A Tale of Two Taxes: Expected Sales and Use Tax Challenges and Solutions in the New Year

Charles Dickens said it best in “A Tale of Two Cities:” “It was the best of times, it was the worst of times.” Who would ever imagine that a quote from a novel, written over 150 years ago, would apply to today’s business environment? Most have grown tired of the overused phrase “unprecedented times,” but few could argue that the challenges faced by businesses today are indeed unparalleled when compared to prior years.

On the one hand, businesses are experiencing explosive growth and the pandemic has accelerated the pace at which new goods and services are brought to market. This growth is largely due to individual/business reliance on the digital marketplace to connect customers with much-needed products, solutions and services. However, all that pent-up demand has caused significant worldwide supply chain backlogs, labor shortages and inflation which is not likely to change in the coming year.

For financial and tax officers in the U.S. and elsewhere, there are a myriad of pressing issues requiring their attention during 2022:

• Impact of legislation/regulation
• Keeping pace with technological changes
• Resource limitations (staffing and budgets), and
• Integrating tax solutions with business strategy

Sales Tax Considerations

All the above issues have implications for those charged in managing the sales/use tax function of an organization, regardless of size. Historically, sales/use tax compliance was considered largely a compliance ministerial function. In today’s world, however, the Supreme Court decision in South Dakota v. Wayfair, Inc.¹  combined with the increased reliance on the digital sale of mixed goods/services has placed sales/use tax squarely at the forefront of major business considerations. Due to the Wayfair decision, virtually all companies are now required to comply with the diversified sales/use tax requirements across 45 states; Washington, D.C.; and over 3,000 local jurisdictions that impose a sales tax. Further complicating matters include the divergent set of rules across each of these states on which goods/services are subject to tax. As a result, companies should address marketing and even billing of these goods/services to ensure correct and consistent compliance.

As we enter the new year, we would like to share some of the key post-Wayfair and post-pandemic takeaways that address the question of what businesses can do to ensure compliance with the often complex and cumbersome sales/use tax requirements. It is equally important to ask how best to manage the sales tax function in a cost-effective manner that compliments the organization’s overall business strategy.

Key Takeaways for the New Year

• Understanding the different taxability of goods/services
• Impact of bundling goods/services
• Understanding the need for data and how best to capture (sourcing of sales)
• Consistency and coordination among marketing, IT, AP, logistics and tax
• Use tax is an important consideration
• Importance of using technology to reduce manual processes and ensure consistent results
• Planning considerations

Understanding the Different Taxability of Goods/Services

The overwhelming majority of states have sales tax provisions that were enacted long before the Internet and web-based product/service offerings came into existence. As such, sales tax generally is imposed on the sale or use of “tangible personal property” and certain “enumerated services.”  Hence, only specific named services are taxable, whereas those not specified are not taxable.²  To apply dated statutes to the modern economy, many states have broadly interpreted the phrase “use of tangible personal property,” or have attempted to fit certain services which are delivered through the Internet as  taxable information or data processing services.

The million dollar question: Is software as a service (SaaS) a service, or tangible personal property?  The answer? It all depends on the state. For instance, New York’s definition of tangible personal property, states that prewritten computer software “regardless of the medium by means of which such software is conveyed to the purchaser,”³  including the use of the software remotely is taxable. Therefore, New York considers SaaS tangible personal property. Other  states, such as California, consider SaaS as a service and exempt it from tax. States’ different definitions and tax treatment for the same product not only creates confusion among  seasoned tax experts but also for multi-state sellers. The key to minimizing time and effort spent on sales tax compliance is understanding each state’s definition and taxation of digital goods and services. Specifically, is the offering considered:

• Tangible personal property
• Enumerated services, and
• Software related services⁴

Impact of Bundling Goods/Services

During these challenging times, many organizations have strived to simplify how products/services are delivered and invoiced to their customers. Doing so often increases both revenues and profit margins. However, simplification is not always the best approach when it comes to sales tax. Take, for example, bundling taxable and non-taxable products or services on an invoice. While this approach may save the business time and effort (and hide the cost of lower-priced goods), it can also have a negative impact on the sales/use tax treatment. Nearly 60% of states will not tax a bundled transaction if the taxable products or services make up a de minimis part of the total charge. However, the threshold is very low. These states define de minimis as 10% or less. Businesses must be careful to not bundle taxable products or services more than the 10% since doing so will subject the entire charge to sales tax. 
In contrast, states not applying the de minimis rule will generally look to the “true object” of the transaction to determine taxability. This essentially removes the appearance of a bundled transaction. For example, picture a company that provides both security monitoring services and hardware bundled on a single invoice. If the “true object” of the transaction is the security monitoring services, then the entire transaction is deemed to be non-taxable regardless of the cost of the monitoring equipment. It is important to know and understand the rules in states in which you sell bundled taxable and non-taxable products or services.

