Fernway DiarySM

Apr 09, 2021

The Software as a Service (SaaS) business model is intentionally designed to enable easy selling globally. However, applying sales tax to this model quickly becomes a complex and nuanced process. When a SaaS company sells its product, it is required to follow tax laws in the jursidiction where the product was purchased – i.e. each state, city, or county in which they sell their products or services. This article provides an overview of the relevant provisions and ways in which recent rulings have impacted sales tax laws and their application to SaaS companies.

Sales tax is a consumption-based tax imposed by state and/or local governments on the sale of goods and services in the US. Conventional sales tax is generally levied at the final point of sale to the end customer, collected by the retailer and passed on to the relevant tax authorities.

Sales Tax on Software:

Understanding the classification of your software will help determine which tax laws apply and under what specific conditions. In the US, software can generally be broken down into three categories: tangible software, downloadable software, and software accessed via the cloud.

Prewritten or “canned” software delivered on tangible property is generally subject to tax in all states that impose a sales tax. However, states vary in their sales and use tax treatment of other types of software such as:

• Custom software, and
• Customized prewritten software.

A state’s sales tax treatment of software may also depend on whether the product is:

• Downloaded electronically, or
• Delivered on tangible property such as a diskette.

Prewritten software (also known as canned software or off-the-shelf software) is created and mass produced for the general public. Many states consider prewritten software to be tangible personal property subject to sales tax, regardless of how it is delivered to the customer – i.e. whether on tangible storage media such as a diskette or delivered over the internet.

Custom software (or non-prewritten software), is generally designed and created for a specific user. Many states consider custom software to be a service not subject to sales tax, because it is developed for a specific purchaser.

Cloud Computing:

The taxability of cloud computing depends on the category under which the activity is classified. From a sales tax perspective, cloud computing is a term used to describe the delivery of computing resources, including software applications, development tools, storage, and servers over the internet.

Rather than purchasing hardware or software, a consumer may purchase access to a cloud computing provider’s hardware or software. Cloud computing offerings are generally divided into three categories: Software as a Service (SaaS), Infrastructure as a Service (IaaS), and Platform as a Service (PaaS).

Software as a Service (SaaS):

From a sales tax perspective, consumers are viewed as purchasing access to a software application that is owned, operated, and maintained by a SaaS provider. The consumer accesses the application over the internet, with the software located on a server that is owned/leased by the SaaS provider. The software is generally not transferred to the customer, and the customer does not have the right to download, copy, or modify the software.

Sales tax guidance on SaaS transactions are still evolving. Some states have taken the position that SaaS transactions are a sale of software, on the basis that using the software by electronically accessing it is no different than downloading it. Other states have deemed it a service since no software is transferred. In some states, the taxability may depend on the specific facts and whether the object of the transaction is the use of software or some other purpose.

As such, the applicability of sales tax on SaaS products varies from state to state. Businesses are liable to charge, collect and remit sales taxes in each jurisdiction if it sells a taxable product/service and is determined to have “nexus” based on the specific laws applicable in that jurisdiction.

Nexus Analysis:

Sales tax nexus occurs once the business has established connection with a state. All states have a slightly different definition of nexus, but most states consider “physical presence” or “economic connection” triggering nexus.

• Physical presence – Physical presence can mean several things including having an office, employee, warehouse, affiliate, storing inventory etc. in that state.
• Economic nexus – This refers to a certain amount of sales in a state (either a certain dollar amount or a certain number of transactions).

Nexus Changes

Nexus is the level of presence that allows a state to tax an out-of-state entity without violating the Constitution’s Commerce Clause. Historically, physical presence was the standard used by the Supreme Court to determine if a business established nexus in a state.

In 2018 the US Supreme Court changed the way state and local sales tax collection was practiced. In the South Dakota v. Wayfair decision, the Court removed the physical presence roadblock on the collection of state sales tax from remote sellers; in other words, it held that sellers who engage in a certain volume of economic transactions within a state may be required to collect and remit taxes, despite not having physical presence within the state. In this particular case, South Dakota used a threshold of $100,000 of sales from the state or 200 transactions to establish economic nexus and trigger a sales tax filing requirement. Similarly, many other states have now enacted statues that create a sales tax nexus threshold based on total gross receipts or number of transactions.

This landmark Supreme Court ruling has forced several states to modify their guidance on SaaS-related laws, resulting in sales tax obligations on many SaaS providers. Historically, in many states, SaaS providers were not required to collect and remit sales taxes on cloud based transactions. Even in states that did previously impose sales tax requirements on cloud-based services, many SaaS providers were exempt from this rule because they did not establish a physical connection to the state.

This Supreme Court ruling, combined with the existing variability in tax laws from state to state, makes it onerous for SaaS companies to remain sales tax compliant in the US. As such, it is imperative for SaaS companies globally to be aware of state-specific sales tax laws for SaaS products and services sold in the US.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com

Disclaimer:
The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.