The Tennessee Department of Revenue recently released Letter Ruling No. 14-05, in which it considered whether certain cloud collaboration services are subject to the state’s sales tax.  At a high level, the provider’s services are provided in a typical Software as a Service (SaaS) form:  (1) the provider owns the hardware and software used to provide the services; (2) the software is installed on the provider’s servers; (3) the provider’s employees monitor and maintain the hardware and software; (4) the provider charges a customer a monthly user fee; and (5) customers remotely access the software (i.e., no software is ever downloaded by a customer).  Of additional note, the provider does not license any of its software to the customers.

As the Tennessee Department has done in the past, it correctly determined that the SaaS arrangement does not constitute a retail sale of computer software because the provider “does not transfer title, possession, or control of any tangible personal property or software to a customer.”  Instead, the provider “ultimately uses and consumes both hardware and software as a means of providing its services.”

However, the Tennessee Department found that the cloud collaboration services are subject to the state’s sales tax as telecommunications services or ancillary services to telecommunications.  The cloud collaboration services instruct a customer’s telecommunications equipment as to how to process and route calls, “augment[ing] a customer’s voice, video, messaging, presence, audio/web conferencing, and mobile capabilities.”  As such, Letter Ruling No. 14-05 highlights a major concern for SaaS providers:  that their services will be considered taxable telecommunications or ancillary services.  While the cloud collaboration services are perhaps more clearly telecommunications or ancillary services than others, many SaaS offerings include an element of telecommunications by the very nature of remotely accessed software.

Fortunately, there are strong arguments in many states for most SaaS offerings to be excluded from the definition of telecommunications or ancillary services.  Streamlined Sales and Use Tax Agreement (SSUTA) member states (Tennessee is an associate member) are required to exclude “data processing and information services that allow data to be generated, acquired, stored, processed, or retrieved and delivered by an electronic transmission to a purchaser where such purchaser’s primary purpose for the underlying transaction is the processed data or information” from the definition of “telecommunications services.”  Therefore, where a provider can demonstrate that the true object of its offering is data processing or information services—and that any telecommunications services are merely incidental to those services—the offering should not constitute taxable telecommunications services.  In fact, demonstrating that the telecommunications component of any SaaS offering is merely incidental to the true object of the service should be effective in almost all states, SSUTA members or not.  Therefore, to adequately defend against the concern that a SaaS offering will be considered taxable telecommunications or ancillary services, providers should ensure that the true object of their offering is apparent and that it is clear that any telecommunications component is provided solely to facilitate that true object.