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The Evolution of Software as a Service Taxes Post-Wayfair

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(This article originally was published by Law360 on May 17, 2019.)

In the last year, several state legislatures have enacted laws and several state courts have published decisions on whether software as a service, or SaaS, is subject to sales and use tax. These developments impact many SaaS providers, especially due to the expanded nexus provisions that many states are enacting after the United States Supreme Court’s South Dakota v. Wayfair Inc. decision.1 The states have gone in different directions—Indiana enacted legislation exempting SaaS, while Iowa and Rhode Island began taxing SaaS. The Massachusetts Appellate Tax Board and the Pennsylvania Board of Finance and Revenue have both issued decisions clarifying the taxability of SaaS offerings.

Background

Evolution of Software Delivery
In its earliest stages, computer software was delivered in physical form in a box at an office supply store. The expansion of the internet in the 1990s enabled an end user to download software from a creator’s website directly to the end user’s computer. Then, as web-based infrastructure developed, more firms began hosting their software and licensing subscriptions for the end user to access the software remotely. This system of access to software applications, servers, storage and databases over the internet is commonly referred to as “cloud computing.”2

“Software as a service” is one of three cloud computing service models, the others being “platform as a service” and “infrastructure as a service.” In the software as a service model, end users access the service provider’s applications running on a cloud-based infrastructure owned by the service provider. The end users typically access the applications through a web browser. The end user does not control the underlying cloud infrastructure (such as the network, operating systems, servers and storage) and has no or very limited control over the applications.3

In the platform as a service, or PaaS, model, end users can deploy their software applications on the PaaS provider’s cloud infrastructure. Meanwhile, the servers, storage and networking are managed by the PaaS provider.4

In the infrastructure as a service, or IaaS, model, end users can access the service provider’s processing, storage, networks, severs, operating systems or other computing resources, which can be more convenient for many users than having to purchase their own hardware (or reduce their hardware ownership when they no longer need it).5 IaaS is similar to traditional information technology resources used by organizations’ IT departments and developers.

State Taxation Overview
Most cloud computing offerings do not fit neatly into traditional state tax categories. These arcane sales tax laws impose tax on tangible personal property and certain services. To date, more than 20 jurisdictions tax SaaS, either explicitly or under a broad definition of “software,” “information services” or “data processing services.” States that impose sales and use tax on SaaS (or specifically exempt it) use varying terminology (in addition to “software as a service”) to describe SaaS, such as: remotely accessed software, vendor-hosted software and electronically delivered software. States do not always define these terms, and the terms may differ in scope from state to state. For example, “electronically delivered software” could be interpreted more broadly than the other definitions because it could include software downloaded to the user’s computer, not just software hosted on the vendor’s servers.6 Some jurisdictions have ambiguous statutory schemes that were enacted when software was generally only delivered on a disk.

A number of states tax “information services” and/or “data processing,” but the scope of these provisions varies. A few states define taxable “data processing” and/or “information services” broadly enough to cover most SaaS.7 In addition, many states tax “digital products” and streaming entertainment services, but these services are typically defined in a way that does not overlap with SaaS (with exceptions, such as Washington’s “digital products” definition).8 Most states that tax “digital products” limit the scope of this term to digital versions of books, music, video games, videos or other historically tangible items.

Wayfair Impact — Expanded Nexus Authority
On June 21, 2018, the U.S. Supreme Court’s decision in South Dakota v. Wayfair Inc. expanded the states’ power to require out-of-state remote sellers to collect and remit sales and use tax. The Supreme Court ruled that a state law requiring an out-of-state seller that has sufficient “economic and virtual contacts” with the state to collect sales tax satisfies the dormant commerce clause “substantial nexus” requirement.9 The prior Supreme Court precedent in National Bellas Hess Inc. v. Department of Revenue of Illinois10 and Quill Corp. v. North Dakota11 required out-of-state sellers to collect and remit sales/use tax on retail sales of certain tangible personal property and services only if the seller had “physical presence” with the state.

