Vermont Software Firms: Taxing the Cloud Has No Silver Lining

When David Borgendale’s company got slapped with a six-figure tax bill last year, he wasn’t just surprised, he felt blindsided.

Borgendale is the chief financial and technical officer for Inntopia [1], a software company based in Stowe that provides online reservation tools for travel agents, ski resorts and innkeepers. Last year, he received a letter from the state saying he owed taxes going back four years on his company’s cloud-based software.

For over a year, the Vermont Department of Taxes has been auditing local businesses such as Inntopia that use and sell cloud-based services. The practice has sparked a debate over if and how the technology should be taxed. At least six companies are contesting the back taxes through formal appeals.

Cloud computing includes any activity that uses software stored on a faraway server instead of downloading the program onto a personal computer — everything from email to social networking and financial services.

The tax department says cloud computing should be subject to the sales and use tax, just as software purchased in a store or downloaded online is. The reason? As more customers and companies migrate to the cloud, a cash-strapped state is losing out on potential revenue. The department estimates that a sales tax on cloud computing could tally $3.6 million in taxes for purchases made between 2006 and 2013.

Susan Mesner, a research economist in the state tax department, likens the dilemma to the growth of online book sales: as customers purchase from Amazon instead of local bookstores, the state tax base erodes.

“There is this tremendous growth [in cloud computing], and the growth is forecasted to accelerate,” says Mesner. “As we become more dependent on these electronic functions, our sales tax isn’t able to keep pace.”

The policy change came as a surprise to many local tech companies that rely on or provide cloud services.

“We were never told about this issue,” says John Canning, chairman of the Vermont Software Developers’ Alliance [2], whose members gathered last week to share concerns about the tax.

Frank Cioffi, president of the Greater Burlington Industrial Corp., says that taxing cloud computing unfairly disadvantages companies in Vermont’s growing tech sector, which Cioffi notes is “clean, green, knowledge based” and includes some of the fastest-growing, entrepreneurial companies in the state. Canning worries the cloud tax could chase such businesses out of state.

The debate stirs up two main complaints. The first is that the department instituted the cloud computing tax on the sly. Rather than let the legislature debate the issue, the department adopted the policy in 2010 using what's called a technical bulletin, a publication meant to inform taxpayers of the department's interpretation of existing tax law.* [3]

Businesses and tax lawyers complain that technical bulletins — which are not subject to public input or hearings — are a backdoor route to implementing policy changes.

“The technology is changing and the question is, is our tax law evolving to keep up?” asks Brian Murphy, a tax lawyer with the Burlington firm Dinse Knapp McAndrew. “If you want to tax this stuff, that’s fine. Go to the legislature and have a discussion about it.”

Another major complaint is that after issuing the bulletin, auditors applied the cloud computing tax back to 2006 — before the bulletin was even published.

“It’s the backward looking — the gotcha — that is really problematic,” says Paul Hanlon, a Montpelier tax lawyer.

Complicating the matter, how cloud computing is taxed depends on how the technology is defined. If software used in the cloud is deemed “tangible personal property,” then it is taxable, the same as downloaded programs or CD-ROMs purchased at OfficeMax.

If it’s a service, on the other hand — like accounting or legal services — it’s not taxable. The tax department’s 2010 bulletin determined that programs used in cloud computing were equivalent to “tangible personal property,” even if the taxpayer didn’t actually own the software he or she used.

Tax Commissioner Mary Peterson admits the issue is “very tricky ... We might be getting to the point where we need different models, if indeed we tax this stuff at all.” Translation: Fitting old rules to new technology isn’t cut and dried.

Borgendale doesn’t object to the idea of a sales tax on cloud computing outright. The tax wouldn’t cut into Inntopia’s bottom line, since the company would just collect sales tax from its own customers and pass it on to the state. But the four-year back-tax bill from the state would deal a serious blow to business, Borgendale says. He wouldn’t reveal the amount of the tax bill. The audit isn’t complete and he may appeal.

“What we are saying is, if you’re going to define our product as tangible personal property or make it subject to tax, you’ve got to do so in a clear manner,” says Borgendale.

With software companies raising alarm about the tax, the House Ways and Means Committee is considering a moratorium on the tax that would refund those who’ve already paid. Peterson couldn’t tell Seven Days how many cloud computing tax bills have gone out or how many businesses have paid, though she confirmed the state has received payments.

This isn’t the first time the tax department has used technical bulletins to apply a retroactive tax — nor the first time tax lawyers have pushed back. A Vermont Supreme Court ruling found that a 2007 technical bulletin related to property transfer taxes effectively rewrote the tax code without any “underlying purpose or justification.”

“They created a rule without any input that was just arbitrary,” says Murphy, who was one of 18 tax litigation lawyers working pro bono on behalf of Polly’s Properties, a Shelburne-based real estate company.

Complaints go deeper still. Murphy says that the department has never offered what he considers a reasonable compromise with taxpayers appealing their audits. Murphy says the Internal Revenue Service will frequently lower bills if both parties agree the tax law is unclear and the taxpayer was acting in good faith. In contrast, Murphy calls the Vermont department’s attitude a “scorched-earth” approach.

“I think most of the firestorm about [cloud computing] has to do not with whether we should be taxing this or not, but rather the way” the department made the decision, he says.

For her part, Peterson understands the critics of the tax department under the previous administration who claimed there wasn’t enough effort to educate taxpayers about changes in policy. She wants to do a better job of it, but warns that outreach can only do so much.

“It’s this fine line,” she says. “It’s your responsibility on some level to figure out what the tax is… We can’t always be signaling in advance. There’s just too many circumstances out there.”

This article was amended on Feb. 16 to correct the definition of a technical bulletin, which was originally identified as a means of changing rather than interpreting regulations. The author regrets the mistake.