The sales and use tax implications of software subscription sales vary substantially from state to state. If your software subscription business makes sales across the country, you may have sales tax liabilities lurking in multiple states due to the ambiguity in the application of sales tax laws to this industry. Most sales tax schemes predate modern software, leaving states struggling to reconcile these products with their existing laws. As a result, states have taken different, often creative approaches to capturing software subscription sales within their tax base. With a mix of new laws imposing tax directly on software subscriptions and new interpretations of old laws stretching statutes to include these sales, there is substantial confusion left for taxpayers. Before software subscription business owners can know all the answers, they need to know all the right questions to ask. The failure to ask questions now can result in a debilitating assessment down the line.
Is a Software Subscription Tangible Personal Property?
One of the most fundamental concepts of sales tax law is that sales of tangible personal property are generally subject to tax while services are typically exempt. When software was first produced for mass markets, it was done so on a CD-ROM. Because CD-ROMs were tangible personal property transferred as part of the transaction, they were clearly taxable. However, as software evolved, the element of tangible personal property was lost in software transactions. With no CD-ROMs, how could software be taxed as tangible personal property?
States approached the issue in three main ways: (1) they let software fall through the cracks and remain nontaxable; (2) they modernized their definitions of “tangible personal property” to include intangibles such as software; and (3) they reclassified remotely accessed software, including most software subscriptions, as a taxable service.
Facing deficits, most states refused to allow the first option to occur. After years of relying on the revenue from software sales, it would be a devastating blow to states to abruptly lose that revenue just because the delivery methods of software had evolved. However, at least one large state, Florida, does not currently tax software subscriptions when they are sold without the transfer of tangible personal property. Several other states similarly have not yet moved to tax remotely accessed software subscriptions, possibly for political reasons or perhaps because they simply haven’t gotten around to it yet.
Those states that modernized their current sales tax laws have typically moved to expand their statutory definition of tangible personal property to include software in its various forms. Often, such states distinguish between “canned” and “custom” software. Canned software is software that is not designed for a specific customer and does not contain customer-specific modifications. Many states have considered “canned” software to be taxable software. Meanwhile, because “custom” software is software that is created specifically for a particular customer, it is generally not considered taxable software as a result. Instead, custom software may be deemed either a taxable or nontaxable service. Ultimately, taxpayers must first determine whether the states in which they are making sales consider software subscriptions to be tangible personal property. Next, owners of businesses selling software subscriptions that are considered tangible personal property should consider whether their software is canned or custom in nature. State definitions may vary on all of these legal terms, so it is important to be familiar with the law in each state in which you are doing business.
Is a Software Subscription “Software as a Service” (SaaS)?
Rather than letting software sales slip through the cracks or modifying current tax schemes to cover evolving technology, many states have gone the route of adopting new legislation altogether. Such legislation explicitly taxes “SaaS,” or Software as a Service, essentially reclassifying software sales from tangible personal property into an articulated taxable service.
If customers are not receiving anything tangible as part of a transaction, they must, states posit, instead be receiving a service provided by remotely accessed software subscriptions. The idea that the taxpayer purchases an intangible is not considered in these laws. In short, states seem to take the position that software must be taxed, and since it can only be taxed as tangible personal property or as a specific service, it will be taxed as a service when there is no tangible personal property transferred.
Oddly enough, some states identify remotely accessed software as Software as a Service but in fact tax this service as a sale of tangible personal property. Yes, you read that correctly. In some states, your sales of software subscriptions could be classified as services while simultaneously taxed as sales of tangible personal property.
It is obvious states are struggling to maintain software subscriptions in their tax base. To add to the confusion of SaaS is the fact that many states haven’t exactly adopted “laws” but instead have posted Department of Revenue guidances of which taxpayers should somehow be aware. Unlike a change in the law, which may be well advertised within the industry, a quietly issued guidance letter from a state may go unnoticed by a company even as it takes a position in conflict with the laws businesses have relied upon for years. Worse yet, agency statements may have varying authority on taxpayers. In some cases, they may be binding on all taxpayers while in others, the guidance may only be binding upon the one taxpayer who requested it. Software business owners must not only be aware of all these various forms of Department notices as they are released, but they must also know whether these notices are binding on their business. Ultimately, SaaS remains a grey area of sales tax law that is unfortunately founded, in many states, not on statutes or even administrative codes but rather on Department guidances of questionable application and authority. Currently, over 15 states impose tax on SaaS, and it is likely this trend will continue as states fear the substantial loss of revenue that would occur should the entire software subscription industry fall through the cracks.
Where is a Software Subscription Sold (Situs)?
Identifying whether your software subscription business is selling tangible personal property or a service is no easy task. However, that information is only helpful if you have identified the right state where the transaction took place. It is easy to overlook the situs of a transaction, especially when it may seem irrelevant in a world of remotely accessed software. However, situs is extremely important for determining the sales tax treatment of your sales.
Imagine a scenario in which a software subscription is purchased in Florida using a Georgia billing address. However, the software subscription is actually used in New York and California. Where did the sale take place for sales tax purposes? Which state is entitled to the sales tax?
