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What CFOs Need to Know About Sales Tax on Software Services

With varying state sales tax rules on software services, CFOs could be faced with giant headaches. A state-by-state analysis is needed.
Scott KaplowitchSeptember 5, 2013

This summer, Massachusetts became the latest state to institute a sales tax on software services, adding to the complexity of state tax laws targeting this important high-tech sector. At least 11 states now have some sort of tax on software services or modifications which could be a giant headache for CFOs.

The imposition of these taxes depends not only on the kind of service provided, but also the geographical location where work is being done. Already New Mexico, Hawaii, South Dakota, Connecticut, Mississippi, Nebraska, South Carolina, Tennessee, West Virginia and Wyoming require the tax.

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CFOs and their staffs must determine which services are subject to taxation and which are not. It’s particularly tough in Massachusetts, where the tax rules are still being defined. In Massachusetts, the sales tax rate of 6.25% makes it the highest in the nation. In some cases, however, these state levies are nominal; Connecticut’s rate, for example, is just 1%.

Paying close attention to geography is critical. If, for example, a Massachusetts company sells software services to a customer in another state, there’s no tax if the work is being done at the buyer’s site. Then, too, if the sale is made to a customer with locations in multiple states, the Massachusetts tax liability can be shifted to the purchasing company through the use of form ST-12 (sales and use tax form). That would mean the purchaser, not the seller, would have to self report any tax owed.

In Massachusetts, sales tax collections went into effect on July 31, but new guidance on the law isn’t expected to be finalized until Sept. 6. That means some companies may find themselves collecting sales tax on items that may be found to be exempt.   

How should CFOs tackle the problem? They can start by doing a state-by-state analysis of the sales tax laws and then follow up with a review of how these rules apply to the services that the company sells.

The process isn’t always straight forward. For example, it initially seemed that IT staffing companies would be subject to the new Massachusetts tax. Yet because these companies provide staffing but don’t actually direct the activities of that staff, it now looks like most of these activities will be exempt from the new tax.

Conversely, computer consulting companies initially appeared to escape the Massachusetts tax. Closer analysis and guidance provided by the state, however, indicate that any system design and/or installation work—whether of servers or other services—would result in a tax liability. The initial installation of client purchased software and updates onto the clients’ system would be subject to sales tax, but the reinstallation of the same software would not be.

To successfully navigate these taxes, CFOs need to have a clear understanding of both the services being offered by their companies and where the work is being performed. One client seeking guidance on this issue recently described its services in a way that would have been exempt under the law. It turned out, however, that they were actually doing something quite different and thus were subject to the tax.  This may also mean having to change the billing methodology for services rendered.

Nonetheless, affected companies will likely want to take a conservative stance when it comes to collecting the tax. If they don’t tack the tax onto their sales now, they could eventually get stuck paying the levy themselves. If new interpretations of the law later make the tax moot, it can always be refunded.

Scott B. Kaplowitch, CPA is a partner with Edelstein & Company, a Massachusetts CPA firm.

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