One of the most common misconceptions with software companies is that they don’t have to charge and remit sales tax on software sales. Although software is an intangible asset, many states require that vendors charge and remit sales tax for both on-premise licenses and software as a service (SaaS) arrangements.
When analyzing these issues from a sales tax perspective, these two key questions must be answered:
1. Is my software license or SaaS arrangement taxable?
This answer varies by state and is often unclear. Historically, the only way a consumer obtained software was to walk into a store and pull off the shelf a box containing a disk with the software on it. Nearly every state taxed this transaction because the state viewed the consumer as obtaining tangible personal property (i.e., the disk), even though the actual software is typically viewed as an intangible asset.
As technology advanced in more recent years, consumers were able to obtain the same software simply by downloading it from the vendor’s website, without obtaining any actual tangible property. Since sales tax is imposed on sales of tangible property, states scrambled to address this loss of revenue through rulings and legislation, and now many states, but not all, tax the sale of electronically downloaded software.
Over the last few years, technology advancements have given rise to SaaS arrangements, where consumers don’t even need to download the software. Instead, the software is accessed from a remote server maintained by the vendor, but the consumer never actually takes possession of the software. Once again, states were left with the prospect of more lost revenues since their statutes and guidance did not address SaaS arrangements. States have begun to address these issues, but vendors and consumers currently face a lot of uncertainty regarding the taxability of SaaS transactions.
2. If the transaction is taxable, is the vendor required to collect the tax from the consumer and remit it to the state?
In order for a state to require such collection and remittance obligations, the vendor must have substantial nexus with the state. Nexus refers to the level of connection between a state and the taxpayer, and what constitutes substantial nexus can vary among states. A taxpayer creates nexus by having physical presence in a state, such as owning or leasing property or having employees perform services in a state. However, nexus also may arise when the taxpayer engages independent contractors to solicit sales in a state or when it contracts with another entity to provide certain services in that state, such as installation, warranty, or training.
Some states are more aggressive on what factors trigger nexus, and something as simple as attending a trade conference or traveling to a state for just a few days to install software can create nexus. The rules can be very cumbersome and are often based on the specific facts and circumstances, and if a company is not diligent in its filings, the potential tax exposure, including substantial penalties and interest, can grow in a short period of time.
Potential risks of sales tax issues
When we are engaged to perform an audit for the first time, we often encounter sales tax issues. The guidance for accounting for contingencies is covered in ASC450-20-25, which requires a loss contingency to be booked if the loss is probable and can be reasonably estimated. There are various factors that go into the probability factor, such as dollar amount of sales in a state and how nexus was established. For example, when a company has employees in a state, they are reporting payroll wages so the state is already aware of that company. If that state doesn’t see that you are filing sales tax returns, it is only a matter of time before someone contacts you to ask why.
Potential sales tax liabilities are one of the most significant issues we uncover when performing tax due diligence on targets that are either selling their company or raising debt and/or equity. Under state tax successor liability rules, even if a buyer purchases the assets of a target, almost all states can hold the purchaser liable for the sales tax liabilities of the target that were incurred prior to the closing. Since there are so many factors that go into determining the ultimate exposure, some of which take time to research, there is a wide range of potential loss in many cases. Depending on the potential maximum exposure, a sales tax issue can quickly derail a transaction or tie up significant proceeds in escrow.
Consider a company that has had nexus for the past five years in four different states that tax sales of software, but never filed sales tax returns. There is no statute of limitations and the states can go back to all five years and assess sales tax on those sales, plus penalties and interest. If sales in those states were $20 million per year for the last 5 years and the average sales tax rate is 5 percent they should have charged sales tax to their customers of $5 million on the $100 million in sales. Potential penalties and interest could increase the $5 million exposure to as much as $7.5 million, which could quickly blow up a deal or put the company into financial distress.
How to reduce your sales tax exposure
One way to reduce exposure is to approach the state though a voluntary disclosure process which generally limits the look-back period for computing tax exposure (in the above example, the state might only require tax for the last three years and completely forgive the first two), and eliminates penalties and sometimes interest. The research process may take several months and would include contacting customers to see if they paid use tax which could further limit the liability. If the customer did not pay use tax, the company would then have to make a business decision whether to try to collect sales tax from customer at the risk of creating a very dissatisfied customer.
Software companies should limit their potential sales tax exposure by having a nexus study performed by a state tax expert, which would also include recommendations for mitigating any potential risk, such as a voluntary disclosure. In addition, as companies enter new states they need to understand the rules in that state or consult with a sales tax professional to determine their filing requirements.
Jeff Glickman is partner-in-charge of the State and Local Tax practice and Robert Casey is an audit partner at Habif, Arogeti & Wynne LLP (HA&W). An ATDC sponsor, HA&W is the largest Georgia-based tax, audit, and business advisory firm. It has been named a “Best of the Best Accounting Firm” in the United States.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding this matter.