Chicago is taxing some cloud services, an increasing trend in the US in recent years

Financially troubled and looking to raise funds to plug a swelling hole in the city’s budgets, Chicago recently extended its existing tax laws to levy a 9 per cent surcharge on cloud-based entertainment streaming services like Netflix and Spotify as well as certain software services hosted on cloud platforms in the city. But will the tax laws in Chicago – and elsewhere – soon be stretched to include other cloud services?

The tax law, an extension of existing laws, came from two separate rulings from the City’s Department of Finance. One covers “electronically delivered amusements”, which relates to music, TV and video streaming services like Netflix and Spotify, and another covering “nonpossessory computer leases,” which effectively includes rented storage and compute resources.

The law covering “electronically delivered amusements” doesn’t require those services to be hosted locally (only consumed locally), but the law relating to “nonpossessory computer leases” does, which means local cloud providers are due to collect 9 per cent on their transactions (the exception being when streaming data is in question / interaction with the “rented equipment” is minimal).

The reasoning for the legal reform is simple enough. Cloud is becoming the dominant means by which software and media are being delivered and consumed, and as a result web-based vendors are dominating brick-and-mortar outfits, with the city feeling the pressure from a loss of related sales and property tax revenue. Naturally, the city is looking to compensate that loss with more cash.

Some have suggested this sets a worrying precedent for the way cloud services could be taxed in the US going forward, but some legal experts believe it is not yet clear how the ruling will apply to a wide range of different kinds of cloud services in practice.

“It is likely that we will see more State and local government adopting a tax for certain services to compensate from the loss of revenue from other services that are not generating as much revenue as they did in the past,” Francoise Gilbert, managing director of the IT Law Group told BCN.

A number of US States have already determined they would tax such cloud services as a sale or license of software; information or data processing software; or a digital product or service.

New York, Colorado, Pennsylvania and Utah are all examples of States that have enacted rulings whereby remote access to software via the cloud is taxable if the software is used by in-State customer; Missouri and Tennessee also extend their tax laws to cloud services that are hosted out of State.

But some of those rulings have been challenged before, and a successful challenge can seemingly depend on how a state defines a cloud service and the level of the stack that offering sits in.

In April this year for instance the New York State Department of Taxation (which does tax some cloud services) released an advisory on a case where a company provided infrastructure-as-a-service to a business.  The Department found that the service provided by the cloud company is not taxable because it was used by one of the provider’s customers to run their own software application (advertising software).

“In purchasing an instance, a customer is provided with an operating system that is necessary for the instance to interact with Petitioner’s server network. The operating system represents prewritten software. The customer uses the operating system to perform certain administrative functions, such as to download an application, delete an application, or search for a file,” the advisory opinion reads.

“By granting the right to use the third-party operating system, Petitioner is transferring the right to use prewritten computer software within the meaning of § 526.7(e)(4) of the Sales Tax Regulations. However, a customer does not subscribe to Petitioner’s Cloud Computing product in order to use the operating system. Rather, it subscribes to the product in order to run an application of its choosing using Petitioner’s computing power. This makes Petitioner’s Cloud Computing product different from those products where the vendor’s transfer of the right to use prewritten software to the customer is what the customer primarily wants from the vendor.”

The opinion also concludes APIs do not constitute a taxable pre-written software good.

“It is not clear whether the Chicago tax decision will have an effect on cloud computing services in general.  For several years, States have examined the different categories of services and have opted, or not, to classify the service as taxable,” Gilbert explained.

But she reaffirmed that States will likely continue looking at cloud services for extra revenue, and that consumers shouldn’t write-off potential unintended consequences of taxing one class of cloud services or another – mainly, more taxation.