States are competing aggressively to attract data centers with various tax incentives. Data center companies and their business customers are taking them up on their offers. But are these incentives really a good deal for the businesses? Tax incentives that seem attractive at first glance may not be beneficial when they are examined in the context of the entire tax picture, especially in the unique, uncertain, and developing world of state taxation of technology and computer services.
With the rise of global commerce, cloud computing, streaming video and a wide array of other internet-related businesses, data centers have become big businesses. In 2014, the colocation data center industry reached $25 billion in annual revenue globally, with North American companies accounting for 43 percent of that revenue.
To get in on the action, states have been trying to outdo one another by offering a slew of competing tax breaks to the industry. According to the Associated Press, states have provided about $1.5 billion in data center tax breaks over the past 10 years. Some states have gone even further, providing tax incentives to the entire data center industry through changes in the tax laws themselves. Such incentives can include reductions or exemptions from sales and use taxes on data center products or services, favorable income tax rates for data center companies and favorable property tax rules for data center assets. According to a recent analysis by the Associated Press, at least 23 states provide such statutory data center tax incentives. Just a few of the most recent examples include a sales tax exemption for data center equipment in Michigan, a broadening of the sales tax exemption for data center electricity and equipment in North Carolina and a favorable apportionment formula for data centers in Virginia. Importantly, many of these incentives apply not only to the data centers themselves, but also to their customers.
Businesses considering whether to take advantage of these incentives would be well advised to consider not only the potential benefit from any particular tax incentive, but also whether the decision would affect their tax picture as a whole. Because of the current uncertain and changing landscape for state and local taxation of technology and computer services, the analysis of these incentives for data centers and their customers can be particularly complex.
One item that a taxpayer might overlook when considering whether to take advantage of an incentive program is what affect, if any, the choice of location might have on the taxpayer’s property factor for income tax apportionment purposes. Obviously, location of a company’s technology equipment in a data center under a colocation agreement will cause the company’s in-state property factor to increase due to its equipment being located in the state. However, data center customers also should be aware that local tax authorities might also argue that the colocation payments themselves constitute consideration for the use of real or tangible personal property and thus the customer’s in-state property factor should be further increased by the amount of those charges. Our Firm has seen the tax authority in one state argue this precise issue.
Therefore, although a data center customer might pay less in sales tax by choosing a data center in a state that provides certain incentives, the customer should also carefully evaluate any potential increase in tax due to colocation in a state, such as a potential increase of their income tax liability due to higher apportionment from the property factor.
Another consideration that data center customers should keep in mind is the sourcing of receipts. For tax purposes, most states source the sale of technology products based on the location of the user, which usually will be the location of the customer’s employees. However, where a vendor provides a product by way of a server, at least one state tax authority has determined that such receipts should be sourced to the location of the server. These contrasting source rules present the risk that a business will essentially be subject to “double tax” on its purchase of technology services. Where IT-sourcing rules are not codified or their interpretation is uncertain, businesses should be cognizant of the risk of other tax authorities adopting this position, especially in light of the growth in services provided by data centers.
These issues demonstrate that although data centers and their customers stand to reap significant benefits from the wide array of state tax incentives available, any decision should include an analysis of the overall tax picture. Even the most attractive tax break may be outweighed by potential increases in other taxes.