Episode 37: Tax Issues With Data Centers

Transcript

IRIS LAWS

This episode, we’re kicking off the first in our mini-series about data centers. This week we welcome Edwin Lam and Ericka Hernandez, who will be focusing on two aspects of data centers that often get overlooked: property tax and sales and use tax. From your one stop for tax updates and analysis, I’m Iris.

LANCE JACOBS

And I’m Lance.

IRIS LAWS

And this is “Tackling Tax.”

Today we’re going to be kicking off the first in a series discussing data centers. In this heavily political season, you know, we’re coming up to the midterms now. It’s probably not a stretch to say that the issue of data centers has come up in most, if not all, debates. So, we thought it would be a good time to talk about the tax issues surrounding them.

We’re pleased to welcome today to the pod Ericka Hernandez and Edwin Lam.

LANCE JACOBS

And Iris. You know, I love sneaking in my pop culture references here on the pod. My first instinct was to call out the 1983 classic film with Matthew Broderick, “WarGames,” but I figured that was a bad idea for obvious reasons. Then looked at Radiohead’s “OK Computer” album for inspiration, but nothing really grabbed me. I turned to Copilot, appropriately enough, for help. And I did find out that the late 70s-early 80s German electronic band Kraftwerk were writing a lot of songs about computers in that time frame.

But with that, I will take this opportunity to introduce my friend Ericka Hernandez. Ericka is a director with more than 15 years of multistate tax experience, including income and franchise, sales and use, and excise taxes across industries such as utilities, manufacturing, construction, oil and gas, retail, consumer goods, and technology. She leads the firm’s Houston state and local tax practice and holds bachelor’s degrees in accounting and finance, and master’s degrees in accountancy and taxation from the University of Houston.

IRIS LAWS

And then Edwin is a senior manager on our property tax team with more than a decade of experience in property tax compliance consulting and controversy matters for clients in oil and gas, pharmaceuticals, pharmaceutical manufacturing, R&D, and industrial sectors. So, he has advised on complex property tax assessments, exemptions, and incentives, audit defense, and appeals. Man, Edwin, this list goes on and on. But he holds a J.D. from the Mc School of Law. So, welcome to you both, Ericka and Edwin.

EDWIN LAM

Yeah, thanks for having us.

IRIS LAWS

I guess just to kick off, I think we were going to tackle the sales and use side of this first. Overall, right, there’s a lot of things to talk about from a tax perspective when it comes to data centers. But probably one of the most overlooked is this sales and use tax side of things.

At a high level, what are the main sales and use tax issues that come up when data centers are built and operated?

ERICKA HERNANDEZ

Thank you, Iris, for the question. I think you’re right on the spot as far as this being overlooked from the get go. Being as big of a spend that, you know, these data centers involve from beginning to end, I will say I will break it into probably lifecycle of data centers. So, the first one being mostly the construction part of it, then the equipment acquisitions and setting up the actual data center, and then kind of the ongoing operations of the center itself.

So, with that, I mean, we’ll go into more details, but I will say on the construction side, one of the key issues as to, you know, who ultimately negotiated incentive with the state and local government and thus is the owner of the land infrastructure, technically? Are they going to; who’s going to be the builder of the facility itself?

Are we using likely contractor or subcontractors? And are the possible exemptions in sales tax applied to them? Because there are plenty of them. A lot of these data center extensions at the sales and use tax level, you know, they are negotiated with the localities and jurisdictions and they might have very specific nuance as to what qualifies and what doesn’t and what gets included on it.

And it obviously goes by state, jurisdiction, and even the fact that you may have it at the state level but may not apply to the locality. So, it’s important on that. But I will say those are the three main broad categories to look at—what phase of the data center are you: the construction, the build out and equipment acquisition and set up, or the ongoing running of the facility itself?

And with that, there is a ton of, you know, considerations to happen, purchases, transactions that occur, you know, all the interplays and where are you in that life cycle? Are you the buyer or the seller? Could these exemptions be flow-through to you as, you know, a contractor, subcontractor, and whatnot? So, there’s a lot of implications on that and I feel like there’s a lot of times the sales tax team, or that part of it doesn’t get a seat at the table to discuss ahead of it and plan ahead as the projects start going.

LANCE JACOBS

You kind of touched on a little bit of this, but I want to delve into it a little bit deeper. You know, obviously there are significant investments in servers, networking equipment, generators, cooling systems and massive amounts of infrastructure. I assume that, from my experience in construction projects and sales tax, items that you would instinctively think are similar and should have similar sales tax ramifications, often or not, the devil can be in the details on all of those items. So, can you give us just a general, broad overview as to how you approach as to whether those purchases in those classes, broadly speaking, are subject to sales tax and or potentially exempt?

