United States: Top 5 Modern Tax Challenges For Digital Health Companies

Digital health companies comprise a broad, fast-growing sector of businesses that deploy technology in order to improve users' health and wellness. Digital health technologies span a wide gamut and include telemedicine, wearable health devices, electronic medical record companies (EHRs or EMRs), mobile health and wellness apps (mHealth), and cost-reducing artificial intelligence deployed by pharmaceutical companies.

These disruptive technologies are revolutionizing the delivery of health care products and services to the full range of participants in the health care market, including patients, care providers, institutions, medical device manufacturers and drug makers. And the digital health market is rapidly evolving with technological innovation.

Advanced technology not only shifts the delivery of health care products and services, but also creates tax uncertainty. The digitization of the economy is requiring jurisdictions around the world to both adapt and modernize their tax codes to capture revenues that would otherwise escape taxation under frameworks put in place long before today's technology existed. This changing tax landscape has led to a host of challenges for digital health companies. Here is an overview of the top five tax challenges facing digital health companies today.

1. State and Local Sales Tax Collection Obligations

States and municipalities have taken dramatically different approaches to the imposition of sales tax on digital products and services. The majority do not tax sales of most services, but do impose tax on sales of physical tangible property, including software. As software sales have shifted from physical media to digital downloads and cloud-based hosting, taxing authorities have taken more aggressive positions with respect to what constitutes the sale of tangible property to attempt to bring digital and cloud-based sales within the scope of taxation, even in the absence of clear statutory authority.

Service delivery has also digitized in recent years. Digital health services — that span from record digitization and access, to care navigation, to treatment delivery — all also rely on software at some level. To determine whether a sale is of taxable software or nontaxable services, most states assess the "object of the transaction." This can mean that if the sale of software is incidental to the underlying service, the transaction will be treated, as a whole, as the sale of a service. Disputes often arise in this context, with companies arguing that they primarily sell nontaxable services and taxing authorities asserting that the ultimate product sold is software.

Digital health companies may face large exposure for uncollected sales tax, as the payment obligation shifts to the seller if it did not properly collect and remit the tax at the time of the sale. Compliance is complicated. The inquiry into what constitutes the object of a sale is fact-intensive, and the contours of the law vary in each jurisdiction. Moreover, in recent years taxing authorities have taken increasingly hard-line positions in sales tax audits, thus adding to the uncertainty of whether transactions are subject to sales tax.

An added layer of complexity is the bifurcation of many health care companies into professional and nonprofessional entities; sometimes called the "friendly" or "captive" PC model. In states where sales of software are taxable but professional services are not, if the nonclinical entity (often referred to as a "management services organization") develops or holds a software license for software used to deliver services, then the software application may be viewed as divorced from the nontaxable professional services furnished by the clinical entity.

In pursuing the captive PC structure, which is ideal for many reasons, companies in the digital health space must think through the potential downstream tax issues due to these regulatory developments.

2. International Uncertainty Surrounding Taxation of the Digital Economy

International tax norms are also shifting. The Organization for Economic Cooperation and Development is actively pursuing a unified, international solution to tax challenges arising from the digitization of the economy. In May, the OECD released a road map for proposed approaches it will explore in the coming months, with a recommendation expected by the end of 2020. The OECD proposals contemplate shifting traditional notions of both nexus and profit allocation.

Under international taxing norms, jurisdictions lack the authority to impose taxes if there is no nexus between the jurisdiction and the items taxed. Traditionally, nexus relied on concepts of physical presence. The OECD proposals instead envision establishing nexus not only through physical presence, but also through alternative criteria that include:

  • Having an active or engaged user base that provides content and data in a jurisdiction in which a taxpayer otherwise has no (or limited) physical presence;
  • Having a remote reach into a jurisdiction to develop a user or customer base, along with other marketing intangibles; and
  • Having remote but sustained and significant involvement in the economy of a taxing jurisdiction through digital or other means.

The OECD proposals likewise reimagine existing profit allocation and transfer pricing rules, whereby taxing rights will be allocated to jurisdictions based upon criteria that may include their local user or customer bases, marketing intangibles, sales, assets, and/or presence of employees.

