State tax policies need to be updated to better address new business models such as cloud computing, as well as a change that began long ago - the nation's shift toward a service-based economy, according to the just-published Bloomberg BNA's 14th Annual Survey of State Tax Departments.

Both of these trends have highlighted the types of transactions that can be subject to a state's tax. As the role of geographical boundaries continues to diminish as a factor in modern commerce, uncertainties appear to be multiplying for both states and businesses over basic issues such as which states are allowed to impose their corporate income tax on sales of services, intangibles or cloud-based transactions. The lack of uniformity in this area raises the likelihood that taxpayers will face unexpected results, according to the survey. In some cases, two or more states may end up taxing the same transaction, while in other cases the transaction may escape taxation by any state altogether.

Moreover, for many states it remains unclear how cloud-based transactions are characterized and taxed, even as the use of such services is growing in popularity.

"It is clear from the results of this year's survey that states are still trying to catch up to the digital economy of the 21st century, at least as it relates to their tax codes," said George Farrah, executive editor of Bloomberg BNA's Tax & Accounting division. "Moreover, the situation creates a great deal of uncertainty for corporations that cannot properly plan for the state tax impact of the cross-border services they provide."

The Bloomberg BNA Survey of State Tax Departments is aimed at clarifying each state's position on the gray areas of corporate income tax, sales and use tax, and nexus policies. This year's survey included new portions to address sales tax nexus for cloud computing and services.

"We focused mainly on income tax and sales tax nexus," said Steven Roll, assistant managing editor of state tax, who conducted the survey. "Every year we add new topics. This year, we added questions on state tax add-backs, and state tax treatment of mergers and acquisitions."



Nexus -- the minimum amount of contact between a taxpayer and a state, allowing the state to tax the business on its activities, arises from two clauses in the Constitution. The Commerce Clause prohibits a state from unduly burdening interstate commerce, and the Due Process Clause requires a minimum connection between a state and the entity it wishes to tax.

Public Law 86-272 further limits the states' power to impose income tax by prohibiting taxing businesses whose only activity in the state is the solicitation of orders, so long as the orders are accepted at and delivered from a point outside the state.

Despite these constitutional and federal nexus standards, states vary greatly in determining what particular activities performed within their borders might trigger income taxation, according to Roll.

Since state tax nexus can change from year to year as the result of administrative change, legislation or litigation, it can come as a surprise to even seasoned tax practitioners, observed Roll.

Much of the survey is focused on clarifying each state's position with respect to specific activities that could trigger corporate income tax or sales tax nexus, he indicated. "While it is fairly easy to track new legislation as states enact it, it is far more difficult to gauge how strictly each jurisdiction interprets and enforces those laws," Roll observed.

The sales tax policy portion of the survey asked about cloud computing, which has arisen as an issue in recent years for state tax departments analyzing sales tax nexus-creating activities. In the past, businesses would provide software purchases via tangible personal property, such as floppy disks or CD-ROMs, but as the Internet evolved, businesses began delivering software electronically, with purchasers downloading the software. With cloud computing, on the other hand, users access the software remotely without having to download anything.

Roll observed that the process creates the following issues over how to fit these services within the existing sales and use tax: Does the access to remote software reach a sufficient threshold to create nexus with the user's home state? And, are the services provided even taxable in the home state? "Because cloud computing is a relatively new innovation, many state's tax laws are lagging behind the technology," he said.

Three states -- Arizona, Hawaii and Utah -- said that nexus would result for an out-of-state corporation that charges fees to in-state customers for the right to access non-downloadable pre-written software that is hosted on a server in another state.

The states were more likely to find nexus when additional activities related to cloud computing were performed within their borders.

If employees entered the state to perform an initial set-up for resident customers, 19 jurisdictions said that they would find nexus. Slightly fewer -- 16 -- said that they would find nexus if an independent contractor provided training to in-state customers.



Among other findings, the survey found that holding a certificate of authority to conduct business will trigger sales tax nexus in 13 jurisdictions -- the District of Columbia, Florida, Georgia, Kansas, Kentucky, Michigan, Missouri, Nevada, New York, North Dakota, Ohio, Pennsylvania and Rhode Island.

Most states agreed that nexus would not result from making sales within their borders by means of an 800 telephone order number and advertising in the state. The states were divided on whether maintaining a post office box within their borders would create nexus.

Corporate income tax nexus is another matter. While the Supreme Court in Quill established a physical presence test for sales tax nexus, it left unanswered the question as to whether the physical presence test must be used for income tax nexus. As the survey notes, almost from the time of the 1992 decision, the results have been varied and contradictory.

Thirty-six states said they do not apply Quill for income tax nexus -- up from 35 last year and 34 in 2012, according to the survey.

Income tax nexus would result from owning a Web server in their jurisdictions, according to 38 states, the District of Columbia and New York City.

Thirty-two states said that providing access to software via the Internet to in-state customers and hiring independent contractors to perform set-up or configuration services within their jurisdiction is sufficient to create income tax nexus. And 16 jurisdictions said that nexus would result for cloud-based service providers that have no physical presence in the state, but have a substantial number of customers with billing addresses in the state or earned a substantial amount of revenue from customers in the state.

Foreign companies are typically not subject to U.S. taxes on business income from the U.S. unless they have a permanent establishment here, as defined by treaty. However, most states adhere to an economic nexus rationale for income taxes, which does not require a physical presence, Roll observed. As a result, a non-U.S. company could achieve nexus with a state even if it lacked a permanent establishment. "Only 22 jurisdictions said they rely on permanent establishment criteria for purposes of making income tax nexus determinations," he said.

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