After 15 months of pandemic lockdown, the world finally is beginning to open up. Despite the physical world having been on hold, businesses continued to evolve, and many thrived during the Covid-19 quarantines.
As companies and consumers emerge from a year of isolation, the common question is, what does the “new normal” look like? Will buying and selling patterns revert, or even partially revert, to pre-Covid-19 patterns, or has the U.S. economy and the way businesses operate changed forever, requiring a reboot of compliance practices and procedures?
A great deal of attention has been focused on the explosive growth of remote consumer sales during the past couple of years, as evidenced by over 45% growth in just the last year. What probably is more noteworthy, is the trend of B2B sales and delivery methodologies relative to past practices. This is evidenced in a recent study conducted by McKinsey & Co., which found that only 20% of B2B buyers said they would revert to in-person sales post Covid-19, and approximately 80% of B2B decision-makers said they prefer remote interactions or digital self-service over in-person meetings.
From a sales tax perspective, the questions and issues requiring immediate responses in terms of adapting to the likely continued digital marketplace (among other longer-term issues) are:
- How do I determine which products/services are taxable?
- Are my current accounting and tax systems adequate to address the added compliance burden imposed as a result of the expansive nexus rules that came into effect several years ago?
- Does my company have sufficient bandwidth to track the taxability of all the products and services that are being currently offered and new ones that will be rolled out in the future?
- What are the implications of under/over compliance of sales/use tax?
- What practices can I put in place to ensure my organization is keeping pace with new buying and delivery trends that may not currently be in effect?
Tangible Property vs Services
Despite the advances by many sales tax software providers, there is no silver bullet to determine which goods and services are taxable in each of the 45 states that currently impose sales tax. Even companies that sell homogeneous products can find the process to be challenging. The reasons for this result are numerous. On the top of the list is that each state has different rules and requirements determining which products and services are taxable. While in most states all sales of tangible property are taxable, there are scores of exceptions.
Examples include certain health care products, food products, products that are sold to certain (but not all) exempt organizations, and those used in a manufacturing process or held for resale (these are exempt). In most jurisdictions, unless the product is exempt from tax regardless of how it is used, the retailer (seller) will be required to secure an exemption/resale certificate from the buyer to avoid its obligation to collect tax. (See further discussion in Part 2).
Taxability of Software/Software-Related Services
The taxation of software and software-related services varies dramatically among the states, a summary of which was compiled by the non-profit Tax Foundation group.
On the services side, most states only tax select or enumerated services. While the list of taxable services varies widely among the states, the more common services subject to tax include sales of software, services delivered through the computer or Software-as-a-Service (SaaS), data processing, and information services.
Complications arise first in categorizing the nature of the services an organization delivers. For example, consider an Internet-based service provider that provides its users with valuable data and metrics with which to aid in running its business, including easy access to databases and competitor information formatted in a manner that is user-friendly, specific to that customer, and provided via a hosted website. The logical question is whether the nature of the services offerings should be categorized as SaaS, information services, and/or data processing.
Each service offering is subject to a different set of rules and taxability determinations by the states. Many states tax SaaS in the same manner as the sale of physical goods. Under this interpretation, the subscription fee paid by a user is viewed as equivalent to a license fee for accessing software, even when the user has no rights to alter or modify the software. Examples include Washington State and New York, where the taxability is determined to be access to computer software that is treated as tangible personal property. Alternatively, many states deem SaaS to be the delivery of a service. And if services commonly are taxable in the state (e.g., Connecticut, Texas, Arizona, New Mexico, Hawaii) then SaaS is viewed as taxable.
There are many exceptions that vary by state as to which services are taxable and, in some states, certain services are taxable at reduced rates. For example, information and data processing services are taxable at lower rates in Texas and Connecticut. In Texas only 80% of the retail price is taxable, and in Connecticut information and data processing services are taxed at 1% versus the standard 6% rate.
Equally confusing, some states do not impose a tax on certain digitally or cloud-delivered products and services, but the same are taxable in certain localities within the state. Chicago imposes a 9% tax on sales of goods and services delivered digitally, and Denver imposes a tax on all software—custom and pre-written software whether it is downloaded, delivered electronically, or accessed via the cloud.
