Software providers, including software-as-a-service (SaaS) providers, should be aware that generating revenue from inbound sales into jurisdictions outside the provider’s home jurisdiction may have consequences for state and local sales and use tax, income tax, franchise tax, and gross receipts tax. In addition, the presence of remote employees may create consequences for payroll tax.
Because software providers deliver products and services through multiple media, the consequences can be complicated. Constant changes in the state and local taxation of software and SaaS mean software providers need to carefully consider tax implications.
Tax Guidance for Software, SaaS Is Complex
The way software and SaaS providers service their clients is innovative and constantly evolves, and state and local tax guidance for software and SaaS providers constantly changes.
Due to inconsistent tax treatment and revenue classification among taxing jurisdictions as it relates to software and SaaS providers, determinations of nexus and taxability can be overwhelming.
For example, economic nexus standards make it increasingly common for software and SaaS providers to have nexus for sales tax purposes but not income tax purposes, or to have nexus for income tax purposes but not for sales tax purposes because the nexus standards are different per tax type.
The rise in telecommuting creates more nexus challenges, and complicates receipts sourcing for most tax types, as well as presents various payroll tax challenges. Software providers should understand these complexities and reduce risk by determining the state and local tax impacts on their business activities.
Following are insights on various sales and use, income, and franchise tax challenges for software and SaaS providers. These include nexus, the imposition of sales and use tax, and apportionment and sourcing considerations for income and franchise tax purposes.
Sales Tax Nexus
Nexus is the legal connection to a state such that the state may assert tax jurisdiction over an out-of-state taxpayer. Nexus regarding taxability of the products and services must first be determined prior to collection and remittance of tax considerations.
Sales and use tax nexus may be triggered by one or both of two ways:
- Physical presence nexus
- Economic nexus
Physical Presence Nexus
Property or payroll generally creates physical presence nexus. Physical presence nexus can be triggered when office locations, computer servers, or other property are present, and additionally when payroll, such as employees, or third-party representatives acting on behalf of the taxpayer are in the state either on a permanent or transient basis.
Physical Nexus and COVID-19
Complexity arises around determining the presence of employees, such as in considering COVID-19 emergency declarations of various taxing jurisdictions.
Several taxing jurisdictions such as California, New Jersey, and South Carolina, determined an employee’s temporary work location in the state due to COVID-19 won’t be considered a nexus-triggering event for some or all the various tax types triggered by having employees in the state.
Other taxing jurisdictions determined the presence of employees is still a nexus-triggering event or haven’t issued guidance. Software providers should understand that such relief is temporary and may already have expired. Some software providers’ state and local tax footprints have or will increase due to the presence of remote employees.
Deriving income from in-state sources while lacking a physical presence may create nexus.
The concept of economic nexus for sales and use tax purposes stems from the 2018 US Supreme Court case South Dakota v. Wayfair, Inc., which ruled that businesses lacking a physical presence can still have sales tax nexus with a jurisdiction, provided certain criteria are met.
The Wayfair case explained that economic nexus is triggered by exceeding a sales or transaction threshold, typically $100,000 of gross or retail sales or 200 separate transactions.
Every state has imposed a sales tax economic nexus standard, with the exception of the following jurisdictions: Alaska, whose localities have economic nexus standards; Delaware; Missouri, whose economic nexus standard is effective January 2023; Montana; New Hampshire; and Oregon. However, not all economic nexus standards are the same.
Understanding the Sales Threshold
The Value of Sales
The first step in understanding the sales threshold is understanding the value of sales. While the South Dakota law in the Wayfair case provided a threshold of $100,000 in sales, some states implemented different value of sales thresholds; California and New York set it at $500,000.
Transactions that Count Toward the Value of Sales
The type of transactions that count toward the value of sales is key to understanding the sales threshold, too.
These types of transactions can generally be separated into three different categories:
- Sales of tangible personal property (TPP)
- Retail sales, which generally includes all taxable sales, such as TPP and taxable services
- Gross sales, which generally includes all sales regardless of taxability
Jurisdictions counting only sales of TPP towards the sales threshold, such as California and New York, typically include gross sales, retail, and may potentially include wholesale sales of TPP.
