Virginia Ruling Discusses Income Tax Based on Contract with Software Hosting Company

For state income tax nexus, determining how to treat the activities of third parties who may be performing services on behalf of a taxpayer can be difficult, as a recent Virginia ruling shows.

By Jess Johannesen, SALT manager

One of the more difficult aspects of analyzing state tax nexus concerns how to treat the activities of third parties who may be performing services for or on behalf of the taxpayer. States do not look just to the activities of the taxpayer and its affiliates; every relationship with a third party must be examined to determine whether or not the presence of those third parties in a state may be attributed to the taxpayer for purposes of determining nexus. This principle was the subject of a Virginia ruling that was issued on June 24, 2016, addressing a taxpayer’s potential income tax nexus. [1]

In the ruling, the taxpayer is an LLC located and headquartered outside of Virginia. The taxpayer licenses software from a software developer through the developer’s reseller, and the taxpayer then modifies the basic software to meet each customers’ needs. The taxpayer then resells the software to its clients. All of the transactions (beginning with the developer and through to the taxpayer’s customers) are performed through cloud-computing/software-as-a-service with no exchange of tangible personal property at any point. The software developer owns the servers and back-up data centers from which the software is hosted and from which the taxpayer’s customers remotely access the software. One of the servers and data centers is located in Virginia. Additionally, the taxpayer itself has no access to, or control over, these servers.

With regard to the taxpayer’s income tax nexus, Virginia looked at whether or not the taxpayer’s activities were protected under Public Law 86-272 (“PL 86-272”). [2] PL 86-272 is a federal law that prohibits states from imposing a net income tax on a business where the business’ only contacts with a state are a narrowly defined set of activities constituting the solicitation of orders for sales of tangible personal property, provided that such sales are approved and filled from outside the state. While the law technically protects only those taxpayers that sell tangible personal property, Virginia has a policy of applying the same PL 86-272 solicitation tests to sales of intangible personal property. The ruling concedes that the taxpayer itself does not have any employees in Virginia performing any solicitation activities or services that are not protected by PL 86-272. Therefore, the state looked to the taxpayer’s relationship with the software developer to determine whether the developer’s activity in Virginia can be attributed to the taxpayer for purposes of establishing income tax nexus.

PL 86-272 standards apply differently to the activities of a “representative” versus the activities of an “independent contractor.” Prior Virginia rulings address the definition of an independent contractor, and the key factor is that the contractor engages in its services for more than one principal and holds himself or herself out as such in the regular course of business. [3] This two-part test, both parts of which must be met in order for an agent to be considered an independent contractor, provides that the agent must represent two or more principals, and the agent must in fact be independent from the principals. Where agents are not independent contractors, they are deemed to be representatives of the principals. [4]

The ruling explains that if a corporation contracts with a third-party service provider in the state, then such activity is considered merely to be the purchase of services if the third-party service provider is an independent contractor. [5] If the service provider is not considered to be independent (i.e., the service provider is a representative of the corporation), then the third-party service provider’s in-state activities can be attributed to the corporation for purposes of establishing nexus.

In the taxpayer’s case above, the state was unable to conclude whether or not the software developer was independent because not enough facts were provided to determine the relationship between the taxpayer and the software developer. Presumably, if the software developer provides the same services (i.e., cloud-computing and hosting of the software on its servers) for other customers, it may be considered an independent contractor of the taxpayer, and the taxpayer is merely purchasing the developer’s software and hosting services. In such case, the activities of the developer would likely not be attributed to the taxpayer, and the taxpayer would likely not be deemed to have established income tax nexus in Virginia.

Aprio’s SALT team routinely conducts nexus studies for our clients to determine where your company is likely to have established income tax nexus (as well as sales and use tax nexus). We examine not only the activities of your employees, but all relationships with third parties to determine whether or not the activities of those third parties should be attributed to the company. In addition, we consider all possible protections from nexus, including PL 86-272. These studies are an important aspect to a business’ state tax compliance profile; it can identify potential exposure, but it can also identify potential refund opportunities if, for example, your company has been paying income tax to a state where it is protected from nexus under PL 86-272.

Contact Jess Johannesen, SALT manager, at or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at for more information.

This article was featured in the September 2016 SALT Newsletter. To view the newsletter, click here.

[1] Virginia Public Document Ruling No. 16-135, 06/24/2016.

[2] 15 USC § 351-384.

[3] 15 USC § 351(d)(1); see Virginia Public Document Ruling No. 99-278, 10/14/1999.

[4] 15 USC § 351(d)(2).

[5] Virginia Public Document Ruling No. 01-136, 09/18/2001.

This article was featured in the
September 2016 SALT Newsletter.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.