Is software-as-a-service “software”? Or a “service”?

Think carefully. Your tax bill may change depending on how you answer.

Increasingly software is being sold as a service (SaaS), where you run or download the software from the cloud, instead of installing it on your computer. There are a number of advantages to this method, ranging from being able to categorize the purchase as an operational expenditure rather than a capital expenditure, to requiring less staff time to get the software up and running.

You know all that. So who cares? Why does it matter?

It matters because some states tax products – such as, computer software in a box. Some states tax services. Some states tax both. And some states tax neither.

While the sales tax is typically collected and paid by the software/service vendor, in practice, the costs will get passed down to the end user. So, switching from one delivery mechanism to another can save — or cost — you money, if your state taxes one type of software and not the other. The sales taxes can add up to hundreds of thousands of dollars, including penalties and interest.

Your tax liability also depends on what’s considered the “nexus” of your operation, or in what state it’s located. Is it your company headquarters? Any remote office? The vendor’s company headquarters? The Internet provider’s location?

If the state suspects that things aren’t quite right, it can audit the vendor going back for yearsincluding auditing the vendor’s customers, writes accounting firm Grant Thornton. That means you.

All this is exacerbated by the fact that people throw the term “cloud computing” around like candy these days, and even different types of cloud computing may or may not be subject to tax, writes KPMG in the Journal of Taxation (in a 60-page article with more than 140 citations – this is complicated stuff).

To make it even more fun, some states are just plain wrong. Idaho, for example, taxes products (even Girl Scout cookies), but not services. Yet SaaS is taxed anyway, because the law is that software is considered a tangible product regardless of how it’s delivered. In fairness, the state legislature is in the process of fixing this, after it was called to its attention. However, because some in the legislature are clamping down on the ballooning numbers of sales tax exemptions, the SaaS change might get swept up in that, even though it’s not an exemption per se.

To add to the confusion, some states that didn’t charge tax on services in the past are considering doing so now, in an attempt to raise more revenue. For example, Arizona, Indiana, New York, Texas and Washington have adopted various approaches to apply sales tax to cloud services, writes the Wall Street Journal.

What that means is, even if your state doesn’t tax SaaS now, it might do so in the future. “While many states struggle with declining revenue, the overall trend continues to move toward expansion of the tax base,” writes Grant Thornton. “States seem eager to tax more services, and SaaS may be a welcome target. While most states do generally exempt services, many of those same states enumerate certain services as taxable.”

Organizations such as the National Conference of State Legislatures — which held a summit on the concept last August — are also studying the issue, hoping to help states come up with a standard method of taxing such services, if they choose to do so.

The upshot? When you’re calculating the TCO (or ROI) of SaaS, be sure to consider the tax implications as well. 

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