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How Software as a Service Is Taxed

Jul 17, 2020

Over the past few decades, computers and computer software have evolved tremendously. Our society has gone from using floppy discs to CDs to downloadable programs and, most recently, to cloud computing—also known as Software as a Service (“SaaS”). Due to the evolution of software, the sales tax treatment of these items has evolved as well.  

Tangible Personal Property

In the past, software was purchased on floppy disks, CDs and other forms of tangible medium, and were often purchased “off the shelf.” This type of software is made for everyday use and is rarely changed from its original format. An example is an off-the-shelf computer game or email program. In just about every state, the purchase of floppy disks, CDs and other tangible media containing software were subject to sales tax.

Downloaded Software

Electronically downloaded software was the next step in software evolution and a pivotal moment for sales tax regulations. Sales tax had commonly been charged on tangible personal property. Canned software, by most state standards, was considered taxable. Lawmakers were presented with the question of whether removing the tangible component to otherwise the same software would change its taxability.

Not surprisingly, the answer varies by state. While most states will say that the software is still subject to sales tax, New Jersey has an exemption for sales of electronically delivered software used exclusively and directly in conduct of a purchaser’s business, trade or occupation[1].

Cloud Computing

The latest software innovation is cloud computing, essentially accessing software remotely (SaaS) via the internet where users access a program over the internet under a limited use license.

SaaS differs from a traditional sale or license agreement for the use of software. Under SaaS, the purchaser does not typically download or install any software on their computer or device, and there is no transfer of tangible personal property. Instead, use of the software is accomplished by accessing it over the internet. 

Usually, the SaaS provider hosts the software on its own server that may be located in a different state from where the purchaser or user is located. Under this arrangement, the purchaser may have access to the software on a limited basis, such as on a per-use payment basis, cost-per-hour of use, or an arrangement where the software can only be accessed for a limited time.

Previously, one would buy canned software on a tangible disc and then install that program to a computer’s hard drive. With downloaded software, one would download software straight from a website and then store it on their computer. With cloud computing, one can purchase software without downloading it to their computer and, instead, access the program through any internet connection. A company can purchase multiple licenses and have their employees in offices all over the world access the software.

In addition to determining whether SaaS is a taxable transaction, states also have to determine to which state the sales are sourced. Should the sale be sourced:

  • To the state the seller is located?
  • To the state where the seller’s server is located?
  • To the state where the purchaser is located?
  • To the state where the user is located?

Service or Software?

What further complicates the matter is that some states look at cloud computing as a service, not a sale of tangible property. Other states look at the underlying transaction itself and whether the buyer is buying a service. Those states look at the type of service provided and determine whether a service was provided or access to software was provided. The states that say that a service is provided will then look at the type of service provided to make the determination if sales tax is due.

For example, New Jersey imposes sales tax on information services[2]. Therefore, if a New Jersey company charges a monthly license fee to access stock quotes via a platform, the service could be subject to sales tax as an information service or possibly a software license.

California, on the other hand, does not tax SaaS[3] or information services[4] and the same transaction will likely not be subject to sales tax in California.

For Example

Company A has offices in California, New Jersey and New York, and enters into an agreement to license cloud-based software. In California, the license would not be subject to sales tax, while in New York it would be. In New Jersey, the license would likely also not be subject to sales tax, unless it could be taxed as, say, an information service. 

The evolution of software has provided us with various state laws, particularly when it comes to cloud-based offerings. Each state tackles the taxability of software services differently, so it’s important to be aware of the rules in the states in which you conduct business.

In addition to the intricacies set forth above, the same SaaS purchase can be taxable at the full rate in one state (e.g., Massachusetts[5]), tax exempt in another state (e.g., New Jersey[6]), and taxable with a partial exemption in another state (e.g., Texas[7]).

Companies that deal with cloud-based software, as either vendors or purchasers, must stay abreast of the varying approaches used by states in order to determine the proper treatment of their own transactions. Risks of falling behind regarding this evolving area include overpaying tax or risking large assessments down the line.

[1] N.J. Rev. Stat. § 54:32B-8.56

[2] N.J. Rev. Stat. § 54:32B-3(b)(12)

[3] Cal. Code Regs. 1502(f)(1)(D)

[4] Cal. Code Regs. 1502(c)(3)

[5] 830 CMR 64H.1.3(3)a

[6] New Jersey TB-72 (Cloud Computing) – July 3, 2013

[7] Tex. Tax Code Ann. § 151.351

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