Although the OECD's work plan ambitiously endeavors to change the global tax regime by the end of 2020, that is not soon enough for some countries seeking to capture tax revenue from the shifting digital economy. France has imposed a 3% gross receipts tax on French revenues earned by large technology companies. While other countries are considering levying their own taxes on digital companies, many nations are advocating for agreement on a global basis.

A digital health company's presence regularly spans international borders in a myriad of situations. For instance:

  • Telemedicine companies connect with patients present in multiple countries.
  • Health technologies leverage global social media networks to advertise.
  • Wearable device and EHR companies sell their products and services to users across the globe.

As the OECD's recommended solution to international tax challenges arising out of the digital economy takes shape, digital health companies with international presence will have to adapt their tax reporting and compliance functions to meet any new requirements.

For instance, if the OECD proposals ultimately require tracking user locations to determine where a company may owe tax, digital health companies will have to ensure that they are able to collect the appropriate data. Likewise, many digital health companies will likely incur tax liabilities in jurisdictions where they lack nexus by today's standards because they have no physical presence in the country. Further, independent nations may impose their own requirements in the meantime (or perhaps even in addition to any agreed-upon global approach). The only certainty in the short-term is uncertainty.

3. States' Aggressive Nexus and Apportionment Stances

Cross-border challenges arising from taxing the digital economy are not confined to sales across international boundaries. In the United States, states are struggling to capture tax revenue from companies making digital sales into their state, including companies lacking any physical presence there. As in the international arena, states are rethinking concepts of both nexus and income allocation to meet the realities of digitization.

Nexus concepts began shifting away from the physical presence requirement in June 2018, with the U.S. Supreme Court's decision in South Dakota v. Wayfair Inc.1 Wayfair arose from a challenge to a South Dakota law designed to capture sales tax revenue from online sales made by remote sellers having no physical presence in the state. The Wayfair court held that a company having sufficient economic and virtual contacts with a state had adequate nexus to require the company to collect and remit sales tax, even if it lacked physical presence in the jurisdiction.

Since Wayfair, states have implemented various thresholds to measure a remote seller's economic and virtual contacts. These thresholds typically consist of sales dollar volume, the number of transactions into a given state, or some combination thereof.

Although the Wayfair decision was in the sales tax context, some states, including Massachusetts and Hawaii, are attempting to import its nexus concepts into their income tax framework, claiming the right to tax a share of the income of corporations having sufficient sustained economic contacts in the state. It is unclear whether expansion of nexus beyond the physical presence requirement outside of the sales tax context will survive a constitutional challenge.

States have also become more aggressive with respect to income allocation as the economy has digitized. U.S. states allocate income for corporate income tax purposes based upon apportionment formulas that compare the taxing state's share of certain relevant factors to the company's overall totals. State apportionment formulas vary, but typically consider some combination of sales into the taxing state, as well as property and payroll in the taxing state.

States vary in their sales sourcing rules, which are particularly challenging to apply in the context of digital transactions. Furthermore, and importantly, income is only allocated to states where companies have nexus. Thus as nexus requirements move away from physical presence, allocation of income will change as well.

Just as digital health companies operate across international borders, those conducting business in the United States almost always have interstate sales and must navigate questions of nexus and apportionment. While these companies have likely evaluated their nexus for sales tax purposes post-Wayfair, we expect that the requirement to analyze nexus under a new framework will extend to the income tax arena in the coming years.

Similarly, states' shifting apportionment and sourcing rules will require digital health companies to keep pace with reporting and data collection obligations, and may both increase and dynamically shift their tax liabilities across state lines. Thus, as in the international arena, digital health companies face near-term uncertainty with respect to their evolving state income tax obligations. In particular, state taxing authorities appear emboldened by the Wayfair decision and will likely push the limits of the Constitution to take increasingly aggressive positions to capture additional tax revenue from digital sources.

