Technology companies, and specifically software companies, have always had challenges related to managing sales tax. Understanding where they have a physical presence as well as the varying taxability rules associated with their products and services was complex. But with the proliferation of Software-as-a-Service (SaaS) as a delivery mechanism and Wayfair, the sales tax landscape has become exponentially more complex.
Tech companies – especially those dealing in downloads of software and (SaaS) delivery – can protect themselves if they understand key terms and processes.
Sales Tax Nexus
A business’s sales and use tax obligation begins with where it has nexus. Nexus is a connection between a company or a person and a taxing authority or jurisdiction. Historically, sales tax nexus was defined as a substantial physical presence. However, since the US Supreme Court ruling in South Dakota vs. Wayfair, sales tax nexus can also be defined as an economic presence.
Today, a business needs to evaluate whether they have either a physical presence or an economic presence in each state. For additional perspective and discussion on physical and economic nexus, please refer to our guide here.
Software Delivery Mechanism Will Influence Taxability
SaaS is currently the predominant delivery method for tech/software companies (especially newer companies), followed by electronically downloaded software. Very few companies continue to deliver software via a tangible CD. Each delivery method can have a different sales tax treatment in each of the states. As software companies continue to change their delivery mechanism, the states must adapt their statutes. Software delivered via CD will have the most states that tax it, while electronically downloaded software will have fewer states, and SaaS will have the least number of states that tax it. (Although SaaS is currently taxable for sales tax purposes in roughly half the states.)
A few examples are referenced below:
- Connecticut taxes SaaS as does Texas. However, Connecticut applies a reduced 1% tax rate on SaaS provided it is sold to a business; otherwise the standard sales tax rate applies. Texas exempts 20% of the charge for SaaS.
- New Jersey doesn’t tax SaaS but does tax sales of downloaded software unless the software is for business use.
- South Carolina exempts sales of downloaded software but taxes SaaS.
- Illinois doesn’t tax SaaS but does tax sales of downloaded software. Separately, the city of Chicago taxes SaaS.
Other Ancillary Products and Services
Often times, when software is sold, regardless of the delivery mechanism, there are ancillary products and services sold with it. For example, hardware, customization, implementation, maintenance contracts, etc. These ancillary products and services have their own unique tax treatment.
Hardware, for example, falls into the category tangible personal property, and all states with a sales tax treat the sale of hardware as a taxable event.
Customization and Implementation. Generally, services such as customization and implementation when separately stated on an invoice will be exempt from sales tax.
Software Maintenance. Historically, hardware or downloaded software can come with a maintenance agreement. This agreement could be mandatory or optional – and there are differences on how the two might be treated for sales and use tax purposes. Generally, the mandatory support and maintenance will follow the tax treatment of the original software while optional support and maintenance can have a different tax treatment.
The tax situs is the location in which a taxing event occurs. Tax situs can affect both nexus determination as well as taxability determination for SaaS businesses. As an example, a company may have a customer based in New York (which taxes SaaS), but the customer accessing the software from all over the country – not all of the users are located in New York. The proper way to look at this from a sales tax perspective is to consider where the benefit of use is received. In this example, the benefit of use is received where the users are located. However, this creates several issues:
1. Do we really know from where all of a customer’s users are accessing the software?
2. Do we have nexus in all the states from where a customer’s users are accessing the software?
3. What is the tax treatment in each of the states from where a customer’s users are accessing the software?
This creates a very complex taxing situation as well as a complex, and unclear invoice when presented to the customer. “Why are you charging me tax for this user but not this user?”
As a result of this level of complexity, many businesses choose to apply tax based on the business bill to address. Some states like Washington, which taxes SaaS, have a multiple points of use exemption. In this situation, the customer may present to you an exemption certificate whereby they are attesting to the fact that certain users are located outside the state of Washington, and therefore relieving you of the obligation to charge sales tax on the entire invoice.
TaxConnex has assisted companies in many industries alleviate the burden of sales tax. We are experts when it comes to navigating tax regulations. Contact us to learn more about how TaxConnex can take sales tax off your plate entirely.
To learn more, check out our webinar on sales tax complexities within the technology industry.