In response to the Wayfair decision, over 40 states have implemented economic factor presence nexus collection requirements similar to those established in Wayfair. Whether a remote seller has economic factor presence nexus in a state is based on the seller’s sales revenue or transaction volume in the state, or a combination of both. In addition, numerous states have enacted laws imposing a sales tax collection obligation on online marketplaces that facilitate taxable sales by third party sellers. Therefore, a SaaS provider may be taxable in many new jurisdictions where it does not have a physical presence but meets the sales or transactions threshold under the states’ post-Wayfair economic factor presence nexus requirement. The provider could also be obligated to collect sales tax under a state’s marketplace facilitator law if the provider sells third parties’ offerings.

Legislative Developments
In the last year, Indiana, Iowa and Rhode Island have all passed legislation affecting the taxability of SaaS. Indiana exempted SaaS from taxation, while Iowa and Rhode Island began taxing SaaS.

Indiana
Prior to July 1, 2018, Indiana generally imposed its sales tax on the sale of prewritten computer software, including the right to access the software on a remotely located server.12 Effective July 1, 2018, Indiana specifically exempts “transaction(s) in which an end user purchases, rents, leases or licenses the right to remotely access prewritten computer software over the [i]nternet” from the definition of a retail transaction and provides that those transactions are not considered to be a transaction in which prewritten computer software is delivered electronically.13

Iowa
Iowa generally did not tax software as a service, information services or digital products prior to Jan. 1, 2019. However, “software as a service,” “information services” and “specified digital products” are now subject to sales and use tax in Iowa as of Jan. 1, 2019.14 “Specified digital products” include electronically transferred “information products” and “computer software applications,” among other categories.15

The new legislation broadly defines “information services” as “delivering or providing access to databases or subscriptions to information through any tangible or electronic medium,” including “database files, research databases, genealogical information, and other similar information.”16 The legislation does not define “software as a service” or “computer software applications.” Iowa will also tax “[s]ervices arising from or related to installing, maintaining, servicing, repairing, operating, upgrading, or enhancing specified digital products.”17

Iowa also expanded its business-to-business exemption to include sales of SaaS, information services, and specified digital products “furnished to a commercial enterprise for use exclusively by the commercial enterprise.”18 Iowa’s business-to-business exemption is unique because it is independent of any sale for resale exemption. The business-to-business exemption also contains some ambiguous provisions. For example, there are questions as to the meaning of the term “exclusively” for purposes of the business-to-business exemption (i.e., when would the purchaser be characterized as using the SaaS “exclusively” versus nonexclusively?).

A taxpayer must collect exemption certificates from customers that it believes will qualify for the exemption. A data storage provider19 asked the Iowa Department of Revenue whether the provider could assume that sales to its customers qualify for the business-to-business exemption. The department issued a declaratory order rejecting this request and advised the data storage provider to collect an exemption certificate from each customer.20

Ultimately, SaaS providers may be able to obtain exemption certificates from some or all of their commercial enterprise customers, but they cannot assume that the customers qualify for the exemption.

Rhode Island
Prior to Oct. 1, 2018, Rhode Island did not tax remotely accessed software.21 However, effective Oct. 1, 2018, Rhode Island imposed sales tax on remotely accessed software (“vendor-hosted prewritten computer software”).22 The new law makes it clear that sales tax will apply regardless of whether access to the software is permanent or temporary and regardless of whether any downloading occurs.

State Court Decisions
In the last year, the Massachusetts Appellate Tax Board and the Pennsylvania Board of Finance and Revenue published decisions clarifying the taxability of SaaS offerings.23 The Massachusetts Appellate Tax Board subjected a taxpayer’s online software products were subject to sales tax. The Pennsylvania Board of Finance and Revenue mostly issued decisions affirming the Pennsylvania Department of Revenue’s taxation of SaaS offerings. However, in a few instances, the Pennsylvania Board of Finance and Revenue reversed the department’s assessment and found that a taxpayer’s offering will not be taxable where a user cannot “manipulate the data” or where the offering includes a sufficiently large service component.