Other states counting only retail sales towards the sales threshold, such as Arkansas and Colorado, typically include only taxable sales, whether such sales be of TPP, digital codes, digital products, or services.
Finally, those counting gross sales towards the sales threshold, such as Idaho and Washington State, typically include all sales—TPP, services, digital codes or products, intangibles—regardless of taxability, towards the sales threshold.
Classification of Revenue to Determine Nexus
Each taxing jurisdiction’s classification of revenue, discussed below, has a direct effect on a software provider’s determination of nexus.
For example, SaaS is subject to transaction privilege tax in Arizona—Arizona’s version of sales tax—but isn’t classified as TPP. Further, only sales of TPP count towards Arizona’s economic nexus calculation. Therefore, a SaaS provider must have physical presence nexus with Arizona before it incurs a sales tax collection and remittance obligation.
Understanding the Transaction Threshold
The first step in understanding the transaction threshold is understanding if economic nexus is triggered with or without a set number of individual transactions. Some jurisdictions, such as Arkansas and Georgia, implement an or standard, meaning that economic nexus is triggered if the sales threshold is exceeded, or the transaction threshold is exceeded.
While less common, other jurisdictions, such as Connecticut and New York, implement an and standard, meaning that economic nexus is triggered if the sales threshold and transaction threshold are exceeded.
Equally as common as the or standard, several jurisdictions, such as California and Washington, don’t utilize, or eliminated, the transaction threshold. This means that merely exceeding the sales threshold is sufficient to trigger economic nexus.
Understanding the Nexus Period
Sales tax nexus is typically examined on a year-by-year basis and exceeding a set value of sales or amount of transactions can trigger economic nexus.
Year-by-Year Basis Versus Trailing Period
When should software providers start tracking the value of sales or number of transactions going into a particular jurisdiction?
Tracking the current tax year is a given for determinations of economic nexus in the current tax year; however, some jurisdictions require that out-of-state software providers also track a trailing period, and that trailing period varies on a jurisdiction-by-jurisdiction basis.
In most jurisdictions if a software provider exceeded economic nexus thresholds in the current or preceding calendar year, that software provider has nexus for the current calendar year.
However, some jurisdictions, such as Connecticut and Illinois, require software providers to examine the preceding 12 months to determine if economic nexus is triggered. Other jurisdictions, such as New York, require software providers to examine the preceding four sales tax quarters.
Regardless of the periods examined, once it’s determined a software provider has sales tax nexus for the current tax year, sales tax nexus generally exists for the remainder of that tax year.
Effect of Economic Nexus on Other Tax Types
The passage of the Wayfair case influenced tax types beyond sales tax, such as corporate income, gross receipts, and telecommunications taxes.
Examples include the economic nexus standard for Hawaii corporate income tax. Persons who don’t have a physical presence but have more than $100,000 of gross receipts from Hawaii or who engage in more than 200 transactions with persons in Hawaii have income tax nexus in Hawaii.
The Washington business and occupation (B&O) tax, a gross receipts tax, provides an economic nexus threshold of $100,000 in gross receipts.
Finally, a 2020 Oregon Tax Court case provided that a telecommunications provider offering voice over internet protocol (VoIP) services and lacking physical presence in Oregon was required to collect and remit E911 fees, because it exceeded the $100,000 sales threshold stipulated in the Wayfair case.
Medium of Providing Software and Classification of Revenue for Sales Tax
Software providers can sell, license, or provide on a subscription basis, their software and software platforms to customers via various media.
Such media include:
- Software transferred on a tangible medium, including load and leave software
- Software delivered electronically, such as downloaded on-premises software
- Remote access software and cloud computing, including the SaaS business model
The medium upon which software is provided to the customer often but not always dictates how state and local taxing jurisdictions classify the provider’s revenue stream for taxability purposes.
