5 Issues Affecting How Sales and Use Tax Apply to Your Software and SaaS Products
Multi-state sales and use tax concerns are a given when you or your clients sell software and provide other items through software-as-a-service (SaaS) models. Managing SUT compliance for these business activities is difficult and requires awareness for the many issues that affect how jurisdiction taxes SaaS. Each state has the potential for unique rules and standards that could apply to your business. When it comes to the sale of software, these are the five issues that are likely to have a great impact on your sales tax obligations.
1. The Location of Your Customers
SaaS companies often have customers all over the country or world because of the many ways to access software through cloud-based, remote downloads, and web-based applications. While these options are good for your market reach, they can become a nightmare for sales tax logistics. Depending on the amount of taxable sales of your SaaS in a given state, you may trigger economic nexus thresholds that require you to register for a seller’s permit and remit tax to the state. Additionally, counties and cities could have local sales tax rates that apply to your sales based on the physical location of your customer within a state.
2. How Customers Receive or Access the Software
The next issue is the way your customers obtain or access the SaaS after they purchase it. Generally, this is done in one of two ways. Tangible transfers of the software provided through mediums such as a disc or flash drive. Alternatively, you might provide access through digital downloads or access to the program over the internet. Many software companies will offer both, but this can lead to diverging sales tax implications when sold in different states.
Some states view the sale of software and SaaS as nontaxable when transferred through intangible means or remote access. In other words, there is no transfer of tangible personal property for the state to tax. For example:
- California (See Reg. 1502(f)(1)(D)).
- Colorado (See Colorado Department of Revenue, Sales & Use Tax Topics: Computer Software).
- Georgia (See Georgia Letter Ruling SUT No. 2014-02-20-01).
Other states will tax the sale of computer software or SaaS regardless of how the customer obtains it. For example, Arizona broadly applies its transaction privilege tax to the sale of computer software no matter the method of transfer. Even if your state does not tax software transferred remotely, it’s important to note that related transfers of property or services could be taxable, such as user manuals.
3. Whether the Software is Prewritten or Custom
Most states also distinguish the sales tax status of software based on if it is prewritten or custom. Prewritten software is a uniform program capable of being sold to many customers without any modification. In contrast, custom software is developed for a single business or user. States that tax software usually view prewritten software as a taxable commodity but find custom software to be a nontaxable service. While prewritten software is usually taxable, you may find that custom upgrades or modifications to that software are not. Consider how you describe and itemize the various software items you offer to avoid accidentally taxing exempt property or services.
4. Whether the Sale of SaaS Is Part of an Integrated Service
SaaS products are difficult for state legislatures and revenue departments to define for sales tax purposes because they often involve integrated services, which refer to single transactions that involve the transfer of both property and service. Other industries where integrated services are common include construction and property repair services (e.g., cars, clothing, appliances, etc.).
Some states have clearer positions than others on how to tax SaaS when it’s part of an integrated service. For example, Ohio’s Administrative Code considers the possibility of “mixed transaction”, which allows for the separation of computer services from the receipt of personal or professional services. See Rule 5703-9-46(B)(4). In these scenarios, the issue usually turns on whether the transfer of software is the primary purpose of the transaction or is an incidental transfer of taxable property that’s part of a nontaxable service. You might hear others refer to this rule as the primary function or true object test.
The test was central to a recent dispute in New York where the Office of Tax Appeals cancelled the sales tax assessment against a company, Yesware, Inc., for its use of software in providing nontaxable information services related to email marketing. Relevant factors in evaluating the taxability of integrated services involving SaaS could include the following:
- The level of control a customer has over the software (e.g., the ability to customize or transfer it).
- The existence of other methods for customers to access the services or information provided through the SaaS (e.g., via phone, in-person, or other mediums).
- The percentage of value driven from the software versus the information accessed through it (i.e., what is the customer truly paying for).
- How you describe the transaction in contracts, invoices, and other sales materials.
5. The Availability of Exemptions for SaaS Purchases
In states that tax SaaS and other computer programs, your particular sales might qualify for exemptions depending on two factors— (1) who your buyer is and (2) the intended use of the software. For example, Iowa offers a commercial enterprise exemption for the sale of computer software and certain digital products when sold to a commercial enterprise, such as a manufacturer, financial institution, or a professional service firm. Second, your customer may qualify for an exemption based on the intended use of the software. For example, New York offers an exemption software is bought for use as part of a manufacturing, production, or research and development process.
Sales and use tax for SaaS and other computer software are complex items for businesses to manage because of the many influencing factors. If your team is facing issues with an audit and assessment or have general concerns about compliance, meet with our sales tax professionals today. We provide cost effective sales tax solutions for businesses and CPAs using our administrative knowledge and experience. Schedule your free consultation now.