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The Sales and Use Taxation of Software – Software Accessed from the Cloud

June 07, 2012

Tony Switajewski, CPA
Partner
BlumShapiro

Since software was first invented, state tax authorities and taxpayers have spent a considerable amount of time and resources to determine its sales and use taxation.  With the introduction of the “Software as a Service” distribution model, the taxation of software has become increasingly complex.

Software Taxation – Evolutionary Background: 

States initially struggled with whether software was tangible personal property, and thus, should be subject to sales and use taxation or was intangible personal property and thus, exempt from taxation. States have eventually concluded that for sales and use taxation purposes, the sale of prewritten software programs (a.k.a. “canned” or “shrink-wrapped” software vs. “custom” software) that reside on a tangible storage medium, such as a CD-ROM (formerly a floppy disk), should be considered taxable. States argued that software should not be treated differently than the sale of any other tangible medium, such as a book or a record album, which incorporate intangibles.  Although all of the value of the purchase is within the intangible, i.e., the author’s writing or musician’s music, states have concluded that software should be similarly taxable if it is carried on a tangible storage medium. The District of Columbia and every state imposing a sales tax subjects the sale of prewritten software to taxation.

In addition, many states hold that software transferred via the load and leave method should betreatedasthe transfer of tangible personal property subject to sales and use taxation, even though no tangible medium is left behind. Furthermore, many states have passed laws that taxes electronically downloaded software as the transfer and possession of tangible personal property.

Cloud Computing – Sales and Use Taxation:

The latest evolution of accessing prewritten software is now within the so called “cloud”.  “Software as a Service” (“SaaS” transaction) is a recent software distribution model in which software applications are hosted by a service provider on its server and made available to customers over the internet.  In other words, the purchaser does not take possession of the software either through a tangible storage medium or via a download of some fashion but rather only has access to it. As a result of this latest technological advancement, state tax authorities have been presented with a new dilemma: when software is accessed from the cloud, has the software been transferred in some manner to the purchaser or is the access to the software considered a service to the purchaser (i.e., a service provided for the right to access and use software without taking any form of possession)? 

Although some states have ruled that non-downloadable computer software accessed from a remote server is not subject to sales or use tax, many states are leaning the other way by either taxing the SaaS transaction as a service or as a deemed transfer of the software.

Some states, such as Connecticut, maytreat SaaS transactions not as a taxable transfer of tangible personal property (software) but rather as a taxable service.  For example, Connecticut not only taxes the sale of tangible personal property (including software delivered on a tangible storage medium) but it also taxes many enumerated services including the sale of computer and data processing services, albeit at a reduced tax rate of 1% (rather than 6.35%).  Although Connecticut has not specifically ruled on whether SaaS transactions are taxable, it is likely that Connecticut would tax such transactions as computer and data processing services.  Connecticut taxes as computer and data processing services software that is either electronically downloaded (PS 2004(2)) or accessed through a computer via the internet (see Cummings & Lockwood v. Commissioner of Revenue Services, CT Superior Court, (7/20/1994).

However, New York taxes SaaS transactions differently. New Yorktaxes SaaS transactions as though software was delivered to a purchaser’s computers or servers in New York. Since 2008, the New York Department of Taxation and Finance has been a prolific author of rulings on the sales and use taxation of SaaS transactions. In New York, like other states, prewritten software is considered tangible personal property, the sale or license of which is subject to sales and use taxation regardless of the medium by which the software is conveyed to the purchaser. The taxation of remotely-housed software is not specifically taxed by statute, but rather New York finds an indirect way to tax it via its regulations. New York Regulation 20 NYCRR §526.7(e)(4) provides that the actual or “constructive possession” of property, as well as “the right to use, or control, or direct the use of tangible personal property,” constitutes a transfer of possession that is subject to sales and use taxation. Accordingly, the vast majority of the dozen of advisory opinions issued by the New York Department of Taxation and Finance have held that accessing prewritten software that is housed remotely constitutes a transfer of software, because the New York purchaser gains “constructive possession” of the software, and gains the “right to use, or control or direct the use” of the software within New York.  However, it is interesting to note that a few advisory opinions, based on the particular facts, have ruled that even if software is utilized to access and customize information, it may be considered a nontaxable “information service”  rather than a taxable right to use prewritten software, if the information is “personal or individual in nature” (e.g., TSB-A-10(47)(S)).

Massachusetts taxes SaaS transactions as the deemed transfer of the software. Massachusetts has issued a Technical Information Release and Regulations which discusses the taxation of software installed on a remote server (TIR 05-15 and Mass. 830 CMR §64H.1.3). Pursuant to the TIR and Regulations, transfers of taxable software are taxable regardless of the method of delivery, including “the right to use prewritten software installed on a remote server.” That seems clear enough, but as MA DOR Letter Ruling 11-2 demonstrates, it is still a foggy area of law. A company requested a letter ruling whether its online services were subject to Massachusetts sales and use taxation. The online services were described in the ruling as (1) a subscription to the company’s on-line database that provides certain information; and (2) access to several web-based “tools” that allowed the company’s Massachusetts customers the ability to access its software, that was hosted remotely on the company’s server, to manipulate and acquire certain data. The Massachusetts Department of Revenue concluded that although the two services were accessed via the internet and required the use of software, the two services should be taxed differently. The distinguishing factor was whether the Massachusetts customers could use the software to manipulate information (i.e., operate, direct or control the software and entry of data). The Department of Revenue held that where the object to the transaction is to access the company’s software itself, a taxable sale of software has occurred, rather than a non-taxable access to information databases (see MA DOR Letter Ruling 12-6, where it was held that access to electronic newsletter software, which allowed companies to produce their own business newsletters, was subject to taxation because the object of the transaction was the sale of a license to use proprietary software hosted on a remote server;seeMA DOR Ruling 11-4, where it was held that since the object of the transaction was to obtain database access rather than the use of software itself, the SaaS transaction was not taxable).

Summary: 

The sales and use taxation of software is a very complex area. In many cases, the taxation of software hinges on its delivery method and where it is used.  States are just beginning to issue interpretive sales and use tax regulations and rulings or modify their laws to address the “Software as a Service” distribution model. It is important to keep in mind that not all SaaS transactions are alike and as a result the taxation of SaaS transactions may vary due to their nature.  SaaS transaction agreements and contracts must be carefully reviewed, in light of state tax laws, regulations, and rulings, in order to determine what the “true object” of the SaaS transaction is and thus its ultimate taxability.     

 

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