Tangible Personal Property
Some jurisdictions, such as Pennsylvania, classify the provision of software regardless of method of delivery as a sale of TPP. On the other hand, other jurisdictions, such as Virginia, classify only software provided on a tangible medium as a sale of TPP.
In Virginia, the provision of software is presumed to be on a tangible medium unless a software provider can demonstrate the software was delivered electronically. This distinction is relevant for out-of-state software providers attempting to determine if they have nexus in a particular taxing jurisdiction.
Data Processing Services, Digital Automated Services, and Information Services
More germane to SaaS providers, different taxing jurisdictions have different nomenclatures for the license or subscription of software that’s accessed remotely.
Software as a Data Processing Service
For example, jurisdictions such as Ohio and Texas may classify such provision of software as a data processing service, which is generally defined as the processing of information for the purpose of maintaining information and entering and retrieving information.
Software as a Digital Automated Service (DAS)
Other jurisdictions, such as Washington, may classify such provision of software as a DAS, which is generally defined as the provision of an electronically delivered service through use of one or more software applications.
Software as an Information Service
Finally, some jurisdictions, such as New Jersey and New York, may classify such provision of software as an information service, which is generally defined as the furnishing of information of any kind that has been collected, compiled, or analyzed by the seller, and provided through any means or method.
The above classifications of SaaS depend on a variety of factors, such as the level of interaction and control the customer has with the underlying software, to determine whether the provision of SaaS is a sale of services or a sale of software. If the sale is of a service, it’s also necessary to determine if it’s a sale of information services.
Sales Taxability of the Various Methods of Providing Software
The method in which software is sold, licensed, or provided via subscription basis, generally has a direct effect on the taxability of the software.
Software Sold on a Tangible Medium
Software sold on a tangible medium, including load and leave software, is generally subject to sales tax in most taxing jurisdictions.
Most states provide exemptions for custom software, which is generally defined as customization of software to a user’s specifications that goes beyond custom integration or installation.
Downloaded Software Delivered Electronically—On-Premises Downloaded Software
Downloaded software delivered electronically—on-premises downloaded software—is generally subject to sales tax in most taxing jurisdictions.
However, some jurisdictions that impose sales tax only on sales of TPP and few services, such as Virginia, don’t impose sales tax on such provision of software because they don’t classify electronically delivered software as a sale of TPP or a specifically enumerated taxable service.
Remote Access Software and Cloud Computing
SaaS is expressly subject to sales tax in about half of the taxing jurisdictions that generally impose tax on sales of software, including but not limited to Arizona, Massachusetts, Pennsylvania, and Washington. The remaining taxing jurisdictions differ in their treatment of SaaS.
Some jurisdictions, such as Colorado, North Carolina, and Indiana, provide guidance that SaaS is expressly not subject to sales tax. However, other jurisdictions, such as West Virginia and Hawaii, that don’t specifically address the taxability of SaaS still impose sales tax on SaaS because their sales tax imposition statutes encompass virtually every economic activity occurring in the jurisdiction, unless specifically exempted.
Finally, a group of jurisdictions, such as Louisiana and North Dakota, don’t specifically address the taxability of SaaS and therefore don’t impose sales tax on SaaS because their sales tax imposition statutes encompass only sales of TPP and specifically enumerated services.
Data Processing Services
Some jurisdictions, such as Connecticut, Ohio, and Texas, impose sales tax on sales of data processing services.
Jurisdictions such as Ohio provide exemptions for specific kinds of services, such as advertising services. Specifically, a true object analysis must be applied to determine whether the sale of a service in Ohio is a taxable data processing service, in whole or in part.
Other jurisdictions, such as Connecticut and Texas, impose sales tax at a reduced rate or reduced tax base on data processing services.
The definition of taxable data processing services is broad and generally goes beyond the examples provided in definitional statutes, as seen in Texas Comptroller’s Decision No. 115, 774, 08/11/2021, and can include services such as website design, creation, hosting, repair, and maintenance, or other services that are otherwise nontaxable but aren’t separately stated from the taxable data processing services.