Massachusetts
The Massachusetts Appellate Tax Board found that a taxpayer’s online software products were subject to sales tax because the customer’s remote access to prewritten software was the “object of the transaction.”24

The board’s decision affirms the department’s historic position that most SaaS is subject to sales tax. Massachusetts’ sales tax statute includes a broad definition of taxable software and the department’s regulations explicitly state that remotely accessed software is taxable.25

The board rejected the taxpayer’s argument that its online products were nontaxable “services” primarily meant to “connect” its customers “with other entities.” Further, the board concluded that the taxpayer’s back-end support services (developing, maintaining, testing and troubleshooting the software) were not the “object of the transaction” because the taxpayer’s customers subscribed to, accessed and used the online products “without any view to the unseen support operations.”26

Therefore, Massachusetts will likely tax SaaS offerings unless the taxpayer’s customers pay primarily for a nontaxable professional service, rather than the software component.

Pennsylvania
The Pennsylvania Board of Finance and Revenue has issued several decisions in the last year affirming the Pennsylvania Department of Revenue’s positions on the taxability of SaaS offerings. However, the board has also determined that a taxpayer’s offering will not be taxable where a user cannot “manipulate the data” or where the offering includes a sufficiently large service component.

The Pennsylvania Department of Revenue has generally taken the position that after the August 2016 statutory change taxing electronically delivered software, SaaS offerings can no longer qualify for Pennsylvania’s “information retrieval services” exemption. “Information retrieval services” and “other computer services” were enumerated taxable services under a repealed statutory provision. The department issued corresponding regulations stating these services were taxable,27 but once the statutory provision was repealed, the department issued a regulation specifically exempting these services.28 In 2017, the department stated in a letter ruling that the statutory definition of “tangible personal property” is broad enough to encompass certain web-based information retrieval products and this definition is controlling, even though the regulation exempts “information retrieval services.”29

However, the Pennsylvania Board of Finance and Revenue rejected the department’s position and held that a SaaS license can qualify as an exempt “information retrieval service” as long as the user cannot “manipulate the data,” even for post-August 2016 tax periods.30 In Houghton International, the board concluded that a taxpayer’s purchase of LinkedIn Corp.’s online recruiting tools was nontaxable because LinkedIn’s service does not allow the user to manipulate any data.31 Similarly, in Fisher Scientific, the board concluded that the taxpayer’s purchase of Bloomberg BNA software and a subscription to Institute for Applied Network Security were both nontaxable information retrieval services because the taxpayer could access information without manipulating the data.32

The Pennsylvania Board of Finance and Revenue has also overruled the department and held that a SaaS offering was nontaxable where it appeared to have a sufficiently large service component. The Board of Finance and Revenue published a series of decisions holding that ADP LLC’s payroll software and service offerings are nontaxable “payroll processing services,” including for post-August 2016 tax periods (i.e., after the statutory change taxing electronically delivered software).33

Therefore, Pennsylvania will tax SaaS offerings except offerings where the end user cannot manipulate the data or offerings that include a sufficiently large service component.

Conclusion
SaaS providers must monitor the ever-changing sales tax landscape as more states are subjecting to SaaS to sales and use tax. Further, SaaS providers should consider whether they are subject to sales tax in new jurisdictions where they do not have a physical presence, but meet the sales or transactions threshold under the state’s post-Wayfair economic factor presence nexus requirement. SaaS providers will need to review whether these states impose sales tax on SaaS or any of the SaaS provider’s related offerings.

