The world of software and Software as a Service (SaaS) presents complex sales tax implications that both businesses and customers must be aware of. Failing to understand and address these tax considerations can lead to significant liabilities. Here are six key factors to keep in mind when dealing with sales tax in the realm of software and SaaS:
1. Don’t Assume Tax Inapplicability: Sales tax applicability varies depending on the type of software or service you are offering and the jurisdiction you’re in. It’s safer to assume that sales tax may apply unless an exception exists. It’s essential to grasp that the rules differ significantly depending on whether you are selling traditional software, SaaS, or a hybrid product. The specifics of how the taxing jurisdiction defines your product or service play a crucial role in determining the tax treatment. Being informed about these nuances is essential to avoid costly surprises.
2. Don’t Overlook Contract Provisions: Contract provisions are essential. The state’s laws govern how a transaction is treated for tax purposes, regardless of how the contract labels it. Ambiguities in contracts can lead to confusion regarding tax responsibilities and liabilities. Three primary issues can be triggered regarding state taxation of software. First, for state tax purposes, the particular state’s laws govern how the state will treat a transaction. Simply labeling a transaction as a lease or a SaaS will not override the state’s laws or its ability to impose a tax. Second, regardless of where the contract is entered into or any choice of law provision, the terms of the contract will generally not affect where the taxing authority deems the transaction occurred. Simply put, a contract entered into in Minnesota between two Delaware entities for the delivery of software to a customer’s terminals in California, Texas, and Tennessee may be subject to sales taxes in any or all of those locations. Finally, standard contract provisions are often unclear and/or incomplete regarding how to handle state taxation issues. The contract should make clear who is liable for the applicable taxes and who is liable for any associated penalties and interest. The language should also address (1) potential tax clawbacks, (2) any relevant tax indemnification obligations, and (3) which party is responsible for litigation and other defense costs if a state audits or attempts to impose a tax at a later date.
3. Beware of Penalties: Penalties for noncompliance can be severe. Even if you lack a physical presence in a state, recent legal changes have extended tax liability. Penalties can range from 2% to 25% of the tax due, plus interest. Nonpayment of taxes could lead to audits for previous years. For starters, generally the liability for nonpayment of sales tax is on the seller of the product or service. A recent U.S. Supreme Court case (South Dakota v. Wayfair, Inc.) also makes it clear that you may have tax liability even if you do not have a physical presence within the particular state. Many states have adopted economic nexus standards that impose liability if the seller has as little as $100,000 in revenue (on a previous or current calendar year or on a rolling 12-month basis) or 200 or more total transactions. If tax is owed but not paid, penalty rates generally range from about 2% to 10%, which can certainly eat into and/or eclipse any of the profit the business may otherwise have expected to receive from the transaction. In California, the failure to pay can impose penalties as high as 25% of the total tax due. Additionally, mandatory interest charges will almost assuredly also apply, which may add approximately an additional 8% to the amount due. Even more harsh is the prospect that your business may be audited not just for the current tax year, but for four or more prior years, which could cause your tax liability to balloon into nearly unmanageable numbers that could jeopardize your entire business.
To avoid these pitfalls, follow these best practices:
4. Understand the Product and Its Use: Differentiate between software and SaaS. Determine how and where customers use your product. This analysis can affect the taxation of your product. The first level of analysis is to understand if you are selling software or SaaS. As previously noted, the focus here is not on your and the client’s understanding but rather on how the specific state treats your transaction. You may need to consult with a technology and tax attorney to assist with this analysis. Once you understand this issue, you will need to determine how and where your customer is using that product. This may implicate additional taxes, including different taxing authorities (e.g., different states/countries). This process usually involves asking your client questions at the time of the contracting process. The overwhelming majority of states have implemented destination-based sourcing for interstate transactions of tangible personal property. This means the sale of canned software, and possibly SaaS, will generally be taxed in the jurisdiction where the purchaser will use the software. However, this is a general statement, and each transaction must be analyzed individually. Care should also be used if the software or SaaS allows for users in more than one state; accordingly, the location of each access point should be clearly defined in the contract. Even more complications arise if you will have foreign users of the software or SaaS.
5. Thoroughly Review Contracts: Contracts should address tax implications and outline procedures for tax assessment, calculation, and payment. Regularly review contracts to ensure compliance with tax laws. The sad fact is that the taxing authorities often will target software companies for unpaid sales tax. Accordingly, if you are not collecting the tax from your customers, you as the software manufacturer are shouldering the risk. Therefore, it is vital that the contract with your customer appropriately address tax implications and the procedures and logistics for how applicable tax will be assessed, calculated, and paid. Having your contract periodically reviewed by a technology and a tax attorney is important to help minimize the liability that could result from not being compliant with the tax laws. Furthermore, if you have contract language that allows you to recoup all taxes owed from your customer, while that may assist you somewhat, you will have an angry customer when they get a surprise bill for the payment of taxes in the distant future from when the initial contract was signed.
6. Train Sales and Accounting Teams: Equip your sales and accounting teams with knowledge of tax implications. Sales teams should understand the taxable aspects of each sale. Accounting teams need to know which taxes may apply and have access to internal and external resources for tax-related questions. These steps help minimize the risk of noncompliance with sales tax laws related to software and SaaS. Understanding these complexities is vital for both businesses and their customers. As the landscape of software and SaaS evolves, staying well-informed and proactive about sales tax issues is crucial for maintaining compliance and preventing financial surprises.
