The Dilemma: Sales Taxation of Digital Services and Products
Over the past several years, the sales taxation of digital goods and services has become a significant issue for businesses because of the boom of software as a service (SaaS), digital products and the distinct challenges of imposing taxes on non-tangible goods or services. As a result, many states have broadened their tax laws to impose sales tax on goods that were previously sold in a tangible form (e.g., music, books and films) and goods and services with no tangible counterpart (e.g., applications, accessed information services, or software or platform as a service).
Nexus can be established by having employees, an office or other physical presence in a state. Since the landmark South Dakota v. Wayfair case, businesses must comply with the sales tax laws in states where they meet certain economic nexus thresholds. For example, New Jersey enacted a threshold of $100,000 of certain sales or 200 transactions during the current or prior year. Therefore, the burden on businesses to comply with sales taxes has increased dramatically if the business sells in multiple states.
Cloud Computing Complexities
SaaS is taxable for either business or personal use in more than 20 states. In contrast, downloaded prewritten software is taxable in more than 30 states. Many neighboring states view SaaS differently. While New York imposes sales tax on software regardless of how it is delivered or accessed, New Jersey has indicated that SaaS is not an enumerated service and, therefore, not taxable unless it meets the definition of a taxable information service. Other states have enacted exemptions based on business or personal usage. For example, Connecticut applies a reduced rate of 1 percent on business purchases of SaaS.
Taxable and Non-Taxable Digital Products
A critical difference between a taxable and non-taxable digital product in some states is whether the customer downloaded it or accessed it online. For example, New Jersey imposes a sales tax on sales of specified digital products, defined as digital books and digital audio-visual works or digital audio works transferred electronically. Therefore, the sale of a specified digital product accessed but not delivered electronically is not taxable in New Jersey. However, if the digital product meets the definition of an information service, the sale will be taxable.
Another critical determinant of whether a digital product should have sales tax applied is whether the equivalent non-digital product would be taxable. In New Jersey, a business must charge and collect sales tax on a digital book just as it would on a hard copy book.
Washington and Pennsylvania recently issued taxability guidance on non-fungible tokens (NFTs), with both states indicating NFTs could be subject to tax. Minnesota also issued guidance indicating that NFTs are subject to sales tax when the underlying product is taxable in Minnesota.
In October 2022, a Maryland County Circuit Court also held that the Maryland Digital Advertising Tax violated the Internet Tax Freedom Act, Commerce Clause and the First Amendment. It appears several other states that were on the verge of passing similar taxes are waiting for a final determination before proceeding to enact their own.
It is important to note that state definitions and guidance regarding the taxability of digital products may not match the taxability of their original non-digital product. Because each state analyzes the taxability of digital products differently, businesses are faced with the task of determining whether a digital product is taxable in the states in which it’s sold.
What About Sourcing?
Since the advent of digital products, the sourcing rules have continued to evolve and focus on new issues. A common problem for sellers is determining which jurisdiction taxes the digital product. While jurisdictions have different rules for sourcing, the general rule of thumb is for the seller to impose tax in the jurisdiction of the ship-to location (e.g., where used) or the bill-to location (if the ship-to location is unknown). However, many states will provide an exemption for digital products billed to their state but used in another.
The taxation of digital products is quite complex. There are many variables to consider before determining whether a digital product is taxable. As states continue to analyze taxing the digital economy and broadening the tax base, digital products will continue to be a problem area for businesses.
Bonnie Ssmano, J.D., is a manager in State and Local Tax Services at Withum.
James A. Bartek
James A. Bartek, CPA, is a partner in charge of State and Local Tax Services at Withum. He is a member of the NJCPA State Taxation Interest Group.
This article appeared in the Spring 2023 issue of New Jersey CPA magazine. Read the full issue.