Software as a service (SaaS) is an increasingly popular technology for businesses and individuals; however, when it comes to taxation of its sale and use, things are still a bit muddled. While you may have already switched from locally installed versions of Microsoft Word or Outlook to an Office 365 subscription, states are all over the board as to whether that subscription is subject to sales/use tax.
States are struggling to determine whether the taxability of software that provides essentially the same functionality should differ based on how it is delivered (local software package versus cloud-based system). The states’ struggles mean your business could be caught up in the fight and potentially face a hefty tax bill.
Tangible (and taxable) media vs. digital (and possibly exempt) service
Traditionally, canned software (that is, not written specifically for one user) has been taxable when delivered on tangible media such as floppy disks or CDs. This makes sense, as sales and use tax generally applies to tangible personal property, and those media definitely fit the criteria. As the delivery method for software began to shift toward downloads, however, states began to differentiate between taxable and exempt status, with a number of states labeling downloaded software as exempt because no tangible media is provided to the customer.
This next evolution to SaaS presents a quandary for states. Is SaaS more like tangible property just delivered in a new form, or is it truly a service? Do users interact only through a website, or is there an additional piece of software or an app downloaded by the user to allow them to interact with the SaaS provider? Is SaaS used where the customer sits or where the provider’s servers are located? Due to thorny questions like these, about 20 percent of states have not ruled on whether they think SaaS is taxable. Even some that have provided guidance have done so in a non-binding way that may not be respected by the courts.
State tax risks for SaaS users
If you are a user of SaaS (and you most likely are), you face risk in a use tax audit if your providers have not made the necessary determinations about how the state where you use the SaaS treats it for sales tax purposes. For instance, Pennsylvania has issued administrative guidance saying SaaS is taxable. While this guidance is not authoritative like legislation or regulations, nor has the guidance been tested such that the courts have definitively ruled on the topic, it is the Department of Revenue’s position that your usage of SaaS in Pennsylvania is taxable. This means if your business gets audited for use tax, you will be responsible for tax if the SaaS provider did not charge you sales tax.
State tax risks for SaaS providers
New economic nexus laws can cause a company to deal with sales tax compliance in states where they have as little as $100,000 of annual sales or 200 sales transactions. As such, businesses that provide SaaS can face risk in many states if they do not understand both their nexus footprint and how each state treats SaaS for taxability purposes. It is imperative that SaaS providers understand the intersection of these nexus and taxability issues, so they can be sure to charge sales tax where necessary instead of bearing the risk the tax might come out of their own pocket during a future audit. For instance, if a SaaS provider fails to recognize they have nexus in Maryland and that Maryland taxes SaaS, that provider will be at risk of paying Maryland tax out of its own pocket in a sales tax audit, instead of being able to collect that tax from customers and remit it.
RKL’s State and Local Tax team can help SaaS providers and users navigate these complexities and find the right balance of taxing SaaS when necessary and avoiding unnecessary payment. Reach out to your RKL advisor or use the form on this page to start the conversation.