Digital Automated Services
A few jurisdictions, including Washington, impose sales tax on DAS. However, exceptions apply for advertising services, payment processing services, and more.
In Washington, Gartner, Inc. v. Department of Revenue, is a seminal case providing the analytical framework to determine whether such exceptions apply.
A minority of jurisdictions such as New Jersey and New York impose sales tax on electronically delivered information services.
As applied to software providers, this would include the collection of:
- Information or data
- The processing of such information or data on a software platform into useful information or a useful report
- The provision of access to said platform to the customer, even if only for purposes of viewing the information or report
Sales tax exemptions exist for processing personal or individual information.
Sales Tax Sourcing Considerations
Software providers should understand where their products are being used to identify the appropriate measure of sales tax, to determine the sourcing of software sales, and to determine if products have multiple points of use (MPU) exemptions or other considerations.
Sourcing of Software Sales
Sourcing of sales for software providers on a multijurisdictional basis is complicated at best. The threshold is often whether the taxing jurisdiction classifies the software provider’s product as TPP or a service.
The overwhelming majority of taxing jurisdictions and the Streamlined Sales and Use Tax Agreement (SSUTA) source sales of TPP to the location where the TPP is delivered or where the purchaser takes possession of the TPP, such as destination-based sourcing.
Sourcing can vary pending whether the transaction is interstate or intrastate, as most interstate transactions are sourced according to destination, but some intrastate transactions are sourced according to origination. A few jurisdictions such as California use mixed sourcing; the state and localities source sales of TPP differently, whether origin-based or destination-based.
To the extent a software provider’s product is considered the sale of a service, most jurisdictions source based on where the software is used.
Multiple Points of Use of Software
Taxing jurisdictions differ on software providers’ obligations to collect and remit sales tax when the software purchased is used by customers concurrently in multiple jurisdictions.
In jurisdictions like Massachusetts and Washington, if purchasers use software concurrently in multiple taxing jurisdictions, the purchaser may claim an MPU exemption, and the software provider is relieved from collecting and remitting sales tax on the transaction.
A recent Massachusetts Appellate Tax Board case illustrates that the imposition of Massachusetts sales tax on the sale of or license to use software in Massachusetts must be limited to the apportioned users in Massachusetts, notwithstanding if the software was downloaded on servers located in Massachusetts. Software providers should be diligent with collecting exemption certificates from purchasers claiming the MPU exemption.
On the other hand, in jurisdictions such as New York, if customers concurrently use software both in and out of the taxing jurisdiction, the software provider should collect and remit sales tax based on the portion of the receipts attributable to users in the taxing jurisdiction. Further, Washington has a statutory MPU exemption that applies to software and digital products. Purchasers may issue to sellers an exemption certificate and self-assess use tax on the apportioned use within Washington.
In these jurisdictions documentation should be collected from the purchaser showing the number and locations of employees with access to the software. The provider should keep these records for the requisite amount of time, usually three years.
Exemptions to Sales Tax on Software
Several jurisdictions provide exemptions to sales tax for the provision of software, regardless of method of delivery, if the software is used directly in a manufacturing or R&D operation.
Use of Software in Manufacturing
Jurisdictions such as Arizona and Washington provide sales tax exemptions for purchases of software used directly in a manufacturing operation.
Generally, this requires the purchaser be a manufacturer of TPP for sale, and that the software be used at least 50% or more in the manufacturing operation. Software providers should be diligent in collecting exemption certificates from manufacturers claiming this exemption.
Use of Software in R&D
Jurisdictions such as Washington provide sales tax exemptions for purchases of software used in R&D operations.
Generally, this requires purchasers to engage in the discovery of new or improved technological information, and that the software be used at least 50% or more in the R&D operation.
Software providers should be diligent in collecting exemption certificates from purchasers claiming this exemption.
Income Tax Considerations for Software Providers
Like state sales tax, there are several state income tax considerations for software providers.