Understanding the Need for Data and How Best to Capture (Sourcing of Sales)

Because organizations are now being required to register, collect and/or remit tax in more jurisdictions compared to prior years, their compliance burden has increased dramatically. It is virtually impossible with all the different rules, requirements, and taxability determinations for companies to manage the compliance process without technology solutions. Companies are rightfully turning to software providers to assist in that regard. However, before doing so there are some critical first steps. After having conducted an initial nexus study, the next step is to conduct a comprehensive taxability review. This is to determine which products/services are taxed and how these are taxed across the states. We have already addressed how bundling transactions can impact the taxability determination, but other factors also weigh into the mix. For example, many states tax intrastate sales differently than interstate sales.⁵  While some states do not impose a tax on certain types of transactions (including software and SaaS), some local jurisdictions do have separate rules, such as Denver and Chicago.⁶  Based on the different taxing schemes, it is crucial that companies capture the correct information from their customers so the correct sales tax can be computed on every transaction. Merely collecting the billing address or shipped-to location is not sufficient. Companies will also have to track where a specific product is shipped from, and when many companies consolidate goods in various distribution centers across the country, tracking this information may prove challenging. So, while the logistics department may be carefully keeping records of this information, it is equally important that the same data is visible and mapped to the sales tax engine which is computing tax on each sale.

One might ask, “Why does it matter if the correct location is not tracked?” In such cases either too little, too much, or no tax may be collected from the buyer. In these instances, companies processing hundreds, or even thousands, of monthly transactions could expose the organization (not its customers) to risk and additional tax in the event of an audit. Equally troubling is that if the organization over collects tax then they are exposed to possible class action lawsuits. This could result in having to refund the additional tax to customers, as well as bad publicity should the overcharge become public.

Another common issue is that while the tax or financial personnel may be charged with determining the taxability of a good/service, how these products/services are marketed to customers via social media or the company’s website can influence the sales taxability. Marketing personnel frequently promote how services/solutions are made more accessible via the company’s hosted website or portal, even if the digital delivery is not the “true object” of the service/solution. In some states, the manner in which these products are marketed and delivered has caused a change from non-taxable to taxable transactions.⁷

Consistency and Coordination Among Marketing, IT, AP, Logistics and Tax

All of the above are reasons why sales/use tax has moved up in the priority chain as an important function in recent years. And as more organizations upgrade their ERP systems, expand their service/product offerings and/or consolidate their supply chain to improve time to market, the complications surrounding sales/use tax are unlikely to diminish. As such, it is critical that tax department personnel are aligned with other functional groups including logistics, marketing, accounts payable and treasury.

Use Tax, Is an Important Consideration

Historically, companies were only required to collect tax in states where they had a physical presence (e.g., employees, property, inventory, or where substantial services were performed). The Wayfair decision has dramatically leveled the playing field between brick and mortar and online retailers through economic nexus. However, there are still situations in which an online retailer selling tangible property is not required to charge sales tax. Thus, the burden of tax payment is transferred to the customer through use tax.

For example, most states have set monetary and/or transactional threshold nexus standards. Online retailers that do not exceed these thresholds in each state are not required to charge sales tax, therefore creating a use tax compliance on the purchaser. Additionally, smaller online retailers either may not have the knowledge or adequate staffing to ensure economic nexus compliance, again transferring the tax burden to the end-user. Lastly, since it is not cost effective for states to audit individuals’ adherence to the sales tax rules, businesses bear the burden of use tax compliance.

Additionally, in today’s digital age it is not uncommon for multiple-user software purchases to be sourced to a single location, thus making the entire transaction either fully taxable or non-taxable based on the ship-to location. For businesses with users situated across the United States and even around the world, understanding specifically where the users of the software are located is essential to limiting tax exposure. For example, since California does not tax software sales, any software license sourced to California will not include tax. However, this can be problematic if the user is in a state that taxes software, such as New York. To limit this exposure, purchasers should allocate the software costs to the user’s locations and self-assess and remit use tax to software taxable states.

It is imperative for businesses to understand these sales tax pitfalls and to have an adequate system in place to self-assess and remit use tax. However, use tax for many organizations is a major cost and time-intensive process and most do not have the employee bandwidth to scrutinize each transaction. For this reason, organizations should research how tax automation can create efficiencies in the use tax process. The benefits to tax automation include real-time integration with ERP system(s), batch/offline integration solutions, use of data analytics, artificial intelligence, and robotic processes.

