Software Taxability 101

The high-tech software sector is a major revenue source for taxing authorities in the United States and around the world, but the taxability issues faced by vendors in this space can be particularly tricky. Just ten years ago, determining the taxability of software was very straight forward.  Most software was delivered on a tangible medium (discs, CD’s, etc.) or via load and leave (remember that?) and the rules for each were clear. Today, most software is delivered electronically or as a service. The taxability rules for electronically delivered software and software-as-a-service vary greatly from one state to the next and can be dizzying, making compliance excruciatingly difficult for many companies.

The complexities of getting correct tax results on daily transactions becomes even more intense when coupled with the multitude of legislative changes occurring each year across the nation, and even around the world. Taxware® software supports a robust suite of good/service code content geared specifically towards the high-tech industry (currently 467 individually researched codes) which substantially eases the compliance burden on our clients. Distinctions covered by these codes include business vs. personal use, recreation vs. non-recreation use, delivery methods, mandatory, optional, canned, custom, qualifying criteria for states such as Illinois and Colorado, and more.

Let’s look at some of the factors involved in determining the taxability of various types of software and software maintenance contracts.

Canned vs. Custom Software
In order to achieve a precise tax result, it is important to know the distinction between “canned” and “custom” software. Canned software constitutes prewritten programs, existing for general or repeated sale or license; by way of example, Taxware software applications are considered “canned” software.  In general, canned software is taxed as a standard good.  Custom software, in contrast, constitutes a computer program prepared to the special order of the customer. Generally, custom software is treated as a service and taxed as such.  The reason for the disparate treatment is that typically, when a customer receives a special order, the provider of that order is construed to provide more of a service rather than a tangible good, therefore, triggering the service tax laws.  This distinction occurs in those jurisdictions where goods are taxable, while services are exempt.

Software Licenses
When discussing software sales, an important distinction exists in the area of software licenses. Where a “sale” occurs, title to the good is transferred to the buyer who is then considered the owner of such good. A “license,” on the other hand, occurs when only permission to use the good occurs, and the licensee is never the owner of such good.  The taxation of software licenses typically depends on the states’ laws regarding service contracts.  In many jurisdictions, renewals of software licenses generally do not constitute new and independent sales, and as such they may be taxed as the original license was taxed.  Internationally, software licenses will nearly always be classified as “services.”

Electronically Delivered Software
Years ago computer software was delivered on discs, tapes and other tangible media. Thus, it was taxable as tangible personal property. These days most software is delivered electronically and discs are quickly becoming a thing of the past.

Even software purchases made in retail stores generally only provide the purchaser with an access code that they can use to access their software download electronically from the Internet. Initially only a few states, such as New York and Pennsylvania, applied sales tax to electronically delivered software, but as time passes, many other states have followed suit and inevitably more will join in the future.

The states that currently tax electronically downloaded software include:

Software as a Service and ASP’s
While many states exempt most services from sales tax, this does not necessarily mean that software as a service is exempt. Software as a service, often referred to as SaaS, as well as Application Service Providers (ASP’s) are both hosted software delivery models that have become increasingly popular in the past few years. These methods of delivering software, often referred to as “cloud-computing” are new technology for most state tax agencies and generally follows the same taxability as services. Cloud computing has been an area of contest for a handful of states and many are developing a completely new set of rules to deal with the taxability. One example is the recent moratorium in Vermont, where confusion arose regarding the taxability of this remote access software.

Below is a list of states that tax SaaS and ASPs:

Maintenance Contracts
Maintenance contracts sold in connection with the sale or lease of pre-written computer programs generally provide that the purchaser will be entitled to receive software updates during the contract period, and may also provide for telephone or on-site consultation services.  The taxability of these contracts typically depends on whether or not the contract is optional or mandatory at the time of the sale of the underlying software.  If the purchaser must purchase the maintenance contract in order to purchase or lease a prewritten computer program, then the charges for the maintenance contract are generally included as part of the sale or lease of the prewritten program and taxed accordingly.  If the purchase of the maintenance contract is optional, then the charges are generally taxed as separate from the sale or lease of the prewritten program, and the contract may be taxable or exempt as a service.