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Monday, April 9, 2012

State tax challenges of taxing digital items and possible federal assistance

Letter Ruling 2012-06 from the Hawaii Department of Taxation is a reminder of challenges of applying sales tax to software and other digital items (or in Hawaii's case, applying gross receipts tax). Despite ruling that the software was not taxable because used by a customer out of state, the ruling notes the following regarding challenges of taxing digital items.

"Technological innovations and the rapid advances being made have now blurred the lines between product and service. Software as a Service ("SAAS") and electronically delivered content perplex both taxing authorities and sellers on the correct tax treatment to be accorded it, with no uniform consensus. Also known as on-demand hosting or subscription-based software, SAAS has grown exponentially and generally enables customers to pay for the use of Web-based software instead of purchasing or licensing the software outright. The software and other digital media application delivery model has also grown exponentially in the past few years, since one no longer needs to wait for the delivery of a physical disk before being able to use it. Not surprisingly, sellers, buyers, legal counsel and tax auditors are arriving at different conclusions on how a transaction should be taxed, depending on how they answer questions such as:

Ø      Should SAAS be treated like electronically delivered software?
Ø      Is a license agreement imperative, and what happens if there is none?
Ø      Is SAAS simply a “license to use”?
Ø      Is SAAS an information service or database?
Ø      What if tangible backup copies are provided to the licensee?
Ø      What if the agreements provide for periodic updates?
Ø      Is a sale sourced to the customer’s billing/shipping address?
Ø      Is a sale sourced to where the hosting server is located, because the software is "used" in that state?
Ø       Is a sale sourced to where users access it?
Ø      What if it's not known where the users are?

It should be noted that a bill has been introduced in Congress, which may provide uniform guidance. The Digital Goods and Services Tax Fairness Act of 2010 (H.R. 5649) was introduced on June 30, 2010, to promote “neutrality, simplicity and fairness in the taxation of digital goods and digital services.” One of the most significant portions of the bill proposes sourcing the sale of digital goods (including software) to a single location for sales tax and use tax purposes.

Regardless of whether the software is a product, a service, or some combination of the
two, the Company has represented that it is consumed entirely outside the state, and that the Company has no Hawai`i customers. As such, the transaction is exempted under HRS § 237-29.5 and/or HRS § 237-29.53, and no GE tax must be paid."

The reference above to H.R. 5649 is an old bill. The current version is H.R. 1860 (112th Congress) and it was addressed by the House Judiciary Committee at a hearing on May 23, 2011. Among other things, H.R. 1860 provides a sourcing rule for sale of digital items. Under this proposed rule:
      "(1) IN GENERAL- Taxes on or with respect to the sale of digital goods or digital services may be imposed only by the State and local jurisdictions whose territorial limits encompass the customer's tax address.
      (2) MULTIPLE LOCATIONS- If the sale of digital goods or digital services is made to multiple locations of a customer, whether simultaneously or over a period of time, the seller may determine the customer's tax address or addresses using the address or addresses of use as provided by the customer.
      (3) SELLER HELD HARMLESS- A seller that relies in good faith on information provided by a customer to determine the customer's tax address or addresses shall not be held liable for any additional tax based on a different determination of the customer's tax address or addresses."
Digital goods and services are defined fairly broadly except that digital services do not include "telecommunications service, Internet access service, or audio or video programming service."

H.R. 1860 also provides that tax may only be imposed with digital goods or services are sold to a customer other than for resale. While that is good tax policy (to avoid cascading or pyramiding of a sales tax), states will likely not like Congress restricting their taxing powers.

Challenges in state taxation of digital items also exist because businesses and states have not reached agreement on the best sourcing approach. At the May 2011 hearing, testimony presented for the Federation of Tax Administrators noted that group's opposition to the legislation. FTA's objections included that the language was overly broad and hindered legitimate taxing authority of state and local governments and would lead to expensive litigation due to overly broad terms such as "resale" and "discriminatory."

In contrast, the Information Technology and Innovation Foundation, supported H.R. 1860: "The Digital Goods and Services Tax Fairness Act of 2011 would set a national framework to ensure fair and equitable taxation of digital content by creating consistent rules for determining which jurisdiction has taxation authority, disallowing multiple and discriminatory taxes, creating consistent definitions, and ensuring that other taxes, such as those applied to telecommunications services, cannot be inappropriately extended to cover digital goods and services. By creating a fairer and more consistent tax system for digital goods, this legislation will help promote and sustain our growing digital economy."

I don't expect that H.R. 1860 will be enacted in the 112th Congress. More study is needed by state governments and industry to better understand the nature and variety of digital transactions, the tax issues, and possible solutions. A solution that follows principles of good tax policy including simplicity, neutrality, equity and transparency and considers state and local taxing authority is a reality at some point in the near future.

What do you think?


Corey C said...

Digital content creates new challenges when determining where tax is to be applied. The proposals under H.R. 1860 lays sourcing rules that seem clear, however there will be complications. One for example is the Multiple locations. Though the seller is to use the billing address provided by the customer. However the customer may not be using the product at the address. The Seller Held Harmless rule seems to be fair because it would cost a fair amount of money to verify that the address or addresses provided by the customer are correct.
This is a complicated issue that will be the topic of discussion for quite sometime.

Clark W. Griswold said...

After reading H.R.1860 and the May 23, 2011 testimonies of Russ Brubaker on behalf of the Federation of Tax Administrators and Robert Atkinson on behalf of the Information Technology and Innovation Foundation, I am not convinced that a bill like H.R. 1860 is necessary at this time.

While Section 4(c)(1) of H.R. 1860 addresses the concern that the same digital transaction may be taxed in two jurisdictions, depending on each state’s sourcing rules, by sourcing the sale of digital goods to the customer’s tax address, Russ Brubaker raised a good point that the same digital transaction being taxed in multiple jurisdictions is a non-issue by stating that “all states that impose sales and use taxes allow credits for tax paid to other jurisdictions”. I agree with Corey C’s post to this blog that the sourcing limitation for multiple locations described in Section 4(c)(2) of H.R. 1860 is very confusing and that the sourcing for multiple locations would need to be clarified before a bill like H.R. 1860 is enacted.

Russ Brubaker made another interesting point in his testimony when he talked about “problems with nowhere sales”. Russ Brubaker explained that a state where a seller is located will not be able to tax a sale to a customer in another jurisdiction unless the seller has a physical presence or a nexus in that state. If H.R. 1860 is enacted, without addressing the nexus issue, the customer’s state may have jurisdiction to take the digital sale but may not meet the nexus requirement to actually impose the tax.

While I agree with Robert Atkinson’s statement that tax rates should be the same for digital and tangible goods, I don’t think H.R. 1860 is necessary at this time because no states are currently imposing discriminatory taxes on digital transactions. In other words, it doesn’t make sense to protect against discriminatory taxes that do not exist now and may never come to fruition.

For these reasons, I agree with Professor Nellen that state governments and private industry need to have more discussions and do more research on the nature and variety of digital transactions before legislation is enacted.