ERICKA HERNANDEZ

Right. So, I think again, if we’re looking more the construction phase is the implication of, you know, dealing with as a contractor? Is that data center exemption and flow-through to them. Do they have, are they going to be considering states like Texas a consumer, versus just passing that through to, ultimately, the owner of the data center?

Is it a lump sun? And in terms of the equipment, is some of the equipment, generally speaking, let’s start with it’s tangible personal property, right? But as it goes into those facilities and gets installed, may become somewhat of a quasi to what we knew in the old days as a manufacturing-type equipment. And or is it going to become real property or not?

So, there’s a lot of implications of that. And the model in where you have a state like Texas that is much more generous with a lot of broader data center exemptions versus somebody like Virginia that’s much more limited and will tax, for instance, utilities. And you have a completely different set of facts on that. But I will say, generally speaking, a lot of the cooling systems, the emergency generators, servers, hardware storage devices, racks, etc., there’s a ton of—some of the states might give you a very specific list out of what qualifies and what doesn’t, particularly on that data center or exemption certificate.

Some of them might be a little broader in more of the intent of how is the equipment being used, you know, more aligned with kind of what we knew, the manufacturing facilities and making the actual, what is it actually doing ultimately to it? So, that’s that part of it, and ultimately, I think the other complex part of it is, as these data centers come to fruition and is like what, ultimately, they’re going to sell or do for customers, right?

So, we talk about construction. Then you’re running this facility, all these purchases, and they’re very expensive purchases. So, I think considering, you know, the amount of spend that goes into it, I know that some taxpayers may not account for the fact that, you know, not every exemption may apply on very substantial equipment. Turbines at times that they ran that are pretty, you know, over a million dollar rental in a month and it’s pretty substantial sales tax if you don’t get it abated. So, a lot of planning that should happen earlier on.

IRIS LAWS

That was going to be one of my follow-up questions actually was related less to the facility itself, but maybe some of the power facilities that are used to power the data center. You know, we’ve seen clean energy facilities pop up; solar, wind, that kind of thing. Would these exemptions apply to those facilities as well, or how does that work?

ERICKA HERNANDEZ

Generally speaking, it will qualify. We saw a lot of those facilities popped up, you know, with the infrastructure bill few years ago with trying to get more of that, you know, wind and solar energy. I have seen though as some of those incentives phased out last year with the Big Beautiful Bill passing, we’re seeing less of that.

And so, a lot of a mix in the market as to where or how they’re going to invest next, right, the clients and whatnot. So, there was a lot of a big footprint, I will say, I saw in Arizona and New Mexico, just because of, you know, the use of the solar and the desert there. But yes, definitely, they could qualify for a lot of that.

And I think that’s where we’re all in that phase in sales tax of a mix of is it like, sort of like a manufacturing facility where we’re used to that? Is it more of, you know, are we storing power? Ultimately, what are we doing to the public and how are these massive computers, you know, generating what, ultimately, they’re doing. And I think that’s where the states are just trying to come and figure that out currently.

LANCE JACOBS

Ericka, you raised an interesting point that I wanted to go back to. And we’re, you know, we and maybe I are so caught up in the build out that it’s important to also consider the sales tax implications of the services that the data center is ultimately going to sell, which obviously could extend beyond and implicate multi-state, probably, you know, up to all 46 or 47 states that have a sales tax. Plus, I guess in those states like Texas or New York that have county, locality, you know, locality-based taxes can be really complicated. Have you seen data centers grappling with this as they’ve come online?

ERICKA HERNANDEZ

Yes, most definitely. I think Colorado, and again, Colorado is probably one state that has put a little more rail guards around data centers. You know, more cautious with this, kind of, issuing an exemption. And I think part of it was also the pushback from the localities that they will have those implications, as do I want that in my locality or whatnot.

But I think that’s the other part in where, again, with throughout the last state, there was a lot of incentive for these data centers for starting. And states were competing the localities for them, right? They were doing great incentives so they would come and they were slowly coming up. But I will say in the last year or so, you’re seeing a little more of a plateau or even more regulation or bills introduced, right, and legislative sessions to kind of maybe look further into the benefit of them.

I mean, I still see them built out all the time, but like here in particular where I sit in Texas, I mean, we had them everywhere. And then there was the issues with obviously the water usage, electricity, and some of that stuff, right? So, now they’re kind of like, really they’re kind of tossing and reconsidering and indeed we even audit them all along.

