As I ask organizations, big and small, what sales and use tax issues cause them the biggest headaches, the answers are overwhelmingly the same – taxability and apportionment of both software and direct mail. I’m going to save direct mail for another day. But for those who are unconcerned about your organization’s treatment of software, I’m here today to read you the riot act.
When it comes to getting sales and use taxes right on your organization’s purchase of software, there are three threshold questions: (1) What are we buying; (2) Where could it be taxed; and (3) Is it actually taxable? The issues that come up are both self-created (i.e., organizations purchase A LOT of software, or things that look like software) and externally created (e.g., states keep imposing taxes on different transactions, defining things differently, etc.).
Today, we’ll examine these issues just enough to get your attention, so you and your colleagues can begin to assess the risks and issues within your organization.
What Are We Buying?
When it comes to purchases of software (or similar products), the question of taxability begins with figuring out exactly what it is that your organization has purchased.
- How is the software delivered to your organization (tangible media, electronically, or not at all)?
- Was the software customized in whole or in part for your organization, and if so, was the customized portion separately stated from the canned portion?
- If the software isn’t delivered to your organization, and you are accessing it on the vendor’s environment (i.e., Software as a Service, “SaaS”), is there any component that is installed in your environment, such as an application?
- Was the application free, or if not, what was the value of that application compared to the value of the software being delivered as a service?
- Did you purchase one user license, several user licenses, or an enterprise license?
All of these questions, and several others, can help you begin to define what exactly your organization purchased. But, of course, nothing is ever that easy. For example, in addition to SaaS, we also have customized, canned, electronically delivered, distributed, and hosted software. Behind door number two we have purchases that look like software, though aren’t actually software, but are still taxed by numerous states – things like information and data processing services. And, like a late-night infomercial, there’s still more! We haven’t even talked about Wisconsin yet.
In Wisconsin, in a thinly veiled attempt to tax SaaS, the Department began telling taxpayers on audit that if they need to use telecommunication services to access something (i.e., software hosted on a vendor’s platform) then what they’re accessing must also be taxable telecommunications services. Contrast that with the statement from the Streamlined Sales and Use Tax Agreement Compliance Review and Interpretations Committee, which in its draft of Interpretive Opinion 2021-1 provides:
Generally, telecommunications services are a means by which a product is received. The requirement that a telecommunications service be necessary as a means of receiving another product or service does not necessarily make that other product or service a “telecommunications service.”
What will Wisconsin do? Will they provide their own commentary on the draft opinion within the next month? Will they discontinue their aggressive policy? Will they ignore the Streamlined opinion altogether? At this point, while we wait and see, organizations in Wisconsin will have to make taxability determinations at their own peril.
Where Could It Be Taxed?
As if the “what” question wasn’t unnecessarily difficult enough, once you establish what you’ve purchased, you get to determine where your purchase could be subject to sales or use tax. For software that resides on your organization’s enterprise server, identifying the location is relatively straightforward. However, when multiple licenses are purchased and distributed within the organization, the answer differs based on the statutes in both the state where the licenses are originally loaded as well as the state where end users are located. Examining the relevant statutes is critical (especially multiple points of use, or “MPU”, statutes) in both the location of the enterprise server (where the master software is likely located, and licenses are maintained) and the location of end users. And while some states have clearly imposed MPU statutes (which, of course, vary from state to state), others rely in some part on temporary storage exemptions. The taxability plot thickens when you incorporate into the mix various state incentives for data centers. Finally, determining where services should be subject to tax is always fraught with challenges.
Is It Actually Taxable?
Once your organization has established what you’ve purchased and where that purchase could be subject to tax, all that is left is the actual determination of taxability. If you’ve done your diligence in answering our first two questions, the determination of taxability becomes easier although never really “easy.” State-by-state definitions of software and of the related services vary wildly, so spending the time to get the analysis of taxability right will put your organization in a better position to reduce both overpayments and audit assessments.
How Can We Get It Right?
Once you’ve done the diligence to get the what, the where, and the taxability pieces right, there are tools available to help you leverage those decisions. Using Extract Transform Load (ETL) and dashboarding software will allow your tax department to identify both underpayments and overpayments of tax in real time, thus getting you to a more accurate tax paid environment and reducing both corresponding interest and penalties.
Ultimately, watching your SaaS might just save your…financial statement reserves.
Kyle is a State and Local Tax practitioner, focused on providing value to clients across a variety of industries: healthcare, financial services, construction, manufacturing and retail. He develops the tax departments with which ...
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