The Application of State Sales Tax in a Digital World: Considerations for Corporate Counsel

Monday, January 26, 2015 - 12:21

Corporate IT purchasing decisions will largely be driven by operational requirements and profit/cost analysis. State sales and gross receipts tax implications are routinely overlooked in the purchasing analysis. They should never be. Sales and gross receipts taxes often represent a substantial cost component of these transactions, and because application varies greatly across states, they provide structuring opportunities that must be considered during the planning stages.

In addition, traditional companies (i.e., those operating outside of the IT industry) typically face more difficulty addressing the sales tax implications of IT purchases because they are not routine. Certainly, these transactions have a greater scope for IT companies. But because IT companies have greater exposure to these issues, they should also have more expertise. IT purchases, on the other hand, can overwhelm traditional companies because of a simple lack of exposure.

Of course, corporate counsel’s roles are already stretched to capacity, and the intent here is not to propose significant additional responsibilities. Corporate counsel should, however, be aware of the various sales tax issues associated with IT purchasing decisions and the practical steps necessary to address those issues.

Overview of State Sales and Gross Receipts Taxes

All but five states (Alaska, Delaware, Montana, New Hampshire and Oregon) have enacted sales or gross receipts taxes. Annual state and local sales tax collections in these 45 states total approximately $340 billion, which represents a substantial portion of the total state tax collections of $800 billion. The average combined state and local sales tax rate is above 7 percent, which should make it a factor in any corporate purchasing decision. Sales and gross receipts taxes are typically imposed by these states on sales of all tangible personal property (unless a specific exemption applies) and specifically enumerated services.

Fortunately (at least for the sake of consistency), each of these states defines canned, off-the-shelf software and other digital items as tangible personal property, thus subjecting digital items to sales or gross receipts tax if acquired on a physical medium. Unfortunately, the consistency ends there.

Thirteen states do not impose sales tax on software solely delivered electronically – via download, ftp or other electronic transfer. On the other hand, all but twelve states do not impose sales tax on custom computer programs (regardless of delivery method), primarily on the basis that a custom computer program more aptly falls under the definition of a service than the sale of tangible personal property. There is yet more incongruence among states respecting treatment of software stored in a cloud-computing environment or on an out-of-state server. Although many states impose sales and use tax on software hosted on an out-of-state server that is accessed from an in-state location, even those states are not consistent on the underlying rationale. Certain states treat the access as a service, yet others treat it as a software license (sale of tangible personal property). Importantly, the terms of the contract and subsequent activities of the contracting parties will significantly affect a state’s sales tax determination.

Cloud Computing Considerations

The prevalence of cloud computing and the resulting sales tax implications necessitate an overview here. In September 2011, the National Institute of Standards and Technology (NIST) of the U.S. Department of Commerce issued recommendations regarding the definition of cloud computing. The NIST defines cloud computing as a model for enabling ubiquitous, convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.

The NIST further provides that the cloud model is composed of five essential characteristics, three service models and four deployment models. The three service models are particularly relevant to state sales tax, especially considering the opportunity to structure a contract as the provision of a nontaxable service in a certain state rather than as a taxable service or sale of software in another. The NIST defines the following three cloud computing service models:

Software as a Service (SaaS): The capability provided to the consumer is to use the provider’s applications running on a cloud infrastructure. The applications are accessible from various client devices through either a thin client interface, such as a web browser (e.g., web-based email), or a program interface. The consumer does not manage or control the underlying cloud infrastructure including network, servers, operating systems, storage, or even individual application capabilities, with the possible exception of limited user-specific application configuration settings.

Platform as a Service (PaaS): The capability provided to the consumer is to deploy onto the cloud infrastructure consumer-created or acquired applications created using programming languages, libraries, services and tools supported by the provider. The consumer does not manage or control the underlying cloud infrastructure including network, servers, operating systems or storage, but has control over the deployed applications and possibly configuration settings for the application-hosting environment.

Infrastructure as a Service (IaaS): The capability provided to the consumer is to provision processing, storage, networks and other fundamental computing resources where the consumer is able to deploy and run arbitrary software, which can include operating systems and applications. The consumer does not manage or control the underlying cloud infrastructure but has control over operating systems, storage and deployed applications, and possibly limited control of select networking components (e.g., host firewalls).

