SALES TAX CONCERNS RELATED TO SOFTWARE AS A SERVICE IN A POST-WAYFAIR RULING LANDSCAPE

By Kevin Sohr, MBA, MST is a State and Local Tax Specialist at Sax with more than 20 years of experience in state taxes. He advises clients on all matters, including income/franchise taxes, sales/use taxes, property tax, unincorporated business tax and various specialty taxes. He can be reached at ksohr@saxllp.com. 

Changes to the economy and sales tax laws and regulations in the past decade have created a dynamic environment for businesses in the Software as a Service (SaaS) industry. For one, SaaS has become ubiquitous in our lives in a way that wasn’t contemplated in years past. Further, the state taxman’s reach has extended to out-of-state vendors in new ways. Further still, old taxing statutes defining taxable goods and services did not contemplate today’s SaaS providers; creative tax authorities will attempt with mixed success to frame today’s SaaS offerings in a way that comports with yesterday’s laws and regulations. 

SaaS typically refers to a software application used over the internet. The vendor controls the software and the program; there is no license to the customer. The vendor updates its offerings without notice or preapproval from its customer. The customer accesses the program through a cloud service. The customer does not control or manipulate the software, but the customer relies on the program to deliver critical business information. This offering is similar to software packages of the past, but different in important ways which may lead to different or less certain taxability determinations. Importantly, it is the mixture of these three factors – SaaS’s growth, the states’ extended jurisdictions, and an offering poorly anticipated by yesterday’s tax authorities – that create a volatile environment for today’s SaaS vendors, and to a lesser extent their customers.  

THE CHANGED NEXUS LANDSCAPE.  

When considering the sales taxes related to a business’s operations, there are two questions that need to be answered and it makes sense to ask them in the proper order. First, does the business have nexus – or a taxable presence – in the jurisdiction? Second, if the business does have nexus in the jurisdiction, is the transaction subject to sales tax? If the taxpayer doesn’t have nexus, it is not necessary to conclude on the taxability of the transaction.  

The approach to that first question, (does the business have nexus?) has been transformed in the past three years. In 2017, a sales tax nexus review focused on two main criteria: people and property. If the business had employees or property in the state, it had nexus. If it did not have a physical presence, it did not have nexus. 

This physical presence criteria had been established by the Supreme Court in the Quill case of 1992, which was consistent with prior cases.  

However, the nexus review of 2017 would be irrelevant in 2020, thanks to the Supreme Court’s ruling in the South Dakota v. Wayfair case of 2018. That case has transformed the landscape of all sales tax considerations but may be felt most acutely by SaaS providers. South Dakota had passed a law asserting nexus over an out-of-state taxpayer with no physical presence if it had sufficient sales ($100,000 or 200 transactions) into the state. Observing the changing nature of the U.S. economy and the billions of uncollected sales tax dollars, the Supreme Court overruled its earlier physical presence standard. Taxpayers no longer need a physical presence to create a taxable presence in a state.  

In the ensuing years, all states with sales and use taxes have adapted to the more relaxed nexus standard. Most have adapted thresholds similar (or identical) to those in South Dakota’s $100,000/200 transaction model. Today, a business with a widespread customer base could have nexus in every jurisdiction, regardless of the size of its physical footprint.  

Let’s consider the application of this rule to a hypothetical SaaS provider: SAAS Inc. provides an offering to bricks-and-mortar retailers to track customers’ buying habits. SAAS Inc. operates exclusively from its Delaware headquarters. SaaS Inc. has several clients, including the omnipresent Box Store Inc. In 2017, prior to the Wayfair decision, SAAS Inc. had no sales tax filing responsibilities. (Delaware does not have a sales tax.) In 2020, without changing any facts and thanks to Box Store Inc.’s extensive footprint, SAAS Inc. has nexus everywhere. In 2017, SAAS Inc. was unconcerned with the taxability of its offering; in 2020, failure to address its sales tax posture could drive it out of business.  

TAXABILITY OF SAAS  

In most states, sales and use taxes are a complementary tax scheme. A vendor (with nexus) is responsible to collect sales tax on its sales. The purchaser is responsible to report use tax on its purchases when the seller does not charge a sales tax. The second part of that complementary system is what inspired the Wayfair case; purchasers are terrible at self-reporting the use tax on their purchases. It is much more efficient for a state tax auditor to find an assessment from a vendor, like Wayfair, than from its purchasers – the thousands of people buying home furnishings over the internet. Similarly, if SaaS is taxable, it will be much more efficient for states to seek that tax from the several vendors than from their thousands of customers. With the expansion of nexus standards in the wake of Wayfair, it then becomes important to determine if SaaS is taxable in the states. 

However, sales tax laws were written at a time when the economy was based on sales of widgets and the performance of personal services. In general, sales of tangible personal property (widgets) are subject to tax unless specifically exempted; sales of services are not subject to tax, unless those services are specifically enumerated in the taxing statutes or regulations. Sales of SaaS? That’s less certain.  

Before the prevalence of SaaS, the taxation of simple software was a question of uncertainty. Was software tangible personal property? Some states argued the mere floppy disc was a tangible personal property (taxable), even though the true value of the software rested in the license to the intangible. Those states might then concede taxes were not due when the very same software was downloaded over the internet. Is custom software taxable? Some states treat custom software as a nontaxable service and canned software as a taxable sale of property. What amount of customization is necessary to transform a generic software package into a nontaxable custom package? It depends. Yes, before the prevalence of SaaS, even the taxation of simple software packages required a state-by-state analysis with nuanced considerations.  

The state has one chance to argue that SaaS is a taxable transmission of software, but it also has a second chance to argue Software as a Service entails the provision of an enumerated taxable service. For example, data processing services may be taxable. Information services may be taxable. Credit reporting services may be taxable. The elements which favor distinguishing SaaS from taxable software may also be the same elements which describe SaaS as a taxable service offering.  

Let’s reconsider our earlier example of SAAS Inc. In 2017, SAAS Inc. was comfortable in its assessment that it did not have a nexus in any state. For that reason, SAAS, Inc. was unconcerned with the taxability of its offerings; its clients could determine the taxability, pay the tax or live with the exposure. However, in 2020, SAAS, Inc. has nexus everywhere. If its offering is subject to tax and they fail to collect and remit to the appropriate states, they are living with an exposure that could jeopardize their future. Imagine a typical sales tax rate of 7% where the vendor failed to collect taxes due, and years of exposure going back to 2018 when the Wayfair case was decided. Further consider potential interest and penalty assessments. Can SAAS Inc. absorb a series of assessments for non-collection? 

For these reasons, it is important for SaaS vendors to review anew their nexus positions and their taxability determinations. The sales tax review which predated Wayfair’s expanded nexus reach or predated their products’ sales growth is capable of leaving the SaaS provider vulnerable to non-collection exposures that it may not be able to settle.  

If you need assistance determining whether your SaaS offerings follow today’s new tax laws and regulations, reach out to a Sax advisor as we understand the intricacies and complexities of the changed nexus landscape. 

Originally Published in Manufacturing Matters magazine! Download your copy today.