So, there’s just a lot of implications, I would say, throughout the life cycle of it. But I think as some of those facilities are now built, again, particularly here in Texas, that they’re running the next question as well, who’s my customer and how am I servicing them, and how do those contracts look and am I selling them? What ultimately right, which is the million-dollar question in sales tax. And so, that becomes rather complicated at times.

IRIS LAWS

So, not knowing much about sales and use tax I hate to say, Ericka, but we’ve been talking a lot about exemptions, right, and that’s the primary opportunity. But let’s say, you know there’s not an exemption available or you want to; are there other opportunities or benefits for these data centers, or is it really you’re going after the exemption and that’s the primary opportunity?

ERICKA HERNANDEZ

Currently, I will say that’s probably the primary opportunity for it as far as, you know, trying to see what qualifies and what doesn’t qualify. I think because of the, how expensive some of this equipment is, it is always the main thing to go after. But I think as again, as we phase that out for now, it will be also the implications of, you know, the other side of it.

But yeah, for now, we’ll say that’s kind of where we’re supporting them. A lot of it is, you know, are they renewing these exemption certificates? I think Mississippi comes to mind. You have to do it every year. And if not, it’s technically you don’t have it. So, there’s a lot of maintenance and compliance requirements. And then also now a lot of states started to audit some of this, you know, are they truly buying it for the intent of that.

And I haven’t seen much of like really data center audits in the past. Obviously they’re newer, but we’re starting to see some of that trend to justify that. But I will say if anybody in our practices is thinking of that when they’re looking at, you know, regular compliance and this big spend, is it, you know, do we understand what they’re doing? Even if, like you said, it’s a contractor and they’re maybe helping building a data center facility of some sort, could they qualify for that exemption and flow through from those data centers?

LANCE JACOBS

Interesting. So, you know, one of the things that we do as state practitioners when we’re considering a new facility, and I would assume this applies in the data center space, is we’ll consider a whole bunch of different states and we’ll try to get negotiated incentives or, you know, statutory credits and negotiated incentives.

And I guess our final question in this is given that that’s the way that businesses work traditionally, and also noting that data centers have been a little bit of a political hot potato over the last couple of years, have we seen any changes on the negotiated incentives side in your space and generally, what is the state of play across the country with respect to exemptions more broadly in this climate for data centers?

ERICKA HERNANDEZ

Yeah, I mean, I think you hit it right on that lens. They’ve always been there, I guess, for the last decade, but you’ve seen much more talk of it in the last, you know, two years, I will say it definitely is causing some pause in there. And I think the savings are still there and available, but I think also like the long-term investment of those facilities and the implications that will be there is kind of what some of the industry is pausing on it.

I still see them build them. I mean, AI is not going anywhere and, you know, they want to be ready to, you know, those facilities take a while to get built. So, I definitely see that pause currently. But I think they will continue to grow and evolve.

IRIS LAWS

Well, great. Well, I think I learned a lot about sales and use tax. I think we’re going to shift now to property tax. Edwin, you’re on the hook. I guess why is property tax so important for data centers specifically, right? Like I’ve worked in a number of industries before where you guys have helped us out with a number of clients. But why specifically for data centers, is this so important?

EDWIN LAM

Yeah, I think this is a great place to start. Property tax is imposed on the value of real and tangible property. So, when companies are expending significant dollars in real and personal property to build these data centers, the tax can be pretty significant. You know, data centers are very capital-intensive assets, they require substantial investment in real estate, infrastructure, technology.

You know, I’ve seen lately announcements for new data centers where the capex expenditures are going up into the billions. And so, the other thing is, unlike income tax, property tax is a recurring above-the-line operating expense that the company will incur regardless of profitability. So, you know, what we typically, you know, will have to consider is that this is a tax that whether or not the company is doing well, they’re going to have to pay year over year.

And, you know, whether or not you are a co-location center that passes the property tax over to the tenant or you’re an enterprise, or hyperscale operator, the tax is still something that needs to be factored into the equation. So, you know, if you’re a co-location center, you’re passing it on to the tenant, you’re reducing the competitiveness against other data centers if they’re able to have a lower property tax burden. So, it’s something that every company who’s considering sites for data centers, they need to be aware of and need to project because it can create a substantial hit to the bottom line.

LANCE JACOBS

Edwin, I’m wondering if you can comment on the dance that we do with state and local tax practitioners, and I know Ericka does it on her side and you do it on your side. And the question is, is it tangible personal property or is it real property? And that can have different implications. By the way, you might not get to the same answer for sales tax and property tax purposes because the laws are different. Can you comment on why that distinction is so important on the property tax side of the ledger?