States take odd positions on identifying the situs of a software subscription sale. Some states take the position that the tax is owed wherever the software resides on a server, but that can lead to a plethora of issues. Other states assume it is where the user of the software is located. Furthermore, it is possible in some states that the sale be apportioned based on the usage of the software. Such a policy would require that purchasers of software are able to anticipate where it will be used at the time of purchase, which may pose a problem to some software subscription sellers.
Unfortunately, it does not seem that clarity is coming anytime soon for those in the software industry. One small form of relief can come from some states in the form of MPU exemption certifications. MPU, or multiple points of use, puts the burden of paying use tax on the purchaser of the software subscription. The seller meanwhile, has no responsibility to collect tax. Software subscription customers must instead apportion their purchase and remit use tax accordingly.
Do You Have to Register to Pay Sales Tax on Software Subscription Sales?
Determining where you make sales and whether those sales are tangible personal property or service transactions does not entirely resolve the issue of whether you need to pay sales tax to a particular state. There is still another determination that must be made to identify the states in which you have nexus.
Nexus is a relationship sufficient enough with a state to allow for that state to impose its taxing authority upon a business. It should be no surprise at this point that each state makes its own definition of what creates that nexus relationship. However, all states agree that physical presence is included in that definition. In short, if your business, its employees, or your inventory is physically located within a state, you probably can be certain that you should be registered to collect and remit sales tax.
Since 2018, states have been aggressively pursuing a new definition of nexus in addition to the physical presence standard. A trend in what is known as “economic nexus” has swept the country in the aftermath of the landmark Supreme Court case South Dakota vs. Wayfair. The Wayfair case upheld South Dakota’s law that established nexus with remote businesses based upon economic thresholds. Since then, roughly 40 states have adopted their own economic nexus thresholds. The thresholds vary from state to state, but the most popular threshold is $100,000 in sales or 200 separate transactions within a calendar year period. Regardless of whether a taxpayer has physical presence, if they surpass this gross receipts or transaction threshold, they are required to register to collect and remit sales tax going forward.
Taxpayers looking to determine which states they must collect and remit sales tax in must first identify where they are physically located and register in those states. Then, software subscription business owners should compare their sales to the economic thresholds in each state in which they do business. Identifying what sales count towards both the gross receipts threshold and transaction number is not always as clear as it seems. Particularly with software subscription sales, it may be ambiguous whether a sale counts as one transaction or many. While some states have offered guidance on this front, many have left lingering questions with their new economic nexus thresholds.
Software subscription business owners do not have an easy task when it comes to sales tax compliance. First, the product itself must be analyzed on a state by state basis to determine the nature of the sale, whether it is one of tangible personal property or a service. If it is tangible personal property, software business owners must go a step further to determine whether their product is canned or custom. Meanwhile, if their software is considered a service, it must be determined whether it is a taxable service or nontaxable service in each applicable state.
Next, business owners must identify the situs, or location, of their sales. It will vary state to state how situs is determined. Occasionally, states will take conflicting positions on the situs of a transaction. This can result in each of the states claiming the tax for the same transaction. Fortunately, some states offer MPU exemption certificates for multiple points of use that shift the burden of allocating and paying tax to the customer rather than the software subscription seller. Such certificates can spare software businesses from the tax implications of some of their most complex sales.
Finally, once the taxpayer has identified the location of their sales, they must compare their sales by state to each state’s nexus thresholds. While physical presence remains the longstanding law of the land in establishing a nexus connection with a state, since 2018, economic nexus standards have been enacted across the country to capture remote sellers as well. Software subscription business owners must identify whether the nature of the sales, quantity of transactions, and gross receipts are included in these thresholds and whether the thresholds are consequently surpassed in the states in which their software is sold. It is only after this full analysis that a software business can know for certain where it is responsible for collecting and remitting sales tax. As one of the most difficult and ambiguous areas of sales tax law, software subscriptions are easy targets for a sales and use tax audit when each state takes different positions on the many issues presented above. Therefore, those in the industry may benefit from a professional analysis done by a competent sales tax attorney. The time and effort spent up front to ensure that you are properly following the sales tax laws of each state could save you from not only one devastating audit down the line, but multiple devastating audits from each state in which you are doing business.
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Sales Tax Changes for Fulfillment by Amazon Sellers, By Jeanette Moffa, May 6, 2019
Jeanette Moffa is an attorney who concentrates on state and local taxes at Moffa, Sutton, & Donnini, P.A. She is an executive council member of the American Bar Association Tax Section State and Local Tax Committee and the Florida Bar Tax Section. Ms. Moffa is an author of both the CCH’s Expert Treatise Library: Sales and Use Tax as well the ABA’s Sales and Use Tax Deskbook. In addition, her regular columns on state and local tax issues can be found in State Tax Notes and Actionline, a publication from the Florida Bar’s Real Property, Probate, and Trust Law Section. She also serves as assistant editor to the Sales and Use Tax Deskbook and Actionline. Ms. Moffa is a regular speaker at the American Bar Association Tax Section conferences, the Institute of Professionals in Taxation, the Florida Bar Tax Section, the Florida Bar Real Property, Probate, and Trust Law Section, and the FICPA. In her free time, she teaches as an adjunct professor at Broward College.