Articles & E-Books


Taxation of Software Downloads Issues to Consider When Licensing a Solution

Jul 25, 2016

Too often the sales and use tax considerations of licensing software are overlooked when entering into the licensing agreement, only to find out years down the road that the transaction is under scrutiny in a state sales and use tax audit. In December 2014, we brought you the article, Sales Tax and Technology Solutions: Accepting the “Mission Impossible.” The article focused on 10 tips to consider up front that would help you navigate the complex sales tax world of technology solutions. This article will focus on the taxability of software that is accessed over the Internet.

Canned Software

This is a software product or solution, usually licensed from a software company that cannot be modified or altered beyond the original functionality. Typically this is referred to as “off the shelf” or “canned” software because it can be used right away. The software is typically downloaded to an individual’s computer or company server.


Most states that impose a sales and use tax will require sales tax to be charged and collected based on where the customer takes possession of the software. To the extent that the seller does not charge sales tax, the responsibility falls on purchasers to self-assess and remit “use tax” to their state revenue agency. In some states such as California, Florida, Iowa, and Nevada (to name a few), states do not impose sales or use tax on canned software that is delivered electronically to the purchaser as long as the purchaser does not receive a physical copy of the software through other means.


The license or purchase of canned software is generally the most commonly adjusted item during a state sales and use tax audit. It is highly recommended that you have procedures in place to track software license arrangements through not only the IT department, but other areas within the organization as well (i.e., engineering, marketing, etc.) to verify that proper taxes have been paid on the transaction.

Software as a Service

Software as a Service (SaaS), or “cloud computing,” is software that is licensed on a subscription distribution model in which a third-party provider hosts the applications and makes them available to customers over the Internet. In this situation, the purchaser that licenses the software will access the software via a user ID and password. The software does not reside on the purchaser’s computer or the company’s server. The key element of SaaS is that it is hosted and maintained by a third party. If your company licenses software and places it on a server that you lease from another provider and you are responsible for the maintenance and upkeep of the software, this would likely not be considered SaaS.


States are slowly coming out with positions on whether this is subject to state sales and use tax or not. The taxability of the SaaS arrangement varies by state. Illinois has not come out with any formal guidance on this topic at this time but has indicated that the state is working on it. Michigan has attempted to tax SaaS under its interpretation of Sec. 205.92b(o) that “prewritten computer software” means computer software, including prewritten upgrades, that is delivered by any means. However, two courts have ruled against SaaS being exempt (Thomson Reuters, Inc. v. Michigan Dept. of Treas., No. 313825, 2014 BL 134598 [Mich. Ct. App. May 13, 2014]; Auto-Owners Ins. Co. v. Michigan Dept. of Treas., No. 12-000082- MT [Mich. Ct. Cl. March 20, 2014]). There has been discussion in Michigan about introducing legislation that would tax this arrangement going forward. Minnesota has not issued any formal guidance on this matter at this time but informally has not imposed sales tax on this arrangement as long as there is a true SaaS arrangement (described above). Wisconsin takes the position that SaaS is not subject to sales or use tax; this guidance was issued in a formal tax release several years ago.


It’s becoming more common that software providers are offering their software subscriptions through a SaaS model. Therefore, it is important that the software license agreement reflect the arrangement as cloud computing or SaaS. Typically, the billing invoice does not indicate whether software resides on the company’s server or is a hosted application, and this is the reason most auditors will initially take the position that this software is subject to sales tax. A state auditor will often request to see a copy of the software license agreement to verify the arrangement is SaaS. The key items the auditor will look for are how the software is accessed (i.e., user ID and password) and who is responsible for all maintenance costs of the software.

Infrastructure as a Service

Infrastructure as a Service (IaaS) is a form of cloud computing that provides virtualized computing resources over the Internet. Typically, the service provider owns, maintains, operates, and houses equipment (i.e., servers, network components, etc.) that is offered to customers on demand. The customer uses the Internet to access the equipment. The key characteristic is that the service provider has control over and provides the maintenance/upkeep of the equipment at all times. In certain situations, the purchaser of the service may have physical access to and control over the equipment.


The taxability of these services is not black and white, and little official guidance has been provided by the states. In Wisconsin, charges for storage of data on someone else’s server that the customer doesn’t have control over or physical access to are not subject to sales or use tax. However, if the customer has control over and physical access to the equipment, the charges may be subject to sales and use tax as a lease or rental (in those states in which tax rental streams).


Review the contract carefully to ensure it addresses who controls the equipment, who has access, and who maintains it, since these will aid in determining whether the arrangement is subject to sales or use tax.

Platform as a Service

In a Platform as a Service (PaaS) situation, a cloud provider delivers hardware and software tools (usually those needed for application development) to its users as a service. PaaS is very similar to SaaS except that rather than being software delivered over the Web, PaaS is a computing platform that developers can use to create applications and games using tools, services, and computing power supplied by the cloud service provider. The customer does not manage or control the underlying cloud infrastructure, including the network, servers, operating systems, and storage, but has control over the deployed applications and possibly the configuration settings for the application-hosting environment. The PaaS model contains elements of both IaaS and SaaS.


The taxability of PaaS is less clear than for IaaS. There has been very little guidance issued by the states as they wrestle with the taxability of PaaS. The states that have provided guidance in this area (Missouri, New Jersey, and Wyoming) have stated that PaaS would not be taxable as long as the customer does not receive any tangible personal property or have the right to use specifically identified tangible personal property.


In today’s environment, care must be exercised when reviewing software licensing arrangements to truly understand what the vendor is providing and the object of the transaction. State auditors are looking at these transactions closely. In determining the proper tax treatment of cloud services, auditors will often request and review any supporting contracts or agreements. Whether the arrangement is structured as a service agreement or a license to use software may impact the taxability of the transaction in hand. Wipfli has the state and local tax resources to help clients navigate through contracts involving software download arrangements and the potential taxability for sales and use tax purposes.

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Craig A. Cookle, CPA
Partner, Tax
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