EDWIN LAM

Absolutely. Yeah, I think there is some overlap with sales tax. You know, I recall Ericka was mentioning sometimes you bring in tangible personal property, it ends up becoming real property. We see that as well on the property tax side. So, real property for property tax purposes for most states it applies to land and buildings.

Any structural improvements and foundations, as well as, depending on how the state views it, any kind of permanently installed electrical, cooling, and mechanical infrastructure, things that are installed to the building and intended to remain there indefinitely are typically considered part of the real estate. On the other hand, the personal property side you would typically see, that includes the things that you could pick up and move within the data center.

So, your servers, your storage devices, your networking equipment, your racks, any other kind of like movable equipment, things that you could take and move to another site without damaging the property is generally considered personal property. And the reason why, you know, I think that’s very important is the two are often not assessed in the same manner.

So, real property is generally assessed by the county assessor with a computer-aided mass appraisal approach. So, they’re going to look at the building size, the square foot, they’ll look at comparable properties and they estimate a value based upon whatever public information they have available. Personal property, you typically have a different division within the county that will value the personal property.

And it’s usually based off of reports that the taxpayer will submit. So, the taxpayer will provide a list of the personal property that’s in the facility and the cost and year of acquisition, and then you actually are able to depreciate the value of that equipment over time, because personal property generally has a much shorter useful life than a large building or the infrastructure within that building.

So, where it goes from personal to real also can be impactful for whether or not you’re actually assessed tax. So, all states tax real property, but only about two-thirds of the states will actually assess personal property. So, not only would the personal property be exempt in some states, it could see a reduction in value year-over-year based upon that depreciation.

One thing that I’ve seen recently, not just in the data center space, but, you know, just across kind of the political climate of property tax is that a lot of state legislatures, they’ve been moving recently to exempt more and more personal property. The whole idea of that is it’s almost kind of like an arms race between states to try to attract additional business.

We’ve seen expansions in the de minimus thresholds for personal property, and we’ve seen legislatures actually phase out personal property in some states. I expect to see less and less burden on personal property taxes as time goes on.

IRIS LAWS

So, a lot of this rate, you’re going to be basing the amount of property tax you pay, whether real or tangible, on the value of the good, right? You know, from experience and my phone or laptop or whatever, technology in my experience tends to become obsolete fairly quickly. So, I’m, you know, less familiar with the technology and data centers, but of course, I would assume depreciation still applies there. And how does that affect the property tax value of the equipment that we’re looking at?

EDWIN LAM

Right. So, with regards to things like, you know, servers, computer equipment etc., yeah, I agree that we’re still kind of in a discovery process of what the correct useful life should be for things like that. You know, we’re seeing technology move faster than ever. And so, the turnover cycles, the refresh cycles for technologies are getting shorter and shorter.

And so, it is kind of a dance with the assessor. So, the way they typically value it is you assign a useful life to the equipment. And for computers you could say it’s a 3-to-5-year useful life; for servers they could go higher. But generally, if the taxpayer disagrees with the assessor on what the useful life would be, the taxpayer can file an appeal and request things like, you know, a change to the useful life table. Or they could say there’s external, you know, obsolescence, there’s economic obsolescence that’s making these things obsolete faster than the tables would capture if you were just to apply them as standard.

And so, you know, one observation I’ve had is a lot of data centers are being placed in areas where the assessor’s never seen one before. So, they’ve never dealt with this type of technology. And so, you know, they’re used to assessing machinery and equipment, industrial facilities where they’ve got equipment in there that have refresh cycles of, you know, eight-to-15 years. And so, when you tell the assessor, no, you should cut 30% of the value after the first year, the assessor, you know, oftentimes doesn’t really know what to do with that.

So, it is an evolving issue. And I think, you know, taxpayers who want to make sure that they’re not being overassessed, they should be looking to a property tax practitioner who has knowledge about, you know, the refresh cycles, the valuation concerns. And you should be exercising your right to appeal the property taxes that are being assessed on the data centers.

LANCE JACOBS

Interesting. So, to close the loop, I’m going to ask you a similar question that we asked Ericka, which is: what about statutory credits and negotiated incentives in this space for property tax?

EDWIN LAM

Those are things I think should always be considered when you’re looking at a significant capex spend like what you would with a data center. You know, most states do offer these kinds of incentives. So, you could get things like a property tax abatement that would say, you know, after we, you know, we placed the asset into service, you get ten, 15 years of no property tax.

They generally come with things like a PILOT agreement. So, a Payment In Lieu Of Tax. You know, oftentimes because of the political climate they will say well, we’ll exclude the school district from the abatement. So, you pay the school taxes, but you don’t need to pay the county or the city taxes on the data center.

