Software, software services, and digital goods
Originally published January 2023
Updated May 2023
No industry appears better poised to take advantage of digital transformation and automation than software and technology.
Companies of all sizes are embracing digital business initiatives in response to an uncertain economy and persistent shortage of skilled workers. Though Gartner lowered its overall growth projection for worldwide IT spending in 2023 from 5.1% to 2.4%, it expects software industry IT spending to grow by 9.3%. By contrast, IT spending related to hardware sales (devices) is projected to contract by 5.1% in 2023.
Cloud computing services in particular continue to experience strong growth: Estimated at $545.8 billion in 2022, the global cloud computing market is on track to exceed $1,240.9 billion by 2027. Chief information officers generally agree that “cloud is an imperative for innovation,” according to an IDC CIO Quick poll, but companies are embracing cloud technology at different paces. Those working under tight budgets may focus on monitoring and optimizing investments in cloud technologies. Others are taking a more holistic approach and reinventing their business through cloud.
The appeal of automation and as-a-service software is clear: Automation technologies allow businesses to streamline processes and do more without adding headcount. Thus, fields from accounting to law are increasingly discovering how these tools can be used to scale growth, as are government agencies. IDC predicts global digital transformation (DX) spending to reach $3.4 trillion in 2026, with the manufacturing, professional services/retail, and securities/investment services industries leading the growth.
But as the global market for software and software services expands, so do new and evermore complex tax compliance obligations: Just look at how much time your finance and accounting departments devote to tax compliance.
What the numbers tell us
SOURCE: Survey conducted by Avalara and Potentiate
SOURCE: Survey conducted by Avalara and Potentiate
As technology becomes more ubiquitous, so does tax pain
Software and software services have become virtually indispensable to all but the most determined technophobes. Day after day, businesses across all industries rely on software solutions to keep employees connected and accomplish a wide range of essential tasks. Those that didn’t do so before the pandemic, including many government tax departments, probably do now.
Business models such as infrastructure as a service (IaaS), platform as a service (PaaS), and software as a service (SaaS) can greatly streamline workflows and processes, especially in the age of remote work. And with the uncertain economic outlook, tools that allow us to do more with fewer resources are critical. Thus, as of this writing, worldwide software revenue is expected to rise at an annual growth rate of 5.4% between 2023 and 2028, and reach a market volume of $858.1 billion by 2028.
Yet IaaS, PaaS, and SaaS products and services can also complicate sales and use tax compliance for the businesses that buy, sell, and use them.
“... with the uncertain economic outlook, tools that allow us to do more with fewer resources are critical.”
How do I tax thee, software? Let me count the ways.
States tend to put software and software services into broad categories: Canned (ready-made) software may be treated one way for tax purposes, custom software another. Software sold on its own may be taxed differently than software sold in conjunction with a service. A business must understand these distinctions in order to get sales tax right.
But tax laws have trouble keeping up with technology, so it’s often unclear how new products or services should be treated. States are constantly updating their policies via legislation or regulation and rule changes. It can often be difficult to determine the latest tax policies in a state, much less how they may apply to one company’s unique set of circumstances.
Maryland is still doggedly fighting to enforce its digital advertising tax, which was ruled unconstitutional in October 2022. Meanwhile, New Mexico is looking to clarify that digital advertising is subject to the state’s gross receipts tax, which applies to other forms of advertising. Having witnessed the trouble surrounding Maryland’s digital ad tax, the New Mexico Taxation and Revenue Department wants to ensure taxing digital advertising services won’t impose “an unconstitutional burden on interstate commerce.”
The Mississippi Department of Revenue is interested in taxing sales of cloud computing services, but it’s waiting to act until a task force created under Senate Bill 2831 can weigh in on the matter. The government task force and many businesses are calling for a full sales and use tax exemption for B2B inputs whether the products and services are delivered, downloaded, or remotely accessed in Mississippi. A senior state director at the National Federation of Independent Business believes taxing these sorts of sales would “create a compliance nightmare,” but as Avalara VP of Government Relations Scott Peterson notes, other states have the same tax policy Mississippi is considering.
The Supreme Court of Ohio noted that the taxability of a bundled transaction is determined by “its true object.” That is, sales tax applies to computer-related services “only when the consumer’s true object is to obtain the work performed by computer systems … rather than to obtain personal and professional services that are coupled with the work that is performed by computer services.”
