Businesses incorporate computer software into their operations in a variety of ways. When it comes to sales and use tax, sometimes software is the taxable product, and other times it is a means to delivering the company’s true service, which is not always subject to tax. But, how do you know which category your software as a service (SaaS) product belongs to? This has become the growing problem for SaaS businesses and their sales and use tax compliance teams. Furthermore, state revenue departments rely on old laws that are ill-equipped to clearly explain when or how to properly tax SaaS. Arizona is one of those states and is why its Court of Appeals recently had to clarify how SaaS is taxable tangible personal property in ADP, LLC v. Arizona Department of Revenue.
The Arizona Department of Revenue’s Current Position on SaaS
The Arizona Department of Revenue (ADOR) broadly taxes the gross receipts from the sale or lease of computer software, regardless of its method of transfer. The main exception being gross receipts from the creation of custom software or modifications that are for the specific use of a customer (R15-5-154, pg. 12).
In a private letter ruling, the ADOR expanded its position on taxable sales of software to include charges for access to software hosted on a company’s servers. See LR09-007. The reasoning behind the Department’s stance in its letter ruling comes from its broad reading of the definition of tangible personal property and A.R.S. § 42-5071, which states that the rents of personal property are subject to the state’s transaction privilege tax (TPT). Arizona statute defines tangible personal property as anything that “may be seen, weighed, measured, felt or touched, or is in any other manner perceptible to the senses.” See A.R.S. § 42-5001(21) (emphasis added).
The Court of Appeals’ Recent Ruling Against ADP, LLC
The Arizona Court of Appeals seemingly affirmed the ADOR’s position on the taxability of SaaS in ADP, LLC when it determined the company’s licensing of its eTime application to Maricopa County was subject to TPT as rented tangible personal property. ADP, LLC is a well-known human resource provider known for its payroll services. The company’s license of eTime software allowed the employees of its clients to directly input time sheet information and other employment data that ADP would take to process paychecks. In its decision, the court noted the following factors that contributed to its finding that ADP’s license of eTime was a taxable rental of software:
- eTime was perceptible and fit the definition of tangible personal property because employees could view the program while using it on a computer or phone.
- ADP’s license of eTime constituted the taxable renting of property because Maricopa County has sufficiently exclusive use through the custom offerings of the program and access with unique login credentials.
- eTime was not the transfer of “incidental property” during the performance of nontaxable services based on ADP’s contract, which showed separate charges for “hosting services” and “ADP Enterprise eTIME”.
For those reasons, the court upheld the ADOR’s denial of ADP’s claim for a sales tax refund. The Court of Appeals’ decision could face review in the Supreme Court of Arizona if it grants review of the case. Until then, businesses that use software and SaaS-type products with their services must be mindful of the potential TPT obligations that likely exist under current ADOR guidelines.
Need Sales Tax Help for Your SaaS Products?
Sales and use tax compliance for SaaS businesses remains a difficult issue for CPAs and business owners due to a variety of reasons. You likely have customers all over the country in several states that could have contradicting applications of the sales tax for the same SaaS product. Additionally, how you market, contract, and invoice SaaS could mean the difference between selling a taxable good or a nontaxable service. These issues make SaaS businesses a strong candidate for state sales tax audits and unfair assessments from your revenue department. If you recently received notice of an audit or have questions about your compliance, get in touch with one of our sales tax professionals today.