4. Treasury's Cloud Computing Regulations

The IRS is also grappling with adapting the federal tax regime to account for the realities of the economy's digitization. In August, the agency issued long-awaited guidance regarding how companies ought to classify cloud computing transactions — including software as a service, platform as a service and infrastructure as a service — for federal tax purposes.2 The proposed regulations set forth a list of relevant factors to apply to cloud-based transactions to determine whether they constitute a provision or services or lease of tangible property.

The preamble to the proposed regulations contemplates that they will apply to a wide swath of cloud-based transactions and provides that, "[i]n general, application of the relevant factors to a cloud transaction will result in the transaction being treated as a provision of services rather than a lease of property." This distinction can have significant implications income treatment for tax purposes, including whether income is U.S.-based or foreign source. Further guidance regarding the sourcing of income from cloud computing transactions — a complicated framework — remains forthcoming.

At the same time, the IRS proposed amendments modernize the application of existing regulations3 by clarifying their application to "digital content." These amendments also contain new rules regarding the sourcing of digital downloads of copyrighted material that provide that the sale is deemed to occur where the customer downloads the copyrighted material or installs it on a device. These sourcing rules are not unlike those under consideration by the OECD and those included in France's digital tax.

The IRS' proposed regulations contain numerous requests for comment, and once finalized, they will impact digital health companies. Many digital health companies operate on the cloud, from EHR companies that offer cloud-based software and storage solutions to technologies that utilize cloud-based software to deliver care. Cloud-based digital health companies have likely welcomed the initial classification guidance, which generally upheld the manner in which most cloud-based companies were already classifying their income.

The guidance surrounding sourcing of cloud-based transactions promises to be more complicated. Yet the sourcing rules contained in the IRS' proposed amendments to the existing regulations with respect to digital downloads suggests that cloud-based digital health companies should, at minimum, anticipate capturing and reporting on users' locations. Thus the compliance challenges digital health companies will face under the IRS' cloud computing regulations are not unlike those outlined with respect to the OECD proposals and state income tax challenges discussed above.

5. Stock-Based Compensation Cost-Sharing Agreements

Many digital health companies may also feel the impact of the recent U.S. Court of Appeals for the Ninth Circuit decision in Altera Corp. v. Commissioner.4 In Altera, a Ninth Circuit panel reversed a 2015 Tax Court decision invalidating the Treasury Regulation Section 1.482-7A(d)(2) requirement that related parties allocate stock-based compensation costs when entering into cost-sharing arrangements to develop intangible assets.

Although Altera has petitioned the Ninth Circuit to review its decision en banc, and many practitioners believe that the case will ultimately make its way to the Supreme Court, the IRS' Large Business and International Division has withdrawn a prior moratorium on audits of cost-sharing arrangements relating to stock-based compensation. This move is expected to simultaneously result in:

  • A wave of audits of companies taking positions contrary to the disputed regulations by excluding stock-based compensation from cost-sharing arrangements; and
  • The denial of existing refund claims filed by companies in response to the 2015 Tax Court decision to invalidate the regulations.

Multinational digital health companies may be significantly impacted by the Altera decision and the IRS' expected actions. Many multinational companies, including digital health businesses, often have a foreign subsidiary that holds licenses to use and exploit the company's intangible property (including intellectual property) abroad.

Digital health companies having such an arrangement face an increased risk of an IRS audit and adjustment if they failed to allocate the costs of stock based compensation paid to U.S. employees to the foreign subsidiary under cost sharing agreements. Likewise, any such digital health company that filed a refund claim based upon the overturned Tax Court decision will likely have their refund denied. While the Altera decision remains in flux, taxpayers, including digital health companies, ought to continue to preserve their right to take contrary positions in case the decision is reversed or otherwise limited.

Footnotes

1 South Dakota v. Wayfair Inc., 585 U.S. __ (2018).

2 Prop. Treas. Reg. §1.861-19.

3 Treas. Reg. §1.861-18.

4 Altera Corp. v. Commissioner, 926 F.3d 1061 (9th Cir. 2019).

This article by partner Kathleen Gregor and counsel Elizabeth Smith was published by Law360 on September 16, 2019.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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