Sales Tax in the Cloud
California, Massachusetts, New York, and Texas
In our September newsletter, we introduced the topic of sales tax in the age of e-commerce and traced developments over the last two decades from the initial rise of internet sales of tangible property by companies such as Amazon to the more recent cloud computing revolution. We discussed the states’ evolving attempts to adapt a sales taxation system rooted in the “old world” of brick and mortar stores to the modern, ever-changing reality of e-commerce, with a specific focus on cloud computing transactions, referred to as “Software as a Service” or SaaS in tax parlance. In this article, we will look in more detail at how several larger states of interest to many of our clients – California, Massachusetts, New York, and Texas – treat software transactions.
As one might expect given the location of Silicon Valley and the long-standing position of California as the heart of the U.S. and worldwide tech sector, tech companies are a strong force in California politics and the state has adopted tax policies favorable to their business. Early in the e-commerce era, California enacted rules exempting software from taxation unless the software is delivered in tangible format, such as on a CD or DVD. These rules continue to this day, and have evolved to specifically exempt all downloaded or remotely accessed (SaaS) software, separately stated charges for customizing prewritten software and the entire charge for fully custom software designed from the ground up to meet the needs of a specific customer. California also exempts digital products, a term describing e-books, music, movies, periodicals, and other media downloaded via the internet – i.e. just about anything purchased from iTunes or a similar service.
Despite the strength of its own tech sector, and perhaps explained by that sector’s focus on biomedical technology as opposed to business and consumer software, Massachusetts has been more aggressive than California in adapting its laws to subject software transactions to sales tax. Massachusetts taxes all non-custom software regardless of the means of delivery, including SaaS, unless the taxpayer can show that the object of the transaction was to obtain information or a service rather than the use of software. This “object of the transaction” standard is a relatively new rule and creates a significant gray area given the inherent subjective analysis of whether the primary goal of the transaction was to obtain information, benefit from a service, or use a software program. Most business software contracts arguably contain portions of all three elements, but the conservative and safest course in most cases would be to assume that the entire charge for cloud-based software is taxable. Similar to California, Massachusetts does not tax digital products.
New York has adopted a similar approach to Massachusetts in that it taxes all non-custom software regardless of whether it is delivered on a CD or DVD, or downloaded. The state has yet to promulgate a rule directly addressing SaaS in general, but has issued rulings on a variety of specific situations presented by taxpayers that arguably fall under the SaaS umbrella, and generally has concluded that these transactions are sales of prewritten computer software for sales tax purposes, and are therefore subject to tax. New York generally exempts digital products from sales tax, but includes specific requirements for e-books, such as that delivery can only be provided by a single download and the product must not be designed to work with any software other than a basic program allowing the book to be read on a device such as a Kindle, IPad, or PC.
On the opposite end of the spectrum from California, Texas taxes all sales of software regardless of the means of delivery, including SaaS, and also taxes digital products as part of an overall tax structure that does not include any individual or business income tax and instead relies on business franchise taxes and sales and use taxes to fund state government.
The four states briefly considered above represent only a small selection intended to illustrate the wide variety of sales tax rules between states, and even in these states, the rules could change at any time as the states struggle to keep up with the pace of technology and capture more tax revenue. If you have questions or are wondering if you or your business should pay use tax or charge sales tax on a particular product or transaction, please contact me, Merrill Barter, Chris DeRosa, or your BNN advisor for a detailed analysis of your specific situation.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.