Understanding how software downloads are taxed
Understanding tax protocols for software and software as a service (SaaS) gets tricky quickly. Some states tax software only when it’s downloaded in a physical or tangible form, say from a CD-ROM. Other states tax all software transfers, even those done digitally.
Similarly, certain states deem custom software to be a professional service — and therefore exempt from tax. In other states, the same software might be deemed tangible property, and therefore taxable.
Businesses may need skilled guidance to navigate the intricacies of software tax law, particularly if they’re doing business across tax jurisdictions. Still, it’s helpful for firms to have at least a broad understanding of how they work — and how they might affect their end-of-year tax liabilities.
Taxability of canned software
So-called “canned” or off-the-shelf software describes products that cannot be modified or altered beyond their original functionality. Such software is generally downloaded to an individual’s computer or company server.
Most states that impose a sales and use tax 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 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 among the most commonly adjusted items during a state sales and use tax audit. To avoid such adjustments, enact procedures to track software license arrangements through the IT department and through other areas within the organization (i.e., engineering, marketing, etc.) to verify that proper taxes have been paid on every off-the-shelf software transaction.
Taxability of infrastructure as a service (IaaS)
Infrastructure as a service (IaaS) is a form of cloud computing that provides on-demand, virtualized computing resources to clients. In these arrangements, the service provider typically owns, maintains, operates and houses equipment such as servers, network components and other digital infrastructure, making them accessible to customers via the cloud.
In these cases, the service provider generally has control over equipment maintenance and upkeep. In certain, less common situations, the purchaser of the service may also have physical access to or control over some equipment.
The taxability of IaaS services is not black and white, and little official guidance has been provided by the states. In Wisconsin, charges for data storage on someone else’s server — assuming the customer has no control or physical access to said server — are not subject to sales or use tax.
However, if the customer has physical access to or control over the equipment, their charges may be subject to sales and use tax as a lease or rental (in states that tax rental streams).
To ensure tax is being allocated properly in these situations, should review the IaaS contract carefully to understand who controls equipment, who has access, and who maintains it — since these factors influence whether the arrangement is subject to sales or use tax.
Taxability of platform as a Service (PaaS)
In a platform as a service (PaaS) situation, a cloud provider delivers hardware and software to its users as a service. PaaS is very similar to SaaS. Rather than delivering software, PaaS involves computing platforms that developers can use to create applications and games using tools, services and computing power supplied by the cloud service provider.
In these transactions, the customer does not manage or control the underlying cloud infrastructure, such as the network, servers, operating systems or storage. But the customer does control the deployed applications and possibly the configuration settings for the application-hosting environment. Thus, the PaaS model contains elements of both IaaS and SaaS.
Given the hybrid nature of PaaS, its taxability can be complicated. States have issued very little advice as they wrestle with the minutia of PaaS taxability. States that have provided guidance in this area (including Missouri, New Jersey and Wyoming) have decided that PaaS would not be taxable if the customer does not receive any tangible personal property or have the right to use specifically identified tangible personal property.
Reading the small print
The tax implications of software downloads can be complex and are subject to change, as regulations evolve.
It’s important to note that state auditors are looking at these transactions closely. To determine the proper tax treatment of cloud services, auditors will often request and review supporting contracts and agreements. Whether the arrangement is structured as a service agreement or a license to use software may impact the taxability of the transaction at hand.
Above all, firms should carefully review all software licensing arrangements to ensure they truly understand what the vendor is providing — and what could be considered taxable — during each transaction.
How Wipfli can help
Need assistance navigating software tax questions? Wipfli’s state and local tax servicesteam can help you understand taxability that results from your software download arrangements. Contact us today to learn more.
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