Untangling revenue source rules for sales and use taxes
The continued growth of digital goods and services offerings has proven to be much more than a temporary pandemic accommodation. Today, businesses and states struggle to determine what goods and services are subject to tax and how to source those sales for both sales and use and tax purposes.
Taxation of services
Sales and use tax collection is the second largest source of state and local government revenue, surpassed only by property tax collection. Central to one state’s sales tax provisions was the theme that sales tax is imposed on the “retail sale of tangible personal property,” or TPP.
As sales of digital goods and services have increased, states have been keen to expand their tax base to include these mixed service offerings. Some states have generally included any service provided through a computer as retail sale of tangible personal property. Others have simply expanded the list of listed services to include broad categories such as software, information services, data processing, and digitally delivered goods and services.
The list of states expanding their definition of taxable goods and services to the sale of digital products illustrates the transformation of states to tax cyber transactions. For example, since 2021, Maryland has taxed all forms of digital products, including digital downloads, electronic publications, audio and video content, subscriptions and licenses to access online content or use of a software application. In 2016, Pennsylvania began applying the TPP definition to canned software and any other electronically or digitally delivered TPP product or service.
Many states mandate data processing services, including Connecticut, New Jersey, Kentucky, and Texas. In 2019, Washington, DC added digital goods to the definition of retail sales subject to tax. This year, Kentucky significantly expanded taxable services to include marketing, telemarketing, lobbying, website hosting, and private investigations. Additionally, pre-written software is now considered taxable.
Kentucky’s legislation takes effect January 1, 2023. Ohio and Rhode Island recently ruled that access to web portals, mobile applications, and online responses for market research qualify as electronic information submitted to tax. New York recently came to a different conclusion: Membership fees, which provide access to web portals, mobile apps and digital content, were not considered taxable.
Adding to the confusion, states remain divided on the taxation of digitally delivered services. For example, digital products are taxable in states such as Michigan, Pennsylvania, New York, Texas, and Washington, regardless of delivery method. In contrast, California, Colorado, Georgia, Florida, and New Jersey do not tax products transferred to a customer over the Internet.
Today, the offering of goods and services bundled or mixed is commonplace, as is the provision of services through hosted websites. Although there is still a long list of mixed goods and services that do not fall under the tax net, 38 states tax the entire bundled price when the non-taxable component is equal to or greater than 10% of the total consideration paid by the consumer. As such, it is not enough to know, state by state or local jurisdiction by jurisdiction, which goods and services are taxable; you also need to know exactly how goods and services are billed to customers. And if it’s bundled, that entire transaction is probably subject to tax.
Which state has jurisdiction over a transaction?
The rules determining which state is entitled to receive sales tax may differ depending on the source, destination, and nature of the product or service offering. Essentially, there are three ways to determine which state or local tax should be collected:
- Destination based: Transactions are governed by the rules applicable in the state and local jurisdiction where the goods and services are delivered. This is the rule followed by most states for interstate and intrastate sales of goods and services.
- Based on origin: Pricing and rules are based on the seller’s location. Arizona, Illinois, Missouri, New Mexico, Tennessee, Ohio, Pennsylvania, Utah, Texas and Virginia all have rules requiring origin-based sourcing in situations specific. These rules generally apply to intrastate sales when the buyer and seller are in the same state. In such cases, the local tax is based on where the inventory is shipped or the sales activity.
- Mixed Sourcing: Rates and rules are mixed based on state rules, including interstate and intrastate. California is a state that, while generally sourcing by destination, applies origin sourcing when the sale originates from an in-state location. In addition to the rules above, some states have specific provisions for service procurement that may differ from TPP sales. For example, Connecticut taxes services based on where the benefit is derived, which may differ from where the purchaser is located or where the services are provided. New Jersey sources Services from the location where the Services are first used, which may also differ from the primary location of the Buyer or Seller.
The rules of origin or allocation of sales for income tax purposes may differ significantly from those applicable to sales and use taxes. Market-based procurement becomes the predominant method of revenue allocation, as opposed to the performance cost method in which revenue is allocated to a state where the predominant cost is incurred to produce the revenue. Market-based sourcing allows sellers to allocate sales based on market information where customers are located and, in the case of services or software sales, where the services are used. Businesses should be careful not to rely on income tax guidelines for the source of income for sales tax purposes.
The guidelines for sourcing sales are complicated and can not only vary from state to state, but also within a state depending on the nature of the sale. Here are some simple planning recommendations:
- Make an inventory of product and service locations, including those sold through a marketplace facilitator.
- Use software to assist in the mapping process. The rules are so diverse and detailed that businesses large and small must rely on third-party software solutions to comply with various state and local requirements. There are many software vendors, all with different applications, benefits, and cost considerations. No software solution is right for every business.
- Seek advice from an independent professional. Even for the most sophisticated business, the nuances of determining how to properly charge sales tax based on the location of the seller, delivery, or use of the product or service require careful analysis. And if the goods or services are not properly mapped, the potential underpayment of tax in the event of an audit can be significant, with no guarantee that the jurisdiction(s) to which the tax was paid will refund the overpayment.
- Periodically test the sourcing decision and mapping process. Once a business has subscribed to a third-party software solution, business-specific data typically must be carefully mapped and entered so that the correct tax can be calculated and directed to the correct state(s) and locality. Businesses would be well advised to periodically run sample data files to ensure transactions are properly characterized in the software.
There is no doubt that the source of revenue for state and local tax purposes is exceptionally confusing, and companies that offer products or services that have digital content or are accessible remotely are particularly susceptible to both overpayment and tax underpayment. There are many options and requirements to consider when properly implementing sourcing and taxation decisions. As such, they should seek professional advice based on the organization’s specific facts and circumstances.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Robert Peters is managing director of Kroll’s Chicago office.
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