A circuit court in Virginia determined a telecommunications equipment company was entitled to a sales tax refund for sales of software, equipment, and related services to a telecommunications company. Though the Virginia Tax Commissioner insisted the software was taxable, the court found the sales qualified for Virginia’s exemption for electronically delivered software.
A similar situation arose in Mississippi. Although the Mississippi Department of Revenue insisted digital images sold by a wedding photographer were taxable, the Supreme Court of Mississippi determined they were not. According to the state Supreme Court, Mississippi sales tax doesn’t apply to digital photography services or to the copyrights to digital images.
Because of the very nature of software and software services, it’s difficult for businesses in the software industry to determine whether they’re obligated to collect and how much sales tax to charge. And it often takes years for a taxing authority and business to resolve conflicts over tax matters.
Sourcing, economic nexus, and marketplace facilitator laws further complicate sales tax compliance for businesses in the software industry.
Sourcing rules on software are a nightmare
Sales tax rates and rules are usually governed by the location where a tangible good is delivered or a service is received. With digital goods and services, the sale is typically sourced to the location where the goods were first used or services first experienced.
Unfortunately, that location can be hard to determine when what’s sold lives in the cloud and is used by lots of people for lots of purposes in lots of locations.
It’s hard enough for B2C transactions: How does one source an ebook sold to a consumer who lives in Seattle and buys/downloads the ebook while in an airport in Chicago? Does the fact that the ebook is first opened somewhere over Indiana or Ohio matter? Or that the sequel was purchased and downloaded from a hotel in New York?
Now think about a business that buys infrastructure, platforms, or software as a service from their headquarters in Nevada. They have offices in California, Texas, and Massachusetts, and many employees working remotely from many states — when they’re not taking a workcation at various destinations worldwide.
Since a physical address isn’t needed to deliver software products and services, many software companies may only collect a customer’s billing address or just their ZIP code. But that might not be the location where the purchased digital goods were first used, or where possession was transferred from the seller to the buyer.
And it’s not entirely clear that the place of first use or possession suffices, from a sales tax perspective. If 50 employees based in State X regularly use IaaS, PaaS, or SaaS, State X may want to tax the monthly fees even if the first use was from the CTO’s home office in State Y. Scott Peterson says this common practice illustrates why states typically don’t rely on first use to source software sales.
You can’t overlook economic nexus and marketplace facilitator laws
Sourcing aside, you can’t talk about sales tax without mentioning economic nexus and marketplace facilitator laws.
Economic nexus laws base a sales tax obligation on a remote seller’s economic activity in a state (e.g., $100,000 in sales or 200 transactions in a state in the previous calendar year). Marketplace facilitator laws require marketplace facilitators to collect, remit, and report sales tax on behalf of their third-party sellers. Together, these laws help determine who’s required to register then collect and remit sales tax in the states where they make sales.
Every state with a general sales tax has an economic nexus law and a marketplace facilitator law. Every state’s economic nexus threshold is unique. If you sold the same amount of goods and services to the same type of customers in four different states, you might need to collect sales tax in State A immediately, in State B in six months, in State C in 10 months, and in State D, never.
It’s common for software companies to have customers in many states, so those companies that don’t already have nexus in a state through physical presence may quickly develop economic nexus. Those that function as a marketplace may need to register as a marketplace and comply with all applicable sales and use tax laws. And those that sell their own goods and services through marketplaces may benefit from such laws, though they may need to comply with certain registration and reporting requirements in some states.
Something to keep in mind: Economic nexus can be established by making 200 transactions in a state in a calendar year. A state may consider an annual subscription that’s billed monthly to be 12 separate transactions, so it may not take long to hit that 200 transactions threshold.
If there’s nothing holding you back from going global …
… don’t let tax stand in your way.
Businesses selling digital goods and services may never find their shipments held up at customs, as can happen with their more concrete counterparts. That doesn’t mean international tax compliance is always smooth sailing for them.
One of the biggest challenges for global digital services providers is determining where it’s necessary to register for value-added tax (VAT), goods and services tax (GST), or sales tax. More than 100 jurisdictions worldwide impose tax obligations on nonresident vendors of digital services and products (aka, a digital tax or digital services tax).
For example: Belarus taxes database access, domain name provision and hosting, and internet advertising services. Canada taxes cross-border sales of certain digital products or services at the federal level and, in some provinces, at the local level. Colombia is looking to implement a tax on digital subscriptions, online education/training, and a variety of other services provided through digital means.
