Most sales tax laws were written 40 or more years ago and have since struggled to keep up with changing technologies. Nowhere is this more pronounced than with computer software. The current proliferation of software as a service (“SaaS”) has the states scrambling to determine the sales tax treatment of these products. To be expected, the conclusions vary greatly among the states and businesses face a difficult task of managing their tax liability.

At the heart of the issue is the question of whether SaaS constitutes a lease of prewritten software, generally a taxable transaction, or the provision of a service, exempt from tax in most states. To make this determination states will look at the written contract for the product, how the user interacts with the software and the level of personal services provided by the seller. Courts have developed a “true object of the transaction” test to consider what motivates the buyer in the transaction.

The tax treatment is further complicated by legal questions regarding remote access to software that is not downloaded on the user’s server. Generally there must be a transfer of property for sales tax to apply, which raises the question of whether remote access is a type of deemed transfer.

Sellers of SaaS must do a careful review of the sales tax laws and rulings in all states where they have nexus. Failure to collect tax on transactions the state determines on audit should have been taxed can result in a large obligation for the seller, with limited possibility to recover the tax from their customers. In effect, the sales tax burden will be shifted from the consumer who purchased the SaaS service to the business which provided the product. Users of SaaS need to be aware of their potential obligation to self-assess use tax on these purchases. Software development companies which provide SaaS may only have nexus in a limited number of states and therefore not be required to collect sales tax. Recently we’ve seen the states, in particular the Massachusetts Department of Revenue, take a very close look at software related expenses during sales and use tax audits.

Questions about your sales and use tax obligations related to SaaS transactions? Contact Norman LeBlanc or any member of our State and Local Tax Services Group.