Importance of Using Technology to Reduce Manual Processes and Ensure Consistent Results

Multiple studies conducted over the past year have demonstrated what most tax and financial executives already have come to realize for some time: to keep pace with the regulatory and increased compliance burden, many processes that were historically performed manually need to now be streamlined using technology-based solutions.⁸  Doing so will not only free up personnel to address more strategic initiatives but also the use of technology provides added assurance that the information gathered, tracked and reported will be more uniform, consistent and easier to access and modify as needed. However, there are many options for companies to move from manual to technological solutions, each with its own benefits, significant risks, and a wide range of costs and time to implement. Among the options are the following:

• Solutions that bolt on to an organization’s existing ERP system(s)
• Offline tools that enable an organization to gather, batch and process large volumes of data in a replicable format without having to directly interface with the existing ERP system(s)
• Outsourcing some or all the compliance processes to a third party
• Use of robotics or artificial intelligence to gather, populate, and format replicable data, including the performance of necessary calculations to compute and report tax
• Some combination of all the above

Planning Considerations

While the issues and pace of change are not likely to diminish over the coming year, how companies react can change.  As organizations attempt to prioritize initiatives for the new year, here are some simple suggestions:

• Review products/service offerings, including contracts, invoicing, and marketing representations (website)
• Consider tax and business implications of bundled versus separately stated software and service agreements (as noted above)
• Secure exemptions or direct pay permits to reduce sales tax liabilities
• Implement policies/procedures to track and determine use tax obligations on purchased software and business license agreements, including usage data
• When in doubt, consider applying for advance determinations (e.g., private letter ruling, voluntary disclosure agreement or solicit a formal opinion from a state). Securing advance guidance from the state serves two purposes: First, it eliminates the risk of additional tax, penalties, and interest. Oftentimes, advance rulings can be secured on an anonymous basis, eliminating the risk of an audit in the event the ruling is adverse. Second (and more important than the first), the advance ruling can be used as documentation to support taxability determinations if questions/conflicts arise from customers.

Summary

Although many are familiar with Dickens’ opening in “A Tale of Two Cities,” his second line, which is equally applicable to our current times, isn’t as widely known:

“It was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.”

While Dickens does tend to put a negative spin on the times, few can argue that organizations have made phenomenal strides to expand their business and to seamlessly connect customers and suppliers. Sales/use tax has become a major consideration for businesses, and if not handled properly, the company can suffer increased financial risk. In addition, the customer experience may also be diminished. The goal, therefore, is to streamline the process so vendors/customers are not adversely impacted. while at the same time improving the organization’s efficiency and accuracy.

Sources
¹138 S. Ct. 2080 (2018)
²As examples,  information services are taxable in a number of jurisdictions including CT, DC, HI, NM, NY, OH, PA, TX and WV, but exempt in most other jurisdictions.
³N.Y. Tax Law § 1101(b)(6)
⁴The states are evenly split on the taxation of digital products delivered via the internet. For example, digital products are taxable in several major states including Michigan, Pennsylvania, New York, Texas, and Washington regardless of method of delivery.  In contrast, California, Colorado, Georgia, Florida and New Jersey, do not tax products that are transferred to a customer over the internet.  
⁵11 states have specific rules which tax intrastate sales differently than interstate sales , AZ, CA, IL, MS, MO, OH, PA, TN, TX UT VA
⁶Although Colorado and Illinois do not tax software. Both the city of Denver and Chicago via its “home rule” authorizations impose sales tax on certain digital transactions based on those users accessing the digital information within city limits, regardless of from where the digital information or content originates. Both also have separate economic nexus guidelines
⁷Maryland passed legislation in 2021 that significantly expanded the taxation of all digital downloads, electric publications, sound & video content and any subscription or license to access content online or via use of an app. Other states have held similarly including Rhode Island Rul. Req. 2020-03 (12/29/2020), Texas (Dec. No. 114,952 (9/5/2019) and Massachusetts (J2 Cloud Services, Inc. v. Comm’r Docket No. c235426). To the contrary, the NYS Appeals court recently struck down an attempt by the Dept of Revenue to tax otherwise exempt services and information delivered though web portals (See NY-1 Life Healthcare ALJ #829434 (11/10/21))
⁸See “2021 Indirect Tax Report: Elevating tax teams to strategic advisors” Thomson-Reuters https://tax.thomsonreuters.com/en/corporation-solutions/c/indirect-tax-report; KPMG Chief Tax Officer Outlook, Dec. 2021;OECD(2020), “Tax Administration 3.0: The Digital Transformation of Tax Administration”, OPEDC, Paris www.oecd.org/tax/forun-on-tax-administration/publications-and-products/tax-administration-3-0-the-digital-transformation-of-tax-administration.htm