On June 30, 2013, the Vermont sales tax moratorium on remote access to software expired.  At that time, the Vermont Department of Taxes (Department) reverted to its prior position that interpreted, without any analysis, the Vermont sales tax to apply to prewritten software that was “licensed for use and available from a remote server.”  Recently, the Department released draft regulatory language relating to the taxation of remotely accessed software and is currently seeking comments on the draft (due by October 1, 2014).

The draft regulations provide a great deal of guidance, some good and some bad.  On the positive side, the regulations recognize that a sale cannot occur unless “use or control [is] given [to] the purchaser with respect to the software” such that “the purchaser is able to use the software to independently perform tasks.”  This language comports with established legal authorities in the state regarding when sales occur, rather than simply stating that a sale has occurred when software is remotely accessed.  See, e.g., In re Merrill Theatre Corp., 415 A.2d 1327 (Vt. 1980) (finding no sale where “[the patron] never comes into possession of [the tangible property], and exerts no control over it” because the vendor was the one with “actual possession” of the property).

The draft regulations also contain a non-exhaustive list of nontaxable transactions, which provide much needed clarity in the area of cloud computing.  These include:  (1) a transaction whose true object is the purchase of a service (to which any transfer of software is merely incidental), (2) sales of data processing and information services, (3) a transaction where the seller processes the purchaser’s data on the seller’s software and (4) a transaction where the customer runs its own software on the seller’s hardware in a cloud computing environment (such arrangements are commonly referred to as Infrastructure as a Service (IaaS), and the draft regulations refer to them as such).  This list is particularly helpful and positive because it recognizes:  (1) the importance of the true object test in determining taxability rather than simply relying on licensing or other language in a contract, (2) that many cloud computing transactions are properly characterized as data processing services performed by the vendor rather than the transfer of software and (3) that IaaS is different in nature than Software as a Service (SaaS) and should be analyzed differently.  The IaaS discussion is particularly significant as many states have not directly addressed the subject.

The draft regulations are less successful when they attempt to provide factors for determining whether a taxable transfer of software has occurred.  These factors include whether:  (1) “[t]he purchaser can use the prewritten software with little or no intervention by the seller other than ‘help desk’ assistance;” and (2) “[t]he purchaser can use an organizational tool or function that is a function of seller’s software.”  The proposed factors are troublesome because of the lack of clarity regarding what it means to “use” the software or the functions of the software, which could subject the regulation to the argument that taxable “use” is indicated by mere “access.”  Although the use factors are to be considered “subject to” the list of nontaxable transactions, the Department would be well advised to provide further clarification on what it means to “use” software or its functions.

Finally, the draft regulations provide examples of taxable and nontaxable transactions involving remote access to software.  These examples provide insight into the thinking of the Department but could be developed further.  Perhaps in recognition of the fact that many cloud computing transactions involve data processing services, one example provides that there is no taxable sale where a purchaser provides information to a seller via the seller’s website, after which the seller processes the information.  On the other hand, another example provides that there is a taxable sale when a purchaser enters the information directly into a seller’s software and instructs the software to process the information “without assistance from Seller, except for occasional trouble-shooting and upgrades to the software.”  As a practical matter, it is difficult to differentiate between the two examples.  How does one determine when a purchaser rather than a seller is providing software instruction?  The Department should provide further guidance here.

Practice Note:  We encourage cloud computing vendors and purchasers to submit comments on the draft regulations to the Department.  Even if you do not have a connection to Vermont, the question of the taxability of cloud computing transactions is of nationwide importance.  As states begin to tackle this question, they surely will consider the more developed approaches of other states, making it all-important for interested parties to make their thoughts known whenever and wherever possible.