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Software Tax

01/25/2016  |  By: Brian McCuller, JD, CPA, Shareholder, Practice Leader Tax

Businesses and individuals are increasingly using cloud-based software. But a change in the Tennessee sales tax law this year means it will no longer be tax-free.

As part of the Tennessee Revenue Modernization Act, state lawmakers made several updates to the tax code to bring it line with changes in commerce. The main changes had to do with requiring out-of-state companies who do business here to pay franchise and excise taxes if they have an “economic nexus” of more than $500,000 in sales or $50,000 in property or payroll here.

But one of the changes will affect many more people and was designed to address the huge growth in cloud-based software. Before the change, you paid sales taxes on software you bought at the store or downloaded on the Internet. But you did not pay taxes if you purchased the software and used it remotely without ever downloading it.

Many people play video games with a subscription to cloud-based software. Another common example is TurboTax Online, where you buy the software, but you only access by using the internet through the TurboTax system.

Regardless of how you get the product, the state now wants sales tax collected on it.

The significant gray area is whether something is a product or a service; this distinction impacts an entire market segment know as Software-as-a-Service, or SaaS. The state’s sales and use tax is generally imposed on the sale of products, not services. Defined as software, SaaS products would be taxed. Defined as a service, not so.

A good example of something that might be in a gray area for business is a cloud model that couples SAAS with business-process outsourcing, such as call center and telemarketing outsourcing.  In this model, the service provider hosts the application and provides service desk personnel as well. Companies have the ability to access the product remotely to manage customer outreach efforts and get information through the program. Is it a service or a product?

The Department of Revenue is expected to publish letter rulings over the next few months on whether specific business activities are considered remote access software or non-taxable services.

Other issues will also likely crop up as businesses and their accountants get a handle on the new law. For example, what if you have a centrally located headquarters in Tennessee, but your facilities throughout the country access the software hosted here?

Two other significant changes in the law:

  • Out-of-state retailers must collect sales and use tax if they pay an in-state party a fee or commission to route customers to their online website (commonly referred to as “Click-Through Nexus”). Tennessee joins 14 other states who already do this.
  • A seller must allocate revenues to Tennessee for franchise and excise taxes if services are delivered to customers in Tennessee, regardless of the seller’s location. This is called “market based sourcing”standard that has been adopted by 20 other states including neighbors Alabama and Georgia.
Software Tax