For many sellers, the move to IoT involves a fundamental shift from selling products alone to selling both products and services — communications services,to be exact. And if it’s determined under audit that an increasing amount of a company’s revenue is coming from communications services, attention then turns to the “internet” component of IoT to determine if, when, and how a device is subject to communications tax. For that, there’s the Internet Tax Freedom Act.
The Internet Tax Freedom Act and ISP tax moratorium
Since 1998, taxing internet access has been prohibited under the Internet Tax Freedom Act (ITFA). To keep this internet service provider (ISP) moratorium in place, Congress had to extend it. And extend it again. And so a series of extensions started in 2001 and ended in 2015, when the moratorium become permanent under the Trade Facilitation and Trade Enforcement Act. The new legislation established a firm cease date of June 30, 2020, to eliminate a grandfather provision for a handful of states that were still imposing taxes on internet access.
The move was intended to keep internet access from becoming overly expensive for consumers, and to make it easier for providers to expand to rural areas. However, it would be an oversight to assume this law broadly applies to any device with a connection. A key requirement of the moratorium is that the service and the seller have to meet narrow definitions to qualify.
Determining communications tax
When it comes to communications taxes, it pays to sweat the small details — particularly with a complex and evolving industry like IoT, where so many applications are being used to connect things and transmit data. The reason: The “I” in IoT is often a bit of a misnomer. Many prominent IoT products rely on a bring-your-own-internet (BYOI) model where the customers’ existing connections are used to transmit data from one device to another. With the permanent moratorium on internet taxation, these types of devices are often a non-issue from a communications tax perspective.
But there are an increasing number of instances where BYOI is not being leveraged. In these instances, companies will need to determine when a connection qualifies for the legal definition of internet access:
If the answer is “yes,” there’s most likely a component to the IoT device that enables a human to connect to the world wide web for activities such as browsing, streaming, or launching apps — no retail communications taxes will apply in this case.
If the answer is “no,” and a machine is simply using the connection to transmit data, there’s a good chance the connection will not fit the definition of ISP service — and hence may be subject to communications taxes.
While it’s often easy to assume that a connected device won’t be subject to taxes or regulatory fees, there are many instances where state communications taxes and federal regulations do come into play.
Let's consider three examples in the form of a simple communications taxability test:
Example 1: Smart thermostats
Many “smart” thermostats, which allow users to adjust temperatures remotely, commonly use home or business Wi-Fi to communicate with a smartphone. There’s no additional web functionality and no web browsing associated with the thermostat itself. A private internet connection is used to power the device, which means communications taxes won’t apply to the IoT device on its own. Even if the user is in a grandfathered state where internet access is still being taxed before 2020, those taxes are between the consumer and their ISP — not the thermostat manufacturer or retailer.
- Is it BYOI? Yes
- Can internet access be used for surfing the web? Yes — just not on the thermostat
- Is it taxable? Not likely
Smart buildings stand to be filled with similar BYOI instances, from the connections used to power parking lot sensors to the ones that help smart refrigerators determine when the company kitchen is running low.
Example 2: Agriculture sensors
On farms, where IoT sensors are leveraged to provide real- time data on topography, temperatures, soil conditions, animal health, climate forecasts, weather patterns, and more, it’s a different story. Because they’re out in the field, these systems often rely on air cards to transmit data wirelessly using cellular connections of their own. Even though the data may be transmitted using Internet Protocol (IP), there is no access to the worldwide web and the argument could be made that ITFA will not apply. Providers of these devices could be looking at some significant communications taxes and regulatory implications.
- Is it BYOI? No
- Is internet access solely machine-based? Yes
- Is it taxable? Very likely
The same logic is likely to apply to similar innovations used to increase the efficiency of industrial equipment, monitor power grids, and more.
Example 3: Trucking monitors
In the over-the-road trucking industry, semitrucks are often equipped with connected devices that allow companies to keep tabs on matters such as fuel efficiency, location, and overall maintenance. Many of these devices are used solely to communicate data from the truck, which means communications taxes may enter the equation. But what happens when those same devices are used to power consoles in the cab and used to stream music or surf the web?
When the device is being used to transmit private data from one machine to another, it might be assumed that communications taxes and regulations will apply. But allow a driver to start using that same device to access the public internet, and an argument could be made that the connection now qualifies for exemption under ITFA. Depending on how it’s being used and which taxing jurisdictions are involved, the system might be taxable ... or it might not.
- Is it BYOI? Maybe
- Can internet access be used for other functions? Sometimes
- Is it taxable? Possibly
The same taxability test could be applied in a variety of IoT uses, from first responder tablets to retail software and devices.
Once an IoT device is determined to be taxable, the complicated matter of nexus also comes into play. Determining a seller’s responsibilities to a state can be an incredibly complex process for mobile IoT devices when there are little more than digital signals, rather thansomething static like an office location, to track. Such products and services may put a company in contact with tax authorities and regulatory bodies in multiple states, each with its own set of rules and rates.
Without a dedicated research team, accurately determining and calculating communications taxes and fees is incredibly difficult, if not impossible.
Communications tax automation
As companies across industries are realizing the revenue that can be made in connecting platforms, products, and processes to the internet, the question of taxability is paramount. IoT complexity continues to increase, and so will the questions around which solutions are subject to communications taxes and who’s responsible for remittance and compliance.
Remaining compliant requires staying up to date on the latest tax law developments and definitions with each new offering and innovation. As federal, state, and local jurisdictions work to align tax laws with new communications technologies, companies must remain vigilant.
The secret to ensuring communications tax accuracy lies in automation and expertise. Having a dedicated specialist in your corner ensures that someone is always monitoring complex communications taxes and updating your compliance processes along with each and every change to tax laws and regulations.
How Avalara can help
AvaTax for Communications is designed specifically for companies that need to easily and reliably meet ever-changing communications tax requirements and regulations. With built-in categories to account for various federal, state, and other communications tax implications of IoT, this tax automation system greatly simplifies the tax determination and calculation process by managing the tedious, time-consuming tasks associated with filing and remittance.
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