Cloud computing refers to a collection of tools and applications offered through the internet, accessed from anywhere, and provided through any one of three service models, including Software as a Service (“SaaS”), Platform as a Service (“PaaS”), and Infrastructure as a Service (“IaaS”). The treatment of cloud computing transactions for state and local sales and use tax purposes is wrought with uncertainty and inconsistencies, making it very difficult for multistate businesses to determine tax liability. While some trends exist among states in treating cloud computing transactions as either sales of software or sales of services, in most cases, since states are relying on old rules that fundamentally differ between states, complicated tax determinations oftentimes hinge on a deep understanding of the taxability of each separate element of a cloud computing transaction, such as the acquisition, delivery, transfer and ownership of tangible property, as well as the rights and obligations with respect to the various elements of the cloud computing offering.
Within Illinois specifically, while the state will not generally impose sales taxes on SAAS unless there is also a transfer of tangible property, and otherwise has little guidance, the City of Chicago (“the City”) imposes its Personal Property Lease Transaction Tax (“Transaction Tax”) – a tax frequently overlooked by unsuspecting taxpayers operating in the City – on cloud computing transactions. As background, the Transaction Tax was first introduced in 1974 under Section 3-32-030(A) of the Municipal Code of Chicago to tax both the lease or rental in Chicago of personal property as well as the privilege of using in the City personal property that is leased or rented outside the City. The tax is imposed on the lessee (or customer) and applies to both possessory and nonpossessory leases, as those terms are defined. The lease or rental of personal property is generally deemed to take place at the location where the lessee takes possession or delivery of the property.
In 2015, the City applied its then existing Transaction Tax to cloud computing services beginning January 1, 2016, and on June 9, 2015, the Chicago Department of Finance issued Ruling #12 to explain how the Transaction Tax applies to such modern technologies under its nonpossessory lease rules as well as the exemption for certain de minimis use and transfer of data. Generally, with respect to the rate of tax, the City applies two tax rates on certain cloud computing lease payments. First, a rate of 5.25% applies to cloud computing products and nonpossessory leases where the lessor’s (or provider’s) computer and software is primarily used for inputting, modifying, and retrieving data or information supplied by the lessee (or customer). If, however, the computer and software is primarily used for inputting, modifying, and retrieving data or information supplied by the lessor (or provider), a higher rate of 9% is applied. The storage of customer information, however, is not generally subject to the Transaction Tax.
For purposes of determining the location of the transaction, because the services and resources can be accessed from any location via the Internet, the City generally defines the location of a cloud computing lease as occurring where the user accesses the computer. If the user accesses from a mobile device, the City will rely on a credit card billing address or other reliable information that was used to purchase the cloud computing lease to determine the taxpayer’s primary residential or business location in Chicago. For those taxpayers with employees that utilize cloud computing inside and outside Chicago, the City also allows taxpayers to apportion the payment for the cloud computing lease. Therefore, the language provided in the guidance provides opportunities for proactive planning to decrease the applicability of the Transaction Tax as well as arguing against the application of the tax during the City’s audits.
Several relevant exemptions from the Transaction Tax are available either based on the volume of a taxpayer’s gross receipts, the status of the lessee/customer, or the use of the leased product. Most importantly, the Transaction Tax will not apply to small new businesses if three requirements are met: (1) the business holds a valid business license issued by the City or another jurisdiction; (2) the business has under $25 million in total federal gross receipts or sales for the most recent full calendar year; and (3) the business has been in operation for less than 60 months. To claim this exemption, a taxpayer must submit an “Application for Small New Business Exemption for Nonpossessory Computer Leases” to the City to request the exemption as either a lessor and/or as a lessee. Further, the Transaction Tax will not apply to transactions with lessees that are governmental bodies, charitable, educational, or religious organizations, or insurance companies. Finally, the Transaction Tax will not apply to the lease of products that are used for securities trading, accessing and managing financial accounts related to the movement of money or securities, or leases for re-lease.
With respect to registration and compliance obligations, lessee customers are ultimately liable for the Transaction Tax; however, lessor providers are required to collect and remit the Transaction Tax. Every lessor that maintains an office or principal place of business in the city or that is required to collect the tax must register with the comptroller within 30 days after establishing an office or principal place of business in the City or becoming subject to tax collection responsibilities. Compliance-related filings consist of monthly payments of tax due on or before the last day of each month, which are based on the previous month’s transaction activity. An annual return is required to be filed with the City each year on the 15th of August.
Lastly, for unwitting taxpayers, the City offers a Voluntary Disclosure Agreement (“VDA”) Program for those who are liable for the Transaction Tax and have not met their filing and payment obligations. The program encourages taxpayers to come forward voluntarily with outstanding tax liability before the City finds them to be noncompliant. In exchange, taxpayers benefit from the waiver of penalties, a lower 6% interest rate instead of a higher 12% interest rate, and a limited lookback period of four years instead of six years.
Because Chicago’s audit activity is increasing significantly in the cloud computing arena, taxpayers in this space must proactively determine if the City’s Transaction Tax applies to past or current transactions for which they may not be compliant. Furthermore, as state revenue departments search for ways to tax cloud computing transactions and impose outdated laws, it is imperative for taxpayers to understand the complexity of this area and to navigate it with assistance from their tax advisors.
If you have questions concerning the taxability of cloud computing in any of its related service models either in the City of Chicago or in another state or local jurisdiction, please contact any one of these members of FGMK LLC’s State and Local Tax (“SALT”) practice.
Matthew T. Fuller
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.