Impact of Remote Workforce
Pre Covid-19, most businesses adhered to the notion that in-person contact enhanced the sales and business experience. Millions of employees commuted each day to/from the office, and many would think nothing of boarding a plane to travel cross-country or across the world to attend a business meeting or conference. The pandemic dismissed that notion, and many predict that working remotely will become permanent for 25%-30% of the workforce both for its convenience and the cost saving accomplished by employers as result of reduced office space. Surveys repeatedly show that 80% of employees want to work from home part of the time. See for example, Kate Lister, Work at Home after Covid our Forecast, Global Workplace Analytics.
A remote workforce creates some unique sales tax concerns. Primary on the list is that having employees work remotely creates a physical presence in the state where the employee works. If a company has a physical presence, then they will be required to register and collect sales tax regardless of the actual amount of sales into the state. A physical presence also likely gives rise to an obligation to pay income/franchise tax. These requirements are in addition to tracking the economic presence thresholds which require companies to register and collect tax if sales into a state exceed a state-specific annual sales threshold ($100,000 per year in the majority of states).
So, due to both the remote workforce and economic nexus rules, companies that previously may have only a sales tax obligation in a handful of states suddenly find themselves having to collect and remit tax in up to 45 states and added local jurisdictions. These requirements are imposed on a legal entity-by-entity basis, so companies that operate through multiple legal entities could see their sales tax collection and remittance obligations grow geometrically.
Intuitively one would think determining the state/local authority in which the sales tax obligation arises should be easy. Remember generations ago (or so it seems) when you walked into a brick-and-mortar store and paid sales tax to the retailer, who would remit the tax to the jurisdiction where the retail store was located.
Now consider a business which has hundreds, if not thousands, of users of taxable software under their operating license or subscription agreement. Historically, tax was remitted based on the location where the software was initially delivered. In today’s world, no software is electronically delivered to a physical location, and the users are scattered across the country, many or most working remotely. In such instances, most states provide that in the case of taxable services, such as SaaS, are deemed taxable based on where the services are delivered or used.
Failure to produce and retain documentation supporting the actual locations of “use” could result in the seller either collecting the incorrect tax based on the billed address of the buyer, or worse, failing to collect any tax. Either result can create a huge potential liability for either the seller or buyer of software or other taxable services.
The New Normal
By all accounts, the delivery of goods and services through the Internet is going to continue expanding for the foreseeable future; the question is, will it continue at the same pace or even faster?
Of major significance is that the states are mindful that both sales of taxable goods (e.g. software) and professional or technical services (traditionally not taxable) are being combined and delivered via the Internet. As such, several states are enacting legislation that includes SaaS and digitally delivered goods as taxable. Just recently Maryland enacted legislation taxing digital goods and services effective July 1 (Maryland House Bill 932), and several states have attempted to expand or impose new guidelines. Nebraska postponed proposed digital advertising services tax legislation, New York proposed expansion to include digital advertising (Assembly Bill 734, Senate Bill 302). Georgia (H.B. 594) and the District of Columbia (B23-0760) also introduced legislation that did not get enacted but will be reintroduced.
Similarly, all states are stepping up their audit efforts to both identify taxpayers that are subject to the economic nexus rules but have failed to comply and those which are purchasers/sellers of taxable services.
Specific industries being targeted are information service providers, professional service organizations, and SaaS providers. These organizations that historically considered their activities to be exempt from tax may need to revisit the nature of their service offerings, and how and where they are delivering these services. Similarly, technology-based companies may not have placed sales tax as a high priority, rather, focusing resources and energies on those efforts that drive current and future business results. Many are finding that the potential sales and use tax risks, including the threat of penalties and interest for prior years, are an obstacle when it comes to valuing the business for sale in any M&A negotiations.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Bob Peters is a managing director and national practice leader of Sales and Use Tax Services at Duff & Phelps, a Kroll business. Bob is based in the Chicago office.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.