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The taxman comes for cloud companies like Netflix, and confusion reigns

Patrick Stewart as Captain Jean-Luc Picard in Star Trek: The Next Generation.Patrick Stewart as Captain Jean-Luc Picard in Star Trek: The Next Generation.
Patrick Stewart as Captain Jean-Luc Picard in Star Trek: The Next Generation.Courtesy of Paramount Television

In recent years, cash-strapped states and cities have started applying their sales tax laws to internet-based activities, and for many companies the process is becoming a nightmare. The reason is that, when it comes to remote services like Netflix or Amazon Web Services, it can be hard to pinpoint where a transaction takes place–and it’s harder still to know when to apply a tax and who should collect it.

The situation is creating confusion in states and cities, and no solution is in sight. Meanwhile, the debate over taxing the cloud offers new grist for long-running legal and political fights over when local governments should have the power to tax online services.

Chicago steps back, New York steps in

For Chicago, like other places that rely on sales tax and so-called use taxes, the boom of e-commerce and cloud computing has meant a decline in sales tax revenue as consumers choose online operations over storefronts. Simply put, there are fewer transactions for the city to tax. In response, Chicago officials recently came up with a bold plan to grab more revenue.

The plan entails dusting off two existing laws designed for taxing “amusements” (i.e. movie tickets) and “personal property” leases, and reinterpreting them to apply to a bevy of cloud computing and internet services. The move affected not only digital entertainment services like Netflix (NLFX), but a broad and growing number of businesses that rely on remote computer tools like Amazon (AMZN) Web Services to power their operations.

Chicago’s tax grab attracted national media attention, and also brought pushback at the local level. It proved controversial partly due to the city’s expansive legal interpretations of amusements and personal property, but also because of practical problems. For instance: Do cloud providers, which may not even have physical plant in the city, have to collect sales tax when they serve Chicago merchants? Or are the customers that use such services obliged to report and pay it themselves?

The fuss has now led the city to partly reconsider. Last week, Chicago announced it would hold off on applying the “personal property lease tax” to cloud computing until next year, saying this would give businesses more time to address billing issues. The city also said the delay would provide time to address “concerns…Chicago businesses [have] about the effect of the lease tax on their operations.”

The respite will not, however, help Netflix since the streaming movie service is for now snared by the city’s amusement tax rather than the impending computer lease tax. But the delay on the lease tax is expected to provide companies of all sorts with a window to lobby Chicago officials to scale back its scope, or at least clarify some of the legal and practical questions.

Netflix declined to comment for this story. Amazon Web Services didn’t reply to an email request for comment over how it has handling the tax issue.

In New York, meanwhile, state officials suggested last week they will take a fairly broad approach to taxing cloud computing. In response to a request for clarification on sales tax policy, the state published a ruling, addressed to an unnamed IT provider, which stated that companies must charge customers tax on various “lit fiber” and electricity services.

Massachusetts, meanwhile, passed a bill to tax the cloud in 2013, but then repealed it a short time later amidst a backlash over what became known as the state’s “tech tax.”

Tax rules are “all over the map”

Who pays sales tax when an app maker in one state relies on a cloud computing provider in another state, and sells to customers in a third state? The answer can be unclear.

A chief financial officer of a Connecticut-based medical device company, who did not want to named for this story, said the state’s computer tax law is a major headache. This person said the company, which uses numerous software-as-service applications, regularly struggles to make sense of which transactions are caught by the tax, and who has to pay the final amount.

This burden is unlikely to disappear soon, according to Rebecca Newton-Clarke, an expert on local taxes at Thomson Reuters.

“States and localities are all over the map on these transactions,” said Newton-Clarke, pointing to places like South Carolina, which does not tax online delivery of software but does tax certain cloud computing transactions, including software as a service and application provider software, under the guise of “communications services.” She also cited New Jersey, which doesn’t tax cloud computing per se, but does tax information services, which may include some cloud computing transactions

For cloud computing companies caught in the middle of all this, one potential lifeline is the Streamlined Sales and Use Tax Agreement, a pact that some states have adopted to create a more uniform tax system. But according to Newton-Clarke, the agreement has so far done little to clear up the prevailing sense of confusion and city and states’ ad hoc tax interpretations.

Meanwhile, even the handful of states with no sales tax at all (Delaware, New Hampshire, Oregon, Alaska, and Montana) risk being drawn into the confusion due to the cross-border nature of the cloud computing industry.

A tax on sales–or the internet?

The debate over taxing the cloud is likely to intensify, especially as states and cities watch more sales tax revenue dry up as an increasing number of goods and services–from DVDs to software–get replaced by online alternatives.

Meanwhile, the fuss over a “Netflix tax” in places like Chicago may soon dovetail with a long-simmering fight over when online retailers should pay out-of-state sales tax. That dispute has seen Congress come close to passing a “Marketplace Fairness Act” several times, but the bill remains stalled amidst pushback by tax opponents and others.

And it doesn’t end there. Adding still more complexity to the puzzle is Congress’ push to make permanent a temporary moratorium on broadband taxes imposed by cities and states. While the measure is meant to ensure local governments can’t add taxes to consumers’ monthly internet bills, it could also help opponents argue that local cloud taxes are an illegal effort to tax the internet.

All of this may eventually require the Supreme Court to step in and clarify how far local governments can go with cloud-related taxes. Doing so would require the top court to revisit a 1992 case in which it declared a retailer must have a “physical nexus” in a state to be subject to its taxing authorities. The court signaled this spring that it’s interested in revisiting the issue.

In the meantime, Newton-Clarke predicts cities and states, in the absence of new oversight from the Supreme Court, will continue pushing the limit on what counts as a “nexus” as they search the cloud for new tax targets.

For more on tech and taxes, here is U.S. Senator Chuck Schumer telling Fortune about an idea Apple likes:

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