The emergence and rapid growth of cloud-based software solutions have brought with them a fog of uncertainty over the taxability and sourcing of these offerings. Cloud-based software, commonly known as software-as-a-service (SaaS) or remotely accessed software, is a software delivery model in which software is hosted on the vendor's servers and accessed, without electronic delivery or download, by customers over the internet. The taxability of SaaS continues to evolve as states address the issue through interpretive guidance, litigation, and legislation.
At this point, a majority of states have indicated whether they consider SaaS taxable. In many of these states, tax departments have weighed in on the issue through interpretive guidance that applies existing laws that impose tax on the sale or rental of tangible personal property or data processing to SaaS transactions. In more limited cases, the issue of taxability has been litigated and addressed by courts. This past year, the Michigan Court of Appeals published an opinion finding that various SaaS offerings were not subject to Michigan's sales tax. Only a few states have adopted statutes specifically addressing SaaS transactions. This past year, Tennessee and Vermont became two such states, perhaps indicating a new trend. This item discusses the recent legislative and judicial developments from Tennessee, Vermont, and Michigan.
Tennessee adopted legislation, effective July 1, 2015, imposing tax on remotely hosted software, making Tennessee one of only a few states to statutorily address the issue (Revenue Modernization Act, H.B. 644). Tennessee has taxed sales of computer software since 1977, periodically amending the law to address new methods by which customers are provided access to the software (e.g., electronic delivery and loaded or programmed into a computer). Prior to the recent legislation, the Tennessee Department of Revenue (DOR) had taken the position that remotely accessed software was not subject to tax unless the server on which the software resided was in Tennessee. In the preface to the new legislation, the Legislature stated its view that the statute taxing computer software was once again outdated and needed to be amended to keep up with modern business practices.
The new legislation imposes sales and use tax on the access and use of software that remains in the possession of the dealer if the customer accesses the software from a location in Tennessee. The location is based on a customer's residential or primary business address. If the software will be accessed from both within and outside Tennessee, then a portion of the purchase price may be allocated to the state based on the percentage of users in Tennessee (Tenn. Code §67-6-231).
Based on guidance issued by the DOR subsequent to adoption of the statute (Notice 15-14, "Remotely Accessed Software" (June 2015, rev. Dec. 2015)), allocation may be handled in one of two ways. If the purchaser is not registered for Tennessee sales and use tax purposes, then it may use a streamlined sales and use tax agreement (SSUTA) exemption certificate to claim an exemption for the portion of the price that corresponds to the percentage of users located outside Tennessee. The vendor must still charge sales tax on the portion of the price that corresponds to the percentage of users located inside the state. If the purchaser is registered with the DOR, the DOR may provide the seller with a direct pay permit, which allows the purchaser to purchase the software without paying tax to the vendor. The purchaser then must pay tax directly to the DOR on the portion of the price that corresponds to the proportion of users located in Tennessee.
Since the statute was enacted, the DOR has issued a number of rulings that respond to requests submitted by taxpayers addressing the use of exemption certificates, direct pay permits, and the taxability of various software offerings, among other issues. In one ruling, the DOR clarified that software purchased and then hosted by the taxpayer on its own servers outside Tennessee is not subject to sales tax when accessed remotely by employees in Tennessee. In this case, the sale of software has already occurred outside the state, and the taxpayer's subsequent access to the internally hosted software is not a sale or lease subject to Tennessee sales or use tax.
Similar to Tennessee, Vermont recently passed legislation aimed at resolving the ambiguity regarding taxation of remotely accessed software (Act 51 (2015), §G.8). In contrast to Tennessee, Vermont's legislation specifically exempts remotely accessed software from the sales and use tax. The law went into effect the same day as Tennessee's—July 1, 2015.
The legislation ended several years of ambiguity regarding whether remotely accessed software was subject to taxation. Vermont has defined tangible personal property to include prewritten computer software since 2003. In 2010, with the emergence of cloud computing, the Vermont Department of Taxes (DOT) issued a technical bulletin interpreting the law as imposing tax on prewritten software regardless of how it is accessed, including software hosted on a remote server and accessed via the internet. In 2012, the Vermont Legislature passed a temporary moratorium prohibiting the DOT from assessing tax on charges for remotely accessed software made before July 1, 2013. This same law created a committee to study potential changes to Vermont's sales and use tax in light of the changing economy; the committee was specifically tasked with considering the taxation of remotely accessed software.
In June 2013, as the moratorium on taxation was set to expire, the DOT issued a fact sheet about remotely accessed software. Avoiding an all-or-nothing approach, the DOT outlined considerations for whether a remotely accessed software transaction may be subject to taxation. The guidance lapsed one year later. As the guidance expired, the DOT circulated draft regulations for comment, which largely described examples of transactions that were outside the scope of the sales tax. Instead of finalizing the regulations, the DOT pushed for the legislation passed last year completely exempting remotely accessed software from taxation.
The taxability of remotely accessed software was also addressed in Michigan this past year. However, unlike in Tennessee and Vermont, the judiciary, not the Legislature, addressed it. Since the emergence of remotely accessed software, the Michigan Department of Treasury (DOT) consistently maintained that remotely accessed software was taxable prewritten computer software. By statute, prewritten computer software "delivered by any means" is subject to sales and use tax. The department maintained that software accessed remotely is, in effect, "delivered."
However, during the last few years, several nonprecedential decisions by the Michigan courts have held otherwise (e.g., GXS Inc. v. Department of Treasury, No. 13-000181-MT (Mich. Ct. Cl. 3/23/15); Rehmann Robson & Co. v. Department of Treasury, No. 12-000098-MT (Mich. Ct. Cl.11/26/14)). Despite these initial decisions, the DOT maintained its position that remotely accessed software was taxable because none of the decisions were binding on it (except for the taxpayers and tax years at issue). Legislation was introduced in the Michigan Legislature in 2013 and 2015 to specifically exclude remotely accessed software from taxation, but it ultimately went nowhere. It was not until October 2015, when the Michigan Court of Appeals handed down its first published decision on the issue, Auto-Owners Insurance Co. v. Department of Treasury, No. 321505 (Mich. Ct. App. 10/27/15), that the DOT changed its position.
In Auto-Owners, the court considered a variety of cloud-computing transactions, holding that none were taxable. The taxpayer at issue, a property and casualty insurance provider, contracted with numerous third parties to purchase remote access to their computer networks, servers, data storage, and software applications. The court held that a majority of the transactions did not involve the "delivery" of software. The court concluded that "delivery" includes electronic delivery but not the mere transfer of data processed using the software of third-party businesses. For certain transactions, in which small amounts of software were transferred electronically, the court applied the six-factor "incidental to service test" developed under Michigan case law and held that, in each instance, the software was incidental to the rendering of services. After Auto-Ownerswas handed down, the DOT issued an official notice announcing that the decision will apply to all open tax years and repudiating all guidance to the contrary.
Despite the clarity achieved last year in Michigan, Vermont, and Tennessee, many jurisdictions still lack significant guidance on the taxability and proper sourcing of SaaS transactions. The Michigan Court of Appeals decision in Auto-Owners serves as a reminder that even states that unequivocally assert tax on SaaS transactions by interpreting existing taxation of tangible personal property as applying to remotely accessed software are subject to challenge. The action taken in two states this past year to resolve ambiguity through legislation is encouraging. Perhaps 2016 will bring further legislative (or even judicial) clarity to this murky area.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
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