Software companies can develop tax obligations in countries where their products and services are used, even if the subscription contract was first established in the U.S. Registration is typically the first step after establishing a tax obligation. In some countries, registering as a foreign business is a fairly straightforward process. In other countries, registration can be quite complicated, especially for businesses with no local representation.
Furthermore, while some jurisdictions provide an exception for businesses whose sales are under a certain threshold, in a growing number of countries, nonresident sellers are required to register from the first sale.
As in the U.S., the classification of digital services and the associated VAT/GST rates and rules vary and change frequently. In addition, the rules governing B2B transactions differ from the rules governing B2C transactions, raising the question of what counts as a business. Finally, many countries have implemented rigorous invoicing standards, including electronic invoicing mandates.
Other issues likely to affect the software industry in 2023
Real-time compliance requirements will continue to spread
More and more countries will adopt, amend, or expand electronic invoicing requirements. For example: Italy changed certain e-invoicing requirements as of July 1, 2022, and further changes will take effect January 1, 2024. Spain will mandate B2B invoicing starting in 2024. France is phasing in mandatory B2B e-invoicing and e-reporting beginning July 1, 2024. Software businesses with an international client base need to stay on top of these requirements.
Security will be top of mind
The real and present threat of cybersecurity breaches and deep fakes calls for heightened security measures, yet many industries still lag in this area. Two-thirds of respondents in The CPA Journal’s 2022 Practice Management and Tax Practice Survey said they were more concerned about cybersecurity attacks on CPA firms than in prior years, while only 40% of respondents in a 2022 American Bar Association survey said they employ the most widely used security measure (secure socket layers). Expect to see a greater emphasis on cybersecurity in 2023, from the White House down.
Global tax compliance will become more transparent
The Organisation for Economic Co-operation and Development (OECD) is refining transfer pricing guidelines to address the complex tax issues plaguing multinational enterprises (MNEs) and tax administrations: MNEs are subject to a host of differing tax laws and administrative requirements; taxing authorities must find a way to tax profits originating in their territory while avoiding double taxation.
When done correctly, transfer pricing can lead to perfectly legal tax savings for multinational groups. The OECD’s revised transfer pricing guidelines for MNEs and tax administrations should help thwart base erosion and profit shifting (BEPS), “tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low.”
“Multinationals today live in a more transparent world,” explains Eran Shif, Senior Director of Transfer Pricing at Avalara, noting the amount of data MNEs need to provide to tax authorities, who in turn share it with other tax authorities. He adds that the mass adoption of BEPS strategies is creating more global unified reporting.
The OECD is also targeting tax challenges arising from the digitalization of the economy. Under Pillar Two of a two-pillar solution signed by 138 member jurisdictions — representing more than 90% of the global GDP — multinational enterprises with at least €750 million in consolidated revenues will be subject to a minimum tax of 15% beginning in 2024. Shif says this will lead to fairer global tax allocation among the countries in which multinationals operate.
“Though complex tax planning may decrease under Pillar Two,” says Vicky Basile, Senior Operations Manager of Transfer Pricing at Avalara, “we expect to see a rise in simple, low-risk transaction types that fairly allocate profits among jurisdictions. These types of transactions lend themselves well to automation.”
One requirement of the global minimum tax plan is repeal of the national digital services taxes (DST) some countries impose on select gross revenues of large global digital companies. Digital services taxes are not the same as VAT, GST, or sales tax on digital goods and services.
Businesses and governments will continue to grapple with cryptocurrency and NFTs
Governments worldwide are working to regulate crypto-assets and non-fungible tokens (NFTs), particularly with respect to tax policies. The OECD’s new Crypto-Asset Reporting Framework (CARF), published in October of 2022, strives “to ensure that recent gains in global tax transparency will not be gradually eroded.” In a similar vein, the IRS has detailed the definition and tax consequences of digital assets. The IRS is alert to abuse in this area and in January 2023 announced it was charging an NFT developer with fraud.
Some U.S. states are starting to craft their own state income tax guidance for digital assets, often following the lead of the IRS. However, policies are slow in coming. And, fewer than a dozen states have clarified how sales tax applies to cryptocurrency and NFT transactions. They’ll need to confront the issue eventually: David Lingerfelt, Senior Director of Indirect Tax at Avalara, believes cryptocurrency, NFTs, and sales activity in the metaverse could trigger the next Wayfair moment in state tax policy. Find out more in the sales tax section of this report.
SOURCE: Bloomberg Tax
Tracking trends in the software and digital goods industry will continue to be crucial as governments further define and implement new tax policies. Keep exploring what’s happening in other industries.