But I think the key thing for considering credits and incentives is you always have to do that early, early, early on in the site selection process because by the time you have a public announcement out there, the economic development authority within those jurisdictions is going to say, well, you know, they’ve already kind of decided to move here.

We don’t really need offer very many incentives to get them, because I can tell they’ve already invested the time and money to, you know, make the announcement, pull permits, etc. So, you do have more leverage if you start early in that process. One thing I have noticed, I think Ericka alluded to this as well, is I think we’ve seen a little bit of a shift in political winds with regard to data centers. Early on in this whole data center boom, we were seeing a lot of jurisdictions trying to attract data centers to their locations.

But I think lately it’s been a little bit more difficult. I think residents have concerns about, you know, are they really, truly creating the jobs that they’re saying or, you know, are there concerns with, you know, how much of the infrastructure they’re taking up or a strain on the electricity or the water in the area?

And so, I think it’s made it a little bit more difficult for incentives to be obtained for data centers. But I think there still are a lot of jurisdictions out there who would like to have that if not, you know, for the jobs, for the tax revenue, because I think it’ll be a significant increase to these local budgets to have a facility like that within their borders.

IRIS LAWS

So, you’re mentioning, you know, a shift in the winds a little bit and maybe less opportunity for incentives. But how does that translate into, like, disputes, right? You’ve dabbled in some controversy and there could be valuation issues or some of that going on. Have you seen that increase as well, or is it a little too early to say?

EDWIN LAM

I would say, we have seen this, the assessors get a little bit more aggressive with their valuations in recent years. I think part of that, though, is just is more education on the value of data center equipment.

You know, like I alluded to earlier, some of these counties, they’ve never seen a data center in their jurisdiction before and now we’re seeing them pop up across the country. And you know, I had conversations with some assessors where they said, you know, we actually called other counties where we know that there are data centers or a large number of data centers to get understanding of how to value these things.

You know, the thing is, in certain states, the disclosure of the amount of spend that you put into the facility is sometimes something that the company does not have to fully release, or at least they don’t have to bifurcate out how much of it is actual, tangible, real, or etc.

So, some of these assessors are trying to, you know, play a guessing game as to what they think the value is. And generally what we see is assessors have three approaches that they can use to come up with the value of a taxable asset. And when we talk about value, you know, most state constitutions, they require that property tax be imposed at a starting point on the fair market value of the asset.

So, with something like data centers moving as quickly as it is, fair market value has been kind of all over the board from what I’ve seen. But usually you’ll see, you know, they’ll either take a cost approach to the assessment, which is where they look at the actual cost to build or replace the facility.

They may take a market approach, which is, you know, look at, you know, what do data centers sell for. If they have any data centers that are close by the subject property, that gives them an idea as to how much it would be, either, you know, per square foot or, you know, based upon the capacity of the of the facility.

And then I think one thing I’ve seen a lot recently is taking an income approach, which is, you know, kind of similar to the way a lot of investors would value property as you look at NOI and you apply a cap rate or you do a DCF on the cash flows to come up with, you know, what would an investor pay for this facility?

And so, all these things, you know, I would recommend if the data center operator feels like the valuation that the local assessors come up with is excessive, absolutely have a practitioner take a look at the county’s work papers. How do they come up with that value. And, you know, see whether or not there’s anything there that, you know, may have been overestimated and needs adjusting.

But, you know, that’s something that, you know, we have been seeing a lot recently is, you know, increase in assessed values just because of the perceived value of these data centers, increasing with the increased use of AI across the industry.

IRIS LAWS

Sure. Well, Ericka, we heard from you about exemptions and the benefit that might be available there. Edwin, we heard about, you know, just now working with folks like those at our firm to think through valuations, also to think about negotiated incentives early on, considering property tax in the planning stages of these projects.

So, it sounds like we’ve given our listeners some great takeaways, and we really appreciate you jumping on for the first of our mini-series for data centers. For our listeners, if you’ve enjoyed this, we’ve got a few more episodes focused on this topic to come, so be sure to hang in there with us. But for now, we’d like to thank you, Ericka and Edwin, for joining us on the pod.

ERICKA HERNANDEZ

Thank you.

EDWIN LAM

Yeah, thanks for having us.

IRIS LAWS

And that’s our show. Thanks for joining. Remember to subscribe and listen in for the next episode of the podcast. Until next time.

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The information set forth in this podcast contains the analysis and conclusions of the panelists based upon his, her, or their research and analysis of industry information and legal authorities. Such analysis and conclusions should not be deemed opinions or conclusions by Forvis Mazars or the panelists as to any individual situation, as situations are fact specific.

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