Ecommerce shops that sell software may run into complex rules regarding sales and use tax. It’s tempting to believe that “intangible” software, such as downloads and streams, are not subject to sales tax, but that is not always correct. As services available via cloud computing grow, states are looking to recoup lost sales tax revenue created by these intangible products. So, when is software taxable? There are three options for selling software and they each have distinct rules for when sales tax need to be collected.
Option 1: Tangible software.
The customer buys a tangible software product, such as a boxed media. Obviously, that is handled traditionally and will incur sales tax if a nexus is present in the state of the purchase. (Learn more about what constitutes a nexus and how affiliate sales programs can affect nexus standing.) However, this option is rare as consumers are more likely to download software or access it via the Cloud.
Option 2: Downloaded software.
The customer purchases a software or license and then downloads the product to their computer. Many states have now set sales tax on these products, considering them to be the same as tangible property. Shops need to consult what sales tax codes are wherever they have a nexus.
Option 3: Software accessed via cloud.
The customer uses software over their internet connection: Services or software obtained via Software as a Service (SaaS), Platform as a Service (PaaS) or Infrastructure as a Service (IaaS), that is, services accessed via the Cloud. These are explained in further detail below. SaaS is the most common of these services in retail, so this article will focus on when SaaS is taxable.
Option 3 is usually where the most confusion in sales tax arises. Common examples include online human resource or content management systems. AccurateTax is also SaaS software, since we provide sales tax services in the Cloud.
What Is SaaS and Is It Taxable?
With SaaS, the customer does not purchase a tangible object and does not download software to their system. Instead, they are accessing the software only via remote access. According to SearchCloudComputing.com, there are two common models for SaaS:
- Hosted application management (Host AM): The software is hosted with the vendor and the customer accesses it via the Internet.
- Software on demand: Customers get “network-based access to a single copy of an application created specifically for SaaS distribution.”
According to TaxFoundation.org in a January, 2014 article, “states tax some kinds of software and exempt others, based on whether it is customized or off-the-shelf and whether it is on CD or downloaded.” Obviously, this is far more complex with SaaS and cloud computing, but retailers can take some concrete steps to determine if the services they sell are taxable.
Steps to Determine if Cloud Computing or SaaS is Taxable:
- Do I have a nexus in this state?
The is always the first step a company should take in this process.
- Is this considered a service or taxable product?
As mentioned, states often consider downloadable software as a taxable product, but not always. In some cases, states will consider the way a client uses the software to claim it as a taxable product. In addition, retailers may be selling products via SaaS that states consider to be a service. Retailers need to understand how states classify the SaaS product they are selling.
- Who controls the end product?
This is a trickier issue for customers using SaaS and thus far, debatable with regard to whether or not sales tax is charged. At present, the state determines this.
- If it’s considered a product, does the state tax SaaS or downloadable software?
The next step is to determine whether that state taxes downloaded or SaaS software, as well as available exemptions.
- If it’s a service, is it taxable?
Some states have very specific rules for different services; others allow exemptions for certain services. Vendors need to be aware of sales tax implications for bundled services and the added question of whether a service is done inside of a taxable area or state or not.
As customers demand more cloud-based services, retailers can expect that states will move towards more ways of charging tax on those items and services.
A Look at How it Works: New York State
In New York State, downloadable software, prewritten software accessed via a license traditionally is subject to sales and use tax. The state’s tax department tried to keep SaaS in that sphere, but instead currently tax SaaS via regulation instead of straightforward sales tax classification. They employ something called “construction possession,” a term defining prewritten software, no matter where it is housed, as an actual transfer of software to the customer and therefore subject to taxes.
However, this regulation has met with some debate since the state is trying to tighten this rule. Last summer, the New York State Department of Taxation and Finance issued a tax bulletin (TB-ST-128) stating “a taxable ‘sale’ of software ‘includes any transfer of title or possession or both, including a license to use’.” According to Burgoyne Law Group, who covered the issue, this means that SaaS and cloud services are subject to sales tax from that state because customers get a license to access and use this software. This is questionable, though, because an end user really has no control over the cloud-based software. While this is still an area of intense debate, expect to pay sales and use tax for the foreseeable future in New York State for SaaS.
The Future of Online and Internet Sales Tax
Now that we’ve discussed how and when retailers can be taxed on cloud computing services and downloadable software, ecommerce companies also need to be aware of the laws that are changing based on these products. This month, the U.S. House of Representatives voted to permanently ban tax on Internet access. Computer World reports that the Permanent Internet Tax Freedom Act (PITFA) prohibits states from “taxing Internet access and from levying any new taxes that target Internet services but have no offline equivalent.” Unfortunately, this does not affect the collection of retail sales tax but at the least, Internet service costs may go down. Retailers need to keep an eye on this issue, as well. Budget-strapped states, such as Texas and Ohio, who currently do tax Internet access will lose revenue and will likely seek to make it up in other areas.
In addition, just this month The National Journal reported that the chair of the U.S. House Oversight Committee, Representative Jason Chaffetz, is preparing to introduce online sales tax legislation on June 15, 2015. This bill would expand a state’s ability to collect tax from ecommerce vendors. While it does not appear to have a lot of support, these bills have reawakened the issue of sale tax. The trade association Retail Industry Leaders Association (RILA) responded to Chaffetz by calling for sales tax parity for retailers. RILA reports that despite Senate passing the Marketplace Fairness Act in 2013, there is no vote from the House to “close the sales tax loophole.” (page has been removed) Jennifer Safavian, RILA’s Executive Vice President for Government Affairs, states, “Retailers support keeping Internet access tax free while closing the online loophole that essentially subsidizes online-only retailers against their brick and mortar competitors.”
While it seems like cloud computing, which is set to grow as a commodity, should be sales and use tax free, states are continuing to work hard to place taxes on these services. Ecommerce shop owners need to be aware of this and take steps to protect their company from inaccurate sales tax collections, especially since states are coming after companies with unpaid taxes. If you know you owe sales taxes on software such as this, it is advised to contact the state through a voluntary disclosure process, which may save you back taxes. In the mean time, smart online retail owners should keep an eye on the changing landscape of Internet, SaaS and cloud computing sales tax collection.