Source: Amy Smith
Although most tax professionals and software companies would like to see one uniform methodology applied to the treatment of software for sales tax purposes, the states continue to present challenges to compliance for sellers of software and software as a service. More states are aggressively pursuing audits of software companies to address these compliance requirements. In addition, these issues arise in due diligence related to potential mergers and acquisitions and regularly present challenges as to how to address uncollected and unremitted sales taxes. Since sales taxes should be collected from customers, failure to properly collect and remit could result in an unnecessary, out-of-pocket expense for a software company.
Each state differs in the sales tax rules they apply to software and it is important to review each state’s requirements to ensure that you are in compliance with their rules. Some items to consider in determining whether you should be charging sales tax on your software sales are discussed below.
Nexus is the minimum connection that you must have with a state in order for a jurisdiction to require that you collect or remit taxes to the state. Retailers of software should review their activities on a regular basis to ensure that they are aware in what states they are creating nexus so that they can determine their sales tax compliance requirements for those jurisdictions.
The nexus requirement is different for sales and franchise taxes versus the nexus requirements for income tax. Sales tax nexus generally requires some minimum physical presence in the state. However, this minimum physical presence is defined differently depending on the state. Some states may determine you have sales tax nexus with as little as one-day presence in the state. In addition, nexus can be created through the use of employees, service people, and independent agents, regardless of their responsibilities. Note that unlike income tax nexus, sales personnel presence cannot be ignored in determining whether you have sales tax nexus. The maintenance of inventory, offices, or warehouses in the state will also likely result in nexus. Many states have also pursued nexus for a seller where its affiliate is doing business in the state or where a seller has sales resulting from “click through” access from an in-state referral agent.
Taxability of the Software
Once you have determined whether you have sales tax nexus in a state, your next challenge is to determine whether the product you are selling is subject to sales tax in the state. Consideration should be given to the following:
· Is your software canned or custom? Many states tax canned or prewritten software, but do not tax custom software (as they consider this a service).
· How is your software delivered? Although some states tax software regardless of the method of delivery, some states do not tax software if it is not delivered on a tangible medium. Other states tax the software if it is delivered via tangible medium or load-and-leave, but not if the software is delivered electronically.
· How does the state tax software as a service? Many states use the true object test to determine the taxability of the software. If the true object of the transaction is the service provided by the software, the state may not apply sales tax to the transaction. Other states look whether control has been transferred over the software so that, if the software is hosted remotely and the customer never has control over the software, the software is not taxable. Some states simply treat software as a service just like any other software.
· Does your sale include other components besides the sale of software? Often, a sale of software includes the sale of other items such as hardware, training services, customization or enhancement services, maintenance contracts, etc. It is important to review the taxability of each of the components of the sale to ensure that you are appropriately applying sales tax to each component of the sale. Note, too, that many states require that the sales price for each component be separately listed on the invoice. Otherwise, the entire sale could be subject to tax.
· Where is the product delivered? Many companies purchase software that is used remotely by employees sitting in numerous jurisdictions. It is important to understand how each jurisdiction sources the software so that you can appropriately apply the correct rate if the software is deemed taxable.
Sales and use taxation of software is a very complex area and is evolving every day as state taxing authorities and courts struggle with how to handle this issue and the ever-changing manner in which companies deliver their products and services. For software companies, there are two important lessons – the application of the law is dependent on your specific facts and circumstances as no two software companies are alike, and each state’s laws are different so you cannot use a one-size-fits-all approach to your compliance obligation.
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