  1. South Dakota v. Wayfair Inc. , 138 S. Ct. 2080 (2018).
  2. See U.S. Dep’t of Commerce, “The NIST Definition of Cloud Computing” at 2 (Sept. 2011), available at https://nvlpubs.nist.gov/nistpubs/Legacy/SP/nistspecialpublication800-145.pdf (“NIST Definition of Cloud Computing”); Amazon, “What is Cloud Computing?”
  3. See NIST Definition of Cloud Computing at 2; Amazon, Types of Cloud Computing.
  4. See NIST Definition of Cloud Computing at 2-3; Types of Cloud Computing.
  5. See NIST Definition of Cloud Computing at 3; Types of Cloud Computing.
  6. See, e.g., Ark. Code Ann. § 26-53-109 (exempting from tax computer software which is “delivered electronically” (i.e. delivered to the purchaser by means other than tangible storage media)).
  7. See, e.g., Texas Comptroller’s Decision, No. 107,961 (Dec. 18, 2018) (adopting an administrative rule to clarify that taxable data processing is a service which includes computerized data and information storage or manipulation); New Jersey Stat. Ann. § 54:32B-3 (taxing information services but generally excluding SaaS unless software is “accessed and used as a tool for providing information to customers by an information service provider”).
  8. Wash. Rev. Code § 82.04.192.
  9. South Dakota v. Wayfair, Inc., supra.
  10. Nat’l Bellas Hess v. Dep’t of Revenue , 386 U.S. 753, 87 S. Ct. 1389 (1967).
  11. Quill Corp. v. North Dakota , 504 U.S. 298, 112 S. Ct. 1904 (1992),
  12. Ind. Code §§ 2.2-4-1(a) ; -2(a).
  13. Ind. Code § 6-2.5-4-16.7(b) ; Indiana Senate Bill 257 § 1 (signed into law March 23, 2018).
  14. Iowa Senate File 2417, 87thG.A. (signed into law May 30, 2018).
  15. Id.
  16. Id.
  17. Id.
  18. Iowa Code § 423.3(103)(a) .
  19. Data storage, like SaaS, is taxable under Iowa’s new statute, but can qualify for the same business to business exemption.
  20. Iowa Declaratory Order No. 2018-300-2-0508 (Dec. 18, 2018). A Iowa declaratory order is comparable to an IRS Revenue Ruling because it reflects the Department’s interpretation of the state’s tax law and can be relied on by the public, not just the taxpayer that requested it.
  21. See Reg. SU 11-25, Rule 7(3).
  22. See Rhode Island General Laws § 44-18-7 ; 2018 – H7200 Substitute A (signed into law June 22, 2018).
  23. In addition to these litigated decisions, numerous state tax departments have issued administrative guidance related to the taxability of SaaS over the last year. However, this administrative guidance has generally reiterated the departments’ previously issued SaaS taxability guidance.
  24. Citrix Systems, Inc. v. Comm’r of Revenue, Mass. ATB, No. 2018-538 (Nov. 2, 2018).
  25. 830 Mass. Code Regs. 64H.1.3(3)(a).
  26. Id.
  27. 1 Pa. Code §§ 9.2 and 9.3 .
  28. 61 Pa. Code § 60.19(a) .
  29. Penn. Dept. Rev. Letter Ruling, SUT-17-002 (May 17, 2017).
  30. See In re Houghton International, Inc., Nos. 1705455, 1720398 (Penn. Bd. of Fin. and Rev. April 3, 2018); In re Fisher Scientific Co., Nos. 1700833, 1700849 (Penn. Bd. of Fin. and Rev. June 12, 2018).
  31. In re Houghton International, Inc., Nos. 1705455, 1720398 (Penn. Bd. of Fin. and Rev. April 3, 2018).
  32. In re Fisher Scientific Co., Nos. 1700833, 1700849 (Penn. Bd. of Fin. and Rev. June 12, 2018).
  33. See, e.g., In re Honesdale National Bank, No. 1722086 (Penn. Bd. of Fin. and Rev. June 12, 2018).