- Apportionment formula
- Sourcing of sales
Income Tax Nexus
For state income tax purposes, a software provider may establish nexus in one of three ways:
- Physical presence
- Economic nexus
- Factor-presence nexus
Physical presence nexus is generally triggered in the same way as nexus for sales tax purposes.
In relatively few jurisdictions, such as Delaware, state income tax nexus can only be triggered by physical presence.
Economic nexus standards for income tax arise from jurisdictions’ deriving income from this state income tax nexus provisions
While deriving income from this state is generally not a defined term, jurisdictions have been using the Wayfair case as a foothold to take the position that if a software provider lacking physical presence in a jurisdiction has economic nexus for sales tax purposes, then economic nexus is likely triggered for income tax purposes.
Finally, states such as California and Colorado utilize a factor-presence standard to determine nexus for income tax purposes.
Typically, factor-presence nexus is established by having a specified amount of property, payroll, sales, or a certain percentage of worldwide property, payroll, or sales in a taxing jurisdiction.
Public Law (PL) 86-272 and State Income Tax
PL 86-272 is a federal statute that exempts out-of-state businesses from the imposition of state or local income tax if the business’s only activity in the state is soliciting orders of TPP that are approved at and fulfilled from points outside the taxing state.
This is applicable to software providers, including SaaS providers, because several jurisdictions, such as Massachusetts and Pennsylvania, consider the provision of software, regardless of method of delivery, to be a sale of TPP.
Other jurisdictions, such as New Jersey, also find the sale of software, but not the provision of cloud-based access to software such as SaaS, to be a sale of TPP even if delivered electronically. Therefore, as held in the New Jersey case Accuzip, Inc. v. Division of Taxation, PL 86-272 protections would apply to most software providers, except cloud-based software providers. However, a determination of the sale as TPP is of utmost importance because sales other than TPP such as royalties, rentals, and services, are not protected by PL 86-272.
The term solicitation can vary slightly on a jurisdiction-by-jurisdiction basis, however, it’s understood to mean the presence of employees or representatives in a taxing jurisdiction for the purpose of making sales of TPP, for which orders are sent outside the taxing jurisdiction for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the taxing jurisdiction.
Generally, activities that go beyond the solicitation of orders for the sale of TPP, such as providing maintenance on premises to the property sold, installing the property on premises, conducting training on premises, or providing technical assistance on premises, may cause a software provider to lose PL 86-272 protection and subject itself to a jurisdiction’s tax on net income.
Multistate Tax Commission (MTC)
The MTC recently refreshed its statement of PL 86-272 with updated considerations for telecommuting and activities conducted via the Internet.
While not binding on its own, MTC compact member taxing jurisdictions generally incorporate these statements into their tax guidance. Further, California issued a Technical Advice Memorandum that mirrors the MTC’s refreshed statement.
With regards to telecommuting, the MTC opines those activities performed by an employee who telecommutes that go beyond solicitation will terminate PL 86-272 in the taxing jurisdiction where the employee sits.
Turning to Internet activities, the MTC provides that Internet sellers of TPP generally require the same analysis with respect to persons that sell TPP by other means. However, some additional considerations arise, such as the placement of Internet cookies to gather customer information, which can terminate PL 86-272 protection in the taxing jurisdictions where the Internet seller’s customers are located.
Nuances Of Navigating PL 86-272
First and foremost, PL 86-272 applies only to jurisdictions that impose a tax on net income. This means tax regimes such as the Washington B&O tax—a tax on gross receipts—and the Texas Franchise Tax—a tax on profit margin—aren’t bound by PL 86-272.
Second, while PL 86-272 protections may apply, some jurisdictions may still require the filing of a zero return or informational report, while others may still require the payment of a minimum tax.
Apportionment of Receipts for Income Tax Purposes
Apportionment is the allocation of a business’s taxable income or in the case of a gross receipts tax, gross receipts, to a particular taxing jurisdiction for purposes of determining a business’s taxable base.
The apportionment of receipts is achieved through several different methodologies, all of which result in a fraction—the apportionment factor—which is multiplied against the business’s federal taxable income, after adjustments for jurisdiction-specific addbacks and deductions, to arrive at the tax base.
