As shown in a recent Texas case involving a financial technology (FinTech) business, the rapid advance of online professional services is colliding with states that impose sales tax on cloud computing or data processing. With limited exceptions, states generally do not impose sales tax on most professional services; however, some states are casting their nets to tax online services that utilize computing in order to deliver otherwise nontaxable services. FinTech companies need to be aware that some states might say their services are taxable as a cloud based or data processing service.

The recent Texas appellate case, CheckFree Services v Texas Comptroller, although a victory for the FinTech company, illustrates Texas’ aggressive pursuit of an expanding definition of data processing services for purposes of sales taxation. That case involved CheckFree Services, a B2B bill paying service that sold its bill paying platform service to banks, in order to allow the bank’s customers to pay their bills online. The Texas Comptroller claimed that CheckFree’s service was taxable under the state’s tax on data processing service, because the customer input data (which bills to pay) and the service processed this information in order to execute the payment instructions. CheckFree paid the disputed sales tax, and sued for a refund in Texas state court.

The trial court looked to the true object of the transaction, and found that the essence of the transaction between CheckFree and the banks was to provide a non-taxable financial service, not a taxable data processing service. The Comptroller appealed, but the Court of Appeals affirmed, a victory for CheckFree.

But there is one major catch here that could result in further enforcement efforts by Texas against other FinTech companies. The Court emphasized the fact that CheckFree employed over 3,000 associates and professionals to facilitate the bill pay service. These associates and professionals managed the bill pay process at multiple stages of the process. The Court noted that these professionals were the “secret sauce” of CheckFree’s platform, thereby classifying its service as a tax-free professional service, not a taxable data processing service. Consequently, the Comptroller will likely look for another test case involving other FinTech companies that do not employ large numbers of employees as part of the service delivery process.

Some, but not all states impose sales tax on cloud computing or data processing – with Texas and New York leading the way. Of these states that tax cloud computing or data processing services, it is likely that a number of them will attempt to impose sales tax on FinTech companies. Even if a FinTech business is based in a nontaxable state, it might be required to collect sales tax in another state where it sells its service if the company has an adequate presence to establish nexus. Quite often, many companies have sufficient nexus for the imposition of tax without realizing it, either through traveling sales reps, independent affiliates who refer business to them, or by merely attending trade shows. Furthermore, even though a 1992 U.S. Supreme Court case requires a company to have some form of physical presence in a state in order to be subject to the state’s sales tax obligations, a few states, in an effort to get the Supreme Court to reverse that case, have adopted rules providing that a company has the required presence in the state merely by achieving customer sales in the state in excess of certain thresholds. Companies providing online services based in states that do not otherwise tax cloud computing or data processing should review potential sales tax exposure in other states as a result of having taxable nexus.