Avoiding sales tax pitfalls in a recurring revenue business model
Predictable revenue, predictable risk?
Historically the subscription-based business model (the domain of monthly book deliveries and auto clubs), has been around for years. Today, companies from Internet service providers to software vendors to financial services firms are adopting the model and reaping the benefits. Zuora and Recurly are popular examples of recurring revenue management tools.
As more commerce has moved to the web, the subscription-based model has encompassed emerging technology as well. Consumers are subscribing to services that let them buy an assortment of goods and services – including music downloads, e-books, clothing, and even food – on a recurring basis, rather than purchasing the same items on a one-off basis.
For merchants, the advantages of this model include predictable revenue streams, better customer relationship management, and greater revenue capture over time. This model also provides companies with a loyal customer base: the longer customers take advantage of the product or service, the more likely they are to renew their subscription. Understanding the number of active users gives companies an added advantage when rolling out new products or capabilities, or to solicit feedback.
Recurring billing, recurring risk
One component often overlooked is the substantial sales tax compliance risk faced by companies using this model. In many cases, recurring billing translates into a recurring source of sales tax risk. This brief outlines 5 things every company needs to know about avoiding sales tax compliance risk when dealing with recurring billing.
1. Know where sales tax liabilities lie
Ecommerce merchants with warehouses or distribution centers in a state have an obvious obligation (nexus) to collect sales tax on transactions in that state. But when it comes to out-of-state or Internet transactions, especially with digital goods, determining nexus is more complex.
Subscription-based business risks: It seems simple enough. Know where your company has a sales tax liability (nexus). But for companies selling subscriptions in multiple states, the work required to track changing rules, rates, and boundaries is a resource drain most companies cannot afford.
2. Know which sales tax rate to apply to each transaction
Once you know where you have nexus, you must know the exact location in which a transaction is taxable. There are multiple tax rates in each state, rates that can vary from street to street and even from block to block. For ecommerce sales, the sourcing rules of the state in question are a good place to start. ZIP code-based solutions are based on US Postal codes. While they may be adequate for simple tax states, using ZIP codes will result in compliance issues in states where sales tax is more complex.
Subscription-based business risks: For subscription-based businesses, sales tax is determined by where an item is sourced (either based on the customer or the seller) and methods of delivery. While most states are origin-based (sales tax is charged based on the origin of transaction), some are destination-based (sales tax is charged based on where an item is shipped) – and a few states use a combination of rules.
3. Apply the right sales tax holiday to the right product or service
Sales tax holidays are specific days when sales tax is not charged in certain circumstances, giving consumers an opportunity to purchase goods and services tax-free. For example, “Back to School” holidays in some states exempt clothing purchases from sales tax on specific days or below certain dollar amounts. By their very nature, these tax holidays are ad hoc and unpredictable. The holidays vary by type of goods exempted, time of year, and duration—and have no consistency from state to state.
Merchants may understand the inconsistent nature of sales tax holidays, but there’s no guarantee that customers do. This means potentially disappointing customers expecting to get a sales tax break on a purchase based on past experience. Incorrect application of holiday tax breaks can mean over-charging sales tax, leading to additional cost in time and effort to correct the errors and refund the over-collection to your customers.
Subscription-based business risks: Understanding the intricacies of sales tax holidays, especially as they apply to specialized goods such as digital downloads, requires resources and expertise that most companies don’t possess.
4. Sales tax-exempt transactions
Not all customers are required to pay sales tax. Depending on the rules in your taxing jurisdiction, certain businesses and individuals may be exempt from paying sales tax. It is incumbent on the vendor (you!) to collect and keep on file a valid exemption certificate for each business, organization, or individual with an exemption. It is also up to you to ensure that exemption certificates are valid for each sales transaction. This requires your business to keep a copy of each exemption certificate and ensure that they are renewed when they expire. For easier accounting, a database or spreadsheet of exemption certificates should be easily accessible.
The best solutions tie directly into your point-of-sale system, making it simple to verify that exemption certificates are current, valid and on file. Businesses that manage large numbers of exemption certificates often confront a major challenge linking specific certificates with specific transactions in the case of an audit. In other words, to prove that tax was not due on a particular sale. Certificates also expire or may be invalid, potentially leaving the business liable for paying uncollected tax
Subscription-based business risks: Tax-exempt transactions occur based on the tax status of the customer or the taxability of the product in question. Often, subscriptions sold to nonprofits are tax-exempt; however, in these cases, a use tax is still required by most jurisdictions. You can reduce your audit risk by developing a comprehensive and robust method of tracking, filing, and verifying the certificates.
5. Understand product taxability for traditional as well as emerging technologies
Many states are addressing budget gaps by increasing product and service taxability. Your business must determine which items require the collection of sales tax, and capture variations arising from the location of the sale. Historically, most sales of Tangible Personal Property (TPP) have been subject to sales tax. This is shifting to include intangibles such as professional services and installation services. Many states routinely apply sales taxes to services, including specialized training, experience, or project-related staff hours.
When it comes to the taxability of virtual products and services such as e-books, digital music, or streamed movies, the taxability issues are legion. How is a digital good defined? How does the relevant authority tax it? Are there certain cases when it is exempt? How does a one-time purchase differ from a subscription model when it comes to purchasing the item?
States that are members of the Streamlined Sales Tax project (SST) use a somewhat-unified definition of digital goods to include movies, music, books, and other related goods. Whether these are considered taxable depends on the jurisdiction in question.
Subscription-based business risks: Product taxability is always a source of confusion. For ecommerce companies providing virtual goods or services, the bottom line is “hire an expert.” Beyond that, the difficulty can be broken down into problems of definition, imputed definition, or interpretation of vague rules by the states in question.
Next steps to better sales tax management
Savvy companies are looking for methods of streamlining operations, spreading costs more evenly throughout their organization, and implementing an effective recurring billing strategy.
If your organization is developing tools for those in the subscription and recurring billing industry, you should know that even a robust platform can only address sales tax within specific parameters. Within existing platforms, sales tax exists as either an add-on capability or is run as a parallel but distinct set of tasks.
Avalara AvaTax is a cloud-based solution that eliminates the need for an on-premise sales tax server or infrastructure, as well as the need to manage or update hardware, software, or tax data. AvaTax integrates with many recurring billing platforms, helps companies make the best use of limited resources and provides an automated sales tax calculation service that reduces risk in each of the five areas of risk discussed above. Don’t let sales tax errors undercut the revenue advantages of your recurring billing model.
Contact us at: 877-780-4848