These categories have unique applications to different businesses and users: the IaaS model typically applies to large corporations that have the capability of assuming complete control over their data; the PaaS model is typically utilized by programmers, developers, and web designers; and the Saas model is utilized by individual users and businesses desiring lower-cost alternatives to traditional licensed software. Likewise, each model has unique characteristics that will drive a state’s imposition of sales tax on the related charges, specifically as it relates to the determination that a transaction pertains to tangible personal property or a service. For instance, a state may categorize the SaaS model as entirely a service, but the IaaS model as either a service (purchases from the cloud computing provider) and tangible personal property (licensing of third-party software installed on the cloud devices) or entirely tangible personal property (licensing of software and rental of hardware).

The underlying complexities should be confronted by establishing protocols and effective communications between corporate counsel, the tax department and the IT department.

Best Practices

Early Involvement of Corporate Counsel and Tax Department: A corporation’s IT department will typically initiate and drive all technology-related purchases. Corporate counsel may not become involved until the contract is ready for final approval. Corporate counsel should establish protocols requiring its IT department to initiate the early involvement of corporate counsel and the tax department in decisions regarding material purchases or the utilization of IT resources in a new state (for nexus reasons). Corporate counsel and the tax department can then ensure that all material issues have been appropriately considered and incorporated into the contract.

Monitoring Services and Use of Software: State taxing agencies are quick to point to either the contract or activities outside the contract to impose sales tax on certain transactions. The contract may be structured perfectly for sales tax purposes, but that may not matter if either contracting party’s activities deviate from the contract. Corporate counsel should communicate to the tax and IT departments the importance of monitoring performance of the services and software contracts to ensure proper compliance. In addition, the tax department should periodically monitor changes in sales tax laws in the relevant states to ensure future compliance – especially since states’ treatment of IT transactions will continue to evolve.

Creation and Maintenance of Records: In addition to monitoring the parties’ activities outside of the contract, it is beneficial to document such compliance in the event of a state sales tax audit. Likewise, it is important to document certain services that are related to the corporation’s out-of-state facilities or users. Certain states exempt taxable services performed for the benefit of out-of-state locations, but the burden to prove this multistate benefit exemption is on the corporation. Ideally, corporate counsel should consider incorporating a provision into the contract obligating the service provider to document the services at the time of performance and in sufficient detail to pass a state taxing agency’s scrutiny.  The benefits are twofold: the corporation will not exhaust any resources documenting the services, and the third-party documentation will serve as more persuasive evidence to a state taxing agency.

Moreover, the software or services contract should clearly identify the location of software installation or performance of the services to prevent multiple states from claiming the right to impose sales tax on the same software license or service. With respect to cloud computing and use of out-of-state servers, corporate counsel or the tax department should request that the appropriate IT personnel document the software and data that is stored on those systems. The tax department should also monitor applicable state sales tax laws and regulations to determine whether the out-of-state warehousing of corporate data creates sales tax nexus where it would otherwise not exist. Although those determinations should first occur during the planning stages, it is equally important to continue monitoring nexus issues in the states in which corporate data and software reside.

Receipt of SoftwareAll states impose sales tax on canned software delivered on a physical medium, but certain states would not impose sales tax on the same software if delivered electronically. Accordingly, a corporation should always require purchased software to be delivered electronically rather than by physical medium, unless there are prevailing business reasons to obtain a physical copy of the software. The contract should clearly specify that delivery will be by electronic means and that no physical copy will be obtained. Last, the contract should require the software vendor to execute a proof of electronic delivery once the software has been electronically transferred.

Although these practices are beneficial for any transaction with significant sales tax implications, they are particularly beneficial for IT purchases because their sales tax treatment is consistently evolving. Corporate counsel are uniquely positioned to work with the tax and IT departments to implement simple, effective measures to address those issues.

Drew McEwen, resident in Dykema’s Austin office, is a senior counsel in the firm’s Tax practice. His practice focuses on tax litigation and planning in the areas of state and local tax and federal tax. 

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