In the 21st century business world, technology has become an increasingly important component to achieve both productivity and profit. Nowhere is that more evident than in the purchase of software solutions. While some software purchases may come with a small price tag, quite often investments in software involve both significant effort and dollars. Effort goes into ensuring the solution purchased meets the business need and is implemented as successfully as possible. However, one area that is often overlooked in a software and technology implementation is the sales tax treatment of the transaction. Often, the implications of failing to address the sales tax impact of the transaction are not discovered until the business is under audit or the ability to file refund claims has passed.
Following are 10 tips to consider up front, that will help you navigate the complex sales tax world of technology solutions.
1. Don’t assume that your vendor will handle the transaction properly
Technology solution vendors have the unenviable task of dealing with sales tax for technology solutions in a multistate environment. Why is it difficult? First, vendors cannot rely on consistent treatment of their product from state to state. What may be exempt in one state may be taxable in another, or there may be consistency for one part of the project but not another. Second, the technology of today was generally not considered when existing sales tax guidance was issued, and because of limited resources, states are often slow to update published guidance that addresses new technology solutions. Third, some providers may choose to shift the risk of a “gray” area to their customers by charging tax on the transaction rather than risking a differing interpretation by state taxing authorities. Fourth, some out-of-state providers may not be registered for collection of sales tax in a particular jurisdiction and therefore cannot collect tax on the transaction. Finally, technology solutions today often have capability for multiple points of use, which further complicates the issue.
2. Determine what you are buying
This is much more difficult than it sounds and absolutely critical to applying the proper sales tax treatment to the transaction. When we talk with clients about technology solutions, the discussion usually begins around the idea that the client is purchasing a software solution. Further investigation may determine that the client is purchasing something other than software. With the advent of Internet-based solutions, it is important to determine whether you are purchasing “software as a service (SaaS),” access to an information service, a telecommunications service, data processing, traditional software, or something else entirely. Each of these items may have entirely different treatment depending on the state in which you operate.
3. Determine where you are buying it
More and more, technology solutions are stored on servers that are accessed remotely by the users of the software. It is important to understand where the solution is housed and where the users are located to apply sales tax correctly. In some circumstances, planning opportunities may exist to source a transaction to states with more favorable sales tax treatment.
4. Determine the various components of the transaction and how much you are paying for them
It is easy to determine that one is purchasing a software solution, but is that all that you are purchasing? Many significant projects involve various components including business analysis, base software packages, custom programming, data migration, testing, implementation, trouble shooting, configuration, maintenance agreements, etc. Often, at least a portion of the items may be purchased exempt from sales tax, provided they are separately stated on the invoice. Many times the proposals or engagement letters will indicate that these services are occurring, but they make no mention of what the purchase price for each item will be. Reasonable, upfront allocations to these items can save a great deal of sales tax.
5. Determine what is optional and what is not
Believe it or not, whether the purchase of a service or item is optional can affect its sales tax treatment. Wisconsin has indicated that certain services such as training (which would normally be exempt) become taxable if they are required to complete the sale of taxable software. Minnesota treats the sale of optional maintenance contracts differently from required maintenance contracts.
Businesses can also involve third-party providers in determining which software solution meets their needs. That same vendor may or may not provide the ultimate solution selected. Some states may tax this needs analysis if connected with the ultimate sale of a taxable solution. Structuring these services as provided under a separate agreement not connected with the sale of a solution may be necessary to ensure the service escapes taxation.
6. Determine whether you are purchasing custom software or canned software
Many states automatically tax canned software but provide an exemption for custom software. The distinction also can affect the sales tax treatment of the maintenance agreement, installation charges, and other implementation services. The sales tax treatment of these services often follows the treatment of the underlying software. Because custom programs may start with a “base package,” it is important to explore the particular state’s definition of custom software prior to determining whether a solution is a custom solution.
7. Determine how you are receiving services
Technology has impacted the delivery of solutions as well. Although less common than it once was, some states may yet distinguish between the methods of software delivery to determine its taxability. For example, software delivered in tangible form (e.g., via CD) may be taxable, while downloaded software may remain exempt as an intangible. Telephone support may be exempt, while support provided by allowing a consultant to access one’s computer or server may involve a taxable service. These are just two examples of the complexity that can be created by changes in the delivery of services.
8. Determine what exemptions may apply to your project
A potentially taxable transaction may become exempt if an exemption will apply based on its use. Common exemptions include use in manufacturing, research and development, agriculture, pollution control, etc. The exemptions available vary from state to state, and what is included within the exemption varies. Research is a must.
9. Carefully review invoicing to ensure it accurately reflects the transaction
Sales tax auditors generally start from the presumption that the invoicing reflects the nature of the transaction. It may be difficult or impossible to overcome invoicing that does not reflect the nature of the transaction. It is especially difficult to overcome a failure to separately state items to achieve exemption. If separate statement of exempt items is required under state law, auditors are well within their rights to tax the entire amount of “mixed” transactions.
10. Make sure your license agreement and other documents support your invoicing
When dollars are significant or the nature of the transaction is difficult to determine, license agreements and engagement letters or proposals may be reviewed to determine the true nature of the transaction. If these sources do not support the sales tax position taken, the sales tax treatment is far more likely to be challenged. While purchasers cannot control the content of vendor marketing materials or websites, they should know that auditors routinely review these items as a source of information in making a decision on sales tax treatment.
While complexities abound, proactive review of the sales tax treatment of technology solution purchases can not only reduce audit and risk exposure, but provide opportunities for sales tax savings. Both you and your vendor will be glad you spent the time.