By David Seiden and Robert Gardner
In general, there are three ways consumers (individuals and businesses) obtain access to software (via purchase/license). They can:
- purchase a tangible disk loaded with software that they install on their computer;
- download software directly to their computer from the Internet; or
- access the software online from "the cloud."
Given the reality that all three of the above scenarios result in granting customers access to software, the issue becomes why certain states treat them differently for sales tax purposes. In addition, if the seller of the software does not collect the sales tax, what is the customer's obligation to pay the tax?
Obviously, when it comes to state taxes, there is never a simple answer. So it's important to remember a few important concepts.
First is the term "nexus." In summary, a state is only allowed to require a remote seller to collect sales tax from in-state residents if such seller has "more than a de minimis amount of physical presence in the state" (not my words but rather from a 1992 U.S Supreme Court decision, Quill).
The second concept to remember is states are generally slow to enact new laws in the face of new technology. Hence many of states find themselves applying existing sales tax laws, developed for brick-and-mortar transactions, to emerging technology transactions (i.e. cloud computing).
The final concept is that there is generally "no free lunch" when it comes to sales tax, meaning if a seller lacks nexus with a state and a resident makes a taxable purchase of software, the customer is responsible for self-assessing/paying use tax. Use tax is applied at the same rate as the sales tax, but must be remitted by the customer if the seller lacks nexus.
Recent rulings in Texas and New Mexico illustrate just how crazy things have become in determining nexus for out-of-state sellers of software. In a recent Texas opinion, that arguably defies the laws of physics, a Utah-based online software seller was held liable for nine years of uncollected and remitted sales tax on software licenses sold to customers in Texas, even though it had no property, employees or representatives there. The taxpayer's only connection with Texas was its licensing of software to Texas residents. The ruling concluded that the software license equated to maintaining property in Texas and thereby created a physical presence required by Quill. While cloud computing and software downloads were not around in 1992 when the U.S. Supreme Court mandated the physical presence test in order for a state to mandate a seller to collect and remit sales tax, it appears to this author that states like Texas are overstepping the rules espoused by the Court in Quill.
In New Mexico, a string of recent rulings has yielded similar results to those in Texas -- that the mere licensing of software to an in-state user, without any other physical contact with the state, creates sales tax nexus. In each of these rulings, nexus was based on the taxpayer's ownership of actual or constructive software licenses used by customers in the state. Like Texas, New Mexico treats a "license to use" as a form of "property." Accordingly, a seller of software is deemed to have in-state property, and therefore sales tax nexus, solely by virtue of actual or constructive ownership of software licenses used by New Mexico customers.
Texas and New Mexico are not alone.
Numerous states are taking the position that the license of software creates a collection and remittance responsibility for the software seller. Software sellers beware. The way a state will find you is when they audit one of your in-state customers and see your invoice without sales tax. The auditor typically goes back to their office the same day and sends the software seller a questionnaire and that becomes the beginning of what typically turns out to be a bad situation for the out-of-state software seller.
Sellers of "anything" should remember, if you are deemed to have nexus in a state, you typically get one chance to collect the applicable sales tax from your customers (upon initial sale). If you do not collect and remit and the state determines you had nexus, the sales tax liability that initially belonged to your customer now belongs to you.
Back to the concept of no "free lunch" when it comes to sales tax. If the software seller does not charge tax and software is deemed taxable in a customer's state, use tax needs to be remitted on the business customer's sales tax return and individuals need to follow their respective state's rules on how to remit use tax.
While many businesses and individuals do not voluntarily remit use tax, be careful. There are so many states beefing up their audit function that may make it just a matter of time before you get the dreaded letter in the mail.
About the authors: David Seiden is a leading authority on state and local tax (SALT) matters. He is a partner based in Citrin Cooperman's White Plains, New York office, where he leads the firm's SALT Practice. He can be reached by phone at (914) 949-2990 or via email at firstname.lastname@example.org. Robert Gardner is a member of Citrin Cooperman's SALT practice. Citrin Cooperman is a full-service accounting and business consulting firm headquartered in New York City with offices in White Plains, NY; Norwalk, CT; Long Island; Livingston, NJ; and Philadelphia.