Technology companies who sell access to software or platforms via the Internet such as software-as-a-service (SaaS), platform-as-a-service (PaaS), or infrastructure-as-a-service (IaaS)) are generally on the cutting edge of business and have become intertwined with almost every industry. As a result, most technology companies have customers across the United States. Unfortunately, technology companies may never step foot outside their headquarter state, but still be subject to sales tax and income tax in multiple states; and once a company determines it is subject to tax, they must go through the painful process of determining the taxability of what they are selling and the location of the sale.
The Web of Complexity
A technology company could have a taxable presence (“nexus”) in a state by either having a physical presence or simply having sales to customers in a state. All states that impose a sales tax have a sales threshold that if a company exceeds, the company will be presumed to have nexus. All states that impose an income tax assert economic nexus creates nexus for income tax, but only a handful of states actually have sales thresholds (similar to sales tax).
Since a company can have nexus in a state by having a certain number of sales to customers in a state, it is very important that a company sources their sales to a state correctly. Consequently, it is imperative to know that sales can be sourced to one state for sales tax purposes, and to a different state for income tax purposes.
A sale of tangible personal property is generally sourced to the ultimate destination for income tax purposes. For sales tax purposes, a sale of tangible personal property is generally sourced to where the title is transferred, or possession takes place.
A sale of a service is generally sourced to the state where the service is delivered or received for sales tax purposes. For income tax purposes, a service could be sourced to where the benefit of the service is derived or received (location of customer), or it could be sourced to where the service is performed. Drop shipments, dock sales and other unique sales situations can also create divergent results.
The Sales Taxability of SaaS
Even before SaaS, the sales taxation of software was complicated. When software was delivered and installed at a customer site, a buyer and seller needed to know whether the software was prewritten or canned, or whether the software was custom. Most states treat the sale of prewritten software as taxable, and custom software as exempt. However, some jurisdictions tax all types of software.
When software began being delivered electronically, that opened up a whole new level of questions and taxability. Some states hold that all sales of software delivered electronically are exempt. Some states hold that all sales of software delivered electronically are taxable. Some states hold that only sales of prewritten software delivered electronically are taxable.
SaaS took the electronic delivery of software to another level. SaaS generally refers to the ability of a user to access software and/or to receive services provided remotely via the internet. SaaS providers generally offer the use of software on a per transaction basis, through a service contract or by subscription and do not transfer software to their customers. Rather, SaaS providers only allow customers to access software through remote means.
States have been slow to provide explicit guidance regarding the taxation of SaaS causing taxpayers to default to the state’s rules regarding the taxation of software. However, even then, the conclusion isn’t easily determined.
There isn’t just a lack of clarity, there is a lack of uniformity among the states. For example, access to an online information database may not be taxable in some states but be taxable in others. Some states hold that SaaS is a sale of prewritten software and as a result, is taxable. Some states provide that SaaS is not considered a transfer of tangible personal property and thus, is not taxable unless it meets the definition of a taxable information service or a taxable data processing service. Some states tax data processing, but don’t tax information services; however, most states don’t provide definitions of either making the ability to make a taxability determination difficult.
The Location of the Sale
Some states hold that SaaS is taxable based on the location of the customer or where the service is used. Some states hold that SaaS is taxable based on the location of the server.
The Sales Taxability of IaaS and PaaS
IaaS providers purchase and maintain hardware, software and any other equipment and services necessary to support and manage the content and data flow of their customers. IaaS may be viewed as the outsourcing of IT functions. IaaS providers maintain ownership of the software and hardware. Most states do not tax IaaS. However, some states tax IaaS as long as the service is used in the state.
PaaS provides customers access to computing platforms. PaaS customers create software using tools and/or libraries provided by the PaaS providers. The PaaS provider provides the networks, servers, storage and other services. Platforms are operating systems. Most states do not tax PaaS. However, some states tax PaaS as long as the service is used in the state or tax PaaS as a sale of prewritten software or even as a telecommunication service.
Related Items to Consider
The taxation of upgrades, maintenance agreements, training, custom programming, etc. can differ based on the contracts and even invoicing. Upgrades could be taxable or not taxable depending on whether the upgrades are delivered electronically, or the upgrades are considered prewritten or custom. Maintenance agreements could be taxable or not taxable depending on whether they are optional or mandatory, or connected to prewritten software or custom software. Training and other computer consulting services could be taxable or not taxable depending on whether they are provided in connection with prewritten or canned software, or simply provided on a stand-alone basis.
Technology companies should proactively reduce their state tax risk to prevent the compound effect of any unidentified exposure. The following represents some action steps a technology company can take:
- Determine if the company has nexus in a state for both sales tax and income tax;
- Determine how the company should source sales for both income tax and sales tax;
- Determine if what the company is selling is subject to sales tax in the nexus states;
- Quantify the historical exposure.
- Determine if filing Voluntary Disclosure Agreements (VDAs) is necessary.
- Implement prospective compliance systems or procedures.