Client Alert: Cloud Computing Ruling issued by City of Chicago Hangs Over Businesses Effective January 1, 2016

The City of Chicago issued long awaited guidance on its most recent interpretation of a tax that has been on the books for decades and originally only applied to leases of tangible property, but now is being applied to a broad range of companies that provide “cloud based” goods and services through a variety of mediums to their customers.

The Information Bulletin issued on November 19, 2015, by the Dept. of Finance, is one in a series of rulings and bulletins on the imposition of a 9% broad based tax on a list of taxable items stemming from use of computers to deliver software, information and related products to customers. Reacting to a series of complaints throughout the business community, the Information Bulletin clarifies a number of issues and provides some important new developments in an effort to address several concerns that have been raised:

• Deferring application of the tax to cloud computing activities from the original effective date of Sept 1, 2015 to January, 1, 2016.
• Reducing the rate of tax from the general 9 percent rate to 5.25 percent for qualifying “cloud” products
• Providing a small new business exemption for qualifying businesses; and
• Instituting a Voluntary Disclosure Program (“VDP”), which provides qualifying taxpayers with the opportunity to:
  • Eliminate tax on certain transactions that meet certain exemption provisions for transactions entered into prior to January 1, 2015.¹
  • Payment of only one year of tax on those transactions that did not qualify for exemption under the previously issued Tax Ruling #12 together with waiver of interest and penalties; and
  • For any other taxes owed (Lease Tax based on leases other than nonpossessory computer leases, or taxes other than Lease Tax) waiver of interest and penalties, and a look-back period of only four years, consistent with the City’s standard VDP.

In order to qualify for these benefits the VDP application must be submitted by January 1, 2016.

Overview of the Cloud Computing Tax
It is important to note that the State of Illinois, like most other states, lacks the statutory authority to impose a sales/use tax on the sale and/or delivery of “services”. Consequently, the City of Chicago has been exceptionally creative in expanding the application of the Personal Property Lease Transaction Tax (“Lease Tax”) from the sale or lease of tangible personal property to include cloud-based goods and services.
The foundation of the “cloud computing” tax, as it has come to be known, stems from legislation and case law which dates back to 1974, long before the internet and personal computers ever came into existence.² At that time, the City of Chicago passed legislation pursuant to the State of Illinois “home rule” provisions, which authorized the City to enact legislation to tax the use of personal property, delivered via a computer to businesses and residents located within the city limits.One such home rule provision included a Gross Transaction tax on the lease or rental of personal property. This tax, pursuant to the holding in Meites, was found to be applicable to online database searches imposed on Lexis/Nexus’ computerized library systems.

The recently issued Information Bulletin is one in a series of rulings intended to provide guidance as well as bright line rules in response to a series of questions raised by business concerns including but not limited to the following:

1. Who is impacted by the Gross Receipts Tax; and
2. How the tax is to be computed

Specifics of the Information Bulletin

Small New Business Exemption
On October 28, 2015, reacting to concerns by startup internet based businesses, which the city hopes to lure into Chicago, the City Council enacted amendments to the Lease Tax that includes an exemption for small new businesses and a lower tax rate for “cloud” products. Both amendments are scheduled to become effective on January 1, 2016.

The term “small business” is defined as a business that:

1. Holds a valid and current business license issued by the City or another jurisdiction,
2. Had under $25 million in gross receipts, during the most recent full calendar year prior to the annual tax year for which the exemption is sought and
3. Has been in operation for fewer than 60 months. A small new business that is the lessor of a non-possessory computer lease shall not be required to collect tax on its charges for such non-possessory computer lease.

A small new business that is the lessee of a non-possessory computer lease is not required to pay tax on its charges for such non-possessory computer lease.

Rate reduction from 9% to 5.25%
As a further concession to cloud based businesses, qualifying businesses are provided a reduced rate of tax from 9 percent to 5.25 percent. The reduced rate applies only in specific situations where the transaction involves a “nonpossessory lease of a computer primarily for the purpose of allowing the customer to use the provider’s computer and software to input, modify or retrieve date or information of the lease or rental price. In general this means that the lower rate will apply to “cloud” products such as PaaS, IaaS and SaaS services (where the nonpossessory lease is primarily for the purpose of allowing the customer to use the provider’s computer and software to input, modify or retrieve data or information that is supplied by the customer), but not “database” products (where the nonpossessory lease is primarily for the purpose of allowing the customer to use the provider’s computer and software to input, modify, or retrieve data or information that is supplied by the provider).

How the Tax is Applied
The Information Bulletin also provides specific guidance on how to know if a customer is a Chicago customer. Specifically, the Bulletin sets forth rules similar to those used in applying the Mobile Telecom Sourcing Conformity Tax3 as well as apportionment rules when users of the nonpossessory lease are both within and outside the City limits.

Important Take-Aways

1. The Cloud Computing Tax is imposed on the users of the nonpossessory leases, specifically the customer (the lessee), BUT the provider (lessor) is required to collect the tax. As such, any business that provides Cloud based goods or services to customers, which are located within the City of Chicago, is subject to the tax. This tax impacts thousands of businesses that have a presence (nexus) within the City and sell to customers that are located or have employees that access the leased computer activities within the city limits. It is important to note that even before issuing this Information Bulletin, the City had initiated an active audit campaign and is likely to increase its audit efforts after the expiration of the January 1, 2016, deadline for companies to elect participation in the VPD.
2. The Bulletin is clear in stating that the Lease Tax is broadly applied to “ANY usage of remote computing or software, including but not limited to SaaS, Iaas and PaaS such as deployment of servers, processing power and networking...“(emphasis added). As such, businesses should be mindful that a very broad net is intentionally being cast to impose tax on those businesses not specifically qualifying for exemption.
3. Taxpayers are strongly encouraged to minimize prior years’ liability by applying for the VDP before the required January 1st deadline; however, please note that granting participating companies with preferential treatment is a double-edged sword and those companies that do not voluntarily come forward will not be granted much latitude to negate the tax.

Timing is of the Essence
Companies that are potentially impacted by this Information Bulletin and other previously issued bulletins by the City of Chicago, are faced with making a series of important decisions before the sunset date of January 1, 2016. Given that the rules are quite complicated and the consequences are significant, companies are encouraged to seek professional advice regarding the potential exposure to prior years’ activities, as well as analyzing the application of the tax on or before the sunset date in order to determine whether or not to participate in the VDP.

Duff & Phelps professionals are available to assist your company in assessing both the benefits of participating in the VDP, the risks of not participating as well as determining whether your company is required to collect or pay the City of Chicago Lease Tax for certain computer related arrangements. We are also well versed in the drafting of private ruling requests and/or assisting with the VDA offer and program to ensure compliance with the Lease Tax, as amended.

To view a copy of the Information Bulletin click here.

^1.Certain exemptions were initially identified in a Chicago Department of Finance ruling issued on June9, 2015 (Tax Ruling #12) adopting application of the Personal Property Lease Transaction Tax to various cloud related activities.
^2.The original Gross Receipts Transaction tax went into effect in 1974 and upheld as applying to broad based information delivered electronically in Thomas R. Meites et. al. v. City of Chicago, 184 III App. 3d, 887 133 Dec 107 540 NE 2nd 973, 6/20/1989. The term, “nonpossessory computer lease” was added in 1994 and broadly defined to include; ANY payments for which the “customer obtains access to the provider’s computer and uses the computer and its software to input, modify or retrieve data or information…(and includes) time sharing or time or other use of a computer with other users.” City of Chicago Ordinance Code Section 3-32-020(l).
^3.Code Section 3-32-020(l) and 35 ILCS 638.