Sales Tax for Software Companies: Navigating Complexities in a Changing Landscape

Software companies, particularly those offering remotely accessed software or software-as-a-service (SaaS), face intricate sales tax implications as they generate revenue across the U.S. With 46 states enforcing sales tax laws, each with its own definitions and regulations, tech companies need a clear understanding of compliance obligations. Key factors such as software classification, sourcing rules, and evolving state interpretations play a critical role in determining the taxability software and related services.

The Basics: Canned vs. Custom Software

Historically, sales tax was applied primarily to tangible personal property. States traditionally treated prewritten software—often referred to as “canned software”—as taxable when provided on a tangible medium, such as a CD. In contrast, custom software tailored for a specific customer was generally considered a nontaxable service, even when delivered on a tangible medium, as it was viewed as a conduit for a programming service.

As technology evolved, many states extended their sales tax frameworks to include electronically downloaded prewritten software, equating it to tangible sales. Accordingly, when access to prewritten software is provided remotely over the internet, many jurisdictions began to treat this as a taxable transaction.

The Rise of Cloud Computing

The advent of cloud computing transformed how software is delivered. Cloud-based software providers use their own hardware and infrastructure to offer services remotely. This shift created discrepancies among states regarding the taxability of cloud services. Some jurisdictions consider that a buyer gains constructive possession of the prewritten cloud software, treating it similarly to electronically delivered software by making it taxable. Conversely, some states maintain that cloud computing does not involve the transfer of tangible personal property and is therefore not subject to sales tax.

Sourcing Challenges

For companies operating in states that tax cloud computing, determining the correct sales tax can be complicated, especially when software is accessed from multiple states. Most states use a destination-based sourcing approach, which is misleading if solely relying on a customer’s billing address. To address this, some states permit the use of a Multiple Point of Use exemption certificate, allowing businesses to allocate software usage for tax purposes. By presenting this certificate to sellers, businesses can reduce their sales tax exposure in jurisdictions where the service is not taxed.

True Object Test

Another challenge arises with software products that include ancillary services, such as marketing or information services, which may not be taxable. The emergence of the “true object test” allows states to evaluate the essence of a transaction on a case-by-case basis. This test aims to discern whether the core offering is software or a service, thereby determining the applicable sales tax rules.

SaaS and Its Implications

SaaS revolutionized how companies store and manage data, yet the taxability of these services varies widely. In many cases, nontaxable states categorize SaaS offerings with data processing or management information services, while others classify them as taxable cloud computing. This inconsistency underscores the importance of understanding local laws when entering new markets.

Digital Goods and Their Taxability

The sales tax implications for digital goods (i.e., audio and visual works) further complicate matters. While states generally follow the same principles as cloud computing for taxability purposes, there is no universal definition, leading to varied interpretations and applications across jurisdictions. For example, downloaded music may be taxed similarly to downloaded software under existing rules.

Data Processing and Information Services

Data processing services—transforming information into accessible formats—are often considered ancillary to software sales. Generally, states do not tax these services unless explicitly stated in state statutes. Similarly, information services like credit reports and marketing surveys are typically exempt, although some states impose taxes on certain types of reports that are for mass consumption and not personal or individual in nature.

Conclusion

The complexities of applying state sales tax rules to software transactions are pronounced, especially given the rapid evolution of technology. Each state has its own approach, making compliance a challenging task for software providers. The nuances of sourcing, taxability classifications, and the true object test create additional layers of complexity.

To navigate this landscape effectively, software companies should partner with qualified professionals specializing in state sales tax regulations. At Anchin, our team assists tech companies to ensure compliance, mitigate the risk of costly assessments, and keep them informed about the ever-changing tax legislation. By understanding the intricacies of sales tax obligations, software providers can focus on delivering tailored strategies while safeguarding their compliance responsibilities.

For more information, please contact Alan Goldenberg, Principal and Leader of the State and Local Taxation (SALT) and Tax Controversy groups, Adam Pizzo, Partner in Anchin’s Technology group, or your Anchin Relationship Partner.