Single Sales Factor
The most common apportionment methodology is the single sales factor. Under this methodology a fraction is created with the software provider’s worldwide gross receipts as the denominator and gross receipts attributable to a particular taxing jurisdiction as the numerator.
Three-Factor Apportionment Formula
The former most common apportionment methodology is the three-factor apportionment formula.
Under this methodology, a business’s sales, payroll, and property each create individual fractions with figures placed in the denominator and figures attributable to the taxing jurisdiction in the numerator. These fractions are averaged together to create an overall apportionment factor.
Jurisdictions such as Alaska, Hawaii, and Kansas still use the three-factor apportionment formula. A handful of jurisdictions use variations of the three-factor apportionment formula such as the double-weighted sales formula—New Hampshire—and the triple weighted sales formula—Tennessee. Under these methodologies, the sales factor of the three-factor apportionment formula is simply duplicated or triplicated, creating a five- or six-factor apportionment formula.
Before considering the above, software and SaaS providers should consider how their business activities are treated for income tax purposes, incremental to sales tax purposes, which may have a direct effect on the type of apportionment methodology used. This issue arose in the Massachusetts Appellate Tax Board case Akamai Technologies, Inc. v. Commissioner of Revenue, where a SaaS provider was determined to be a manufacturer for income tax purposes. The provision of SaaS is a sale of TPP in Massachusetts, thereby allowing the SaaS provider to use the single sales factor apportionment methodology available to manufacturing corporations, as opposed to the less preferential three-factor formula.
Sourcing of Receipts for Income Tax Purposes
The sourcing of a software provider’s sales is relevant for states that impose economic presence or factor-presence nexus standards for state income tax purposes. To the extent a software provider’s sales represent the sale of TPP, receipts are almost always sourced to where the software is being used.
If a software provider’s sales represent the sale of services, the two general methodologies for sourcing sales are market-based sourcing and cost-of-performance-based sourcing.
Under market-based sourcing, receipts are sourced to the state where the benefit of the service is received or where the customer is located.
In the context of SaaS providers, the source state is likely going to be the state where the customer uses the software, but may be the state where the customer maintains a billing address. Most states, such as California and Oregon, implement market-based sourcing.
States that implement the cost-of-performance approach, such as Arizona, source receipts to where the income-producing activity takes place, either wholly within the state or in the state where the greatest cost of performing the service occurred. This approach is likely most problematic for SaaS providers because the income-producing activity could occur at the location of servers that host the software, or where the software is developed or maintained, or in some cases, both.
Specific to software and SaaS, taxing jurisdictions generally don’t have specific carve-outs in their codes and regulations for sourcing beyond classification as either the sale of TPP, intangible personal property, or services.
However, applicable to taxing jurisdictions using the cost-of-performance sourcing approach, some taxing jurisdictions, such as Florida, may interpret the income producing activity, such as cost of performance, for sales of software or the provision of SaaS to be the customer’s location rather than where the software is developed or maintained, or where the servers are.
Texas is also unique, as per the recent Texas Supreme Court holding in Sirius XM Radio, Inc. v. Hegar, which instructs taxpayers to apportion receipts based on where the work was performed as opposed to where the end-product act occurs, which was an argument of the Comptroller for market-based sourcing, for Texas Franchise Tax purposes, which is a complex analysis.
Multistate Payroll Tax Considerations
Companies with employees in states outside of where the company maintains offices or other facilities must consider whether the remote employees create sales and use, income, franchise, or gross receipts tax nexus. In addition, software and SaaS companies should consider personal income tax withholding and payroll tax reporting.
Not all states impose a personal income tax, but most do, and all states have some form of payroll tax and registration for unemployment reporting. There may also be sales and use tax considerations directly imposed on the company through the maintenance of property such as a company-issued computer or phone at the location of the employee.
We’re Here to Help
For guidance in sourcing revenue or if you have questions about the tax implications for your software company, contact your Moss Adams professional.
You can also visit our State & Local Tax Services page for additional resources.