GUEST BLOG PAT DERDENGER, TAX PARTNER, STEPTOE
In a recent private letter ruling, the Arizona Department of Revenue ruled that gross receipts from “renting” prewritten software available online are subject to Arizona’s transaction privilege tax (“TPT”), commonly called sales tax, under the rental of personal property classification if the customer only has the right to the “use of the software for a specified period,” (i.e. a monthly or annual license fee) If the use period is unlimited, then the Department will tax the transaction under the TPT retail classification. Software companies with an office in Arizona that sell to local users or businesses are required to charge the TPT tax. The ruling originated from a case in which the requesting company’s customers had enough control over the software product to constitute a rental, which allows the product to be taxable. In this case, a rental of the software was found to exist due to the company’s customer having the ability to “add, delete, and modify job descriptions” and “to search and sort information in the reports produced by [the company].”
Pat Derdenger, Tax Partner at Steptoe, weighs in on the ruling and what it means for Arizona’s software companies.
State tax laws have struggled to keep up with the rapidly changing technological world. Nowhere is this more readily apparent than in the context of cloud computing and software services provided on the web.
In recent years, it has become increasingly common for software companies to provide access to their products over the internet, rather than selling their products to customers on a physical medium off a store shelf or through a download onto the customer’s computer. Frequently, the software provider will simply host its software on servers located in one particular state, and license the software to customers for a fee; the customer may be located in any state or anywhere in the world. How state sales taxes apply in such situations varies by state, and such situations generally raise two important tax questions: (1) does the state tax the hosted software in the first place; and (2) where is the software sourced, or in other words which state may tax the software – the state where the server is located, or the state where the customer is located?
The Arizona Department of Revenue published a ruling clarifying its position on these two questions on April 29, 2013 in Private Taxpayer Ruling LR13-005 (Ariz. Dep’t of Revenue April 29, 2013) and took the position that it will tax based upon where the software customers are located.
Is hosted software subject to sales tax in Arizona?
As a general rule, software companies charge their customers a software license fee for the use of their hosted software. Many states treat software licenses as the equivalent of sales of tangible personal property. The Arizona Department of Revenue, in LR13-005 stated its position that it will treat software licenses as the equivalent of tangible personal property, including licenses of hosted software. Consequently, the Arizona Department of Revenue has taken the position that a software license is to be taxed as a retail sale of tangible personal property if it is for a perpetual or indefinite period.
Conversely, if the software license only allows a customer to access or use the software for a limited time – for example, one month or one year before it must be renewed – the Department’s position is that the software license is taxed as a rental of tangible personal property. As most hosted software is provided for a limited duration, the Arizona Department of Revenue generally treats such software as a rental of tangible personal property.
Where does Arizona source hosted software for sales tax purposes?
States that tax licenses for the use of hosted software may take differing approaches on how the software should be sourced. Some states may take the position that hosted software should be sourced to, and taxed by, the state where the software is hosted on a server – i.e. the location of the software. Other states take the position that hosted software should be sourced to and taxed by the state where the customer is located. In LR13-005, the Arizona Department of Revenue stated its position that hosted software, as a rental of tangible personal property, should be sourced to the state where the customer is located.
For example, software hosted on a server in Silicon Valley, but licensed for use by a customer in Arizona, would be taxable in Arizona (assuming the software company has nexus, or a physical presence in Arizona such that it is subject to Arizona’s taxing jurisdiction). Conversely, under Arizona’s position software hosted on a server in Scottsdale, Arizona but licensed to a customer in Cedar Rapids, Iowa would be sourced outside of Arizona and would not be taxable in Arizona.
The problem with this dual approach to sourcing is that a software vendor that hosts its software on its cloud computers could find itself being taxed by two states—the state where the customers using the software are located–like Arizona—and the state where the server is located if that state’s sourcing rule is to source the software rentals to the state where the server is located.
Software providers located both outside and within Arizona should be aware of the Arizona Department of Revenue’s position on cloud hosted software as stated in LR 13-005, as it is the position they can expect the state to take in the event of a sales tax audit.
Should you have any questions about this article, please feel free to contact the following Steptoe tax lawyers:
Pat Derdenger, Tax Partner, firstname.lastname@example.org
Ben Gardner, Associate, email@example.com
This article is provided by Steptoe & Johnson LLP for educational and informational purposes only and does not constitute the rendering of legal counseling or other professional services. No attorney−client relationship is created, nor is there any offer to provide legal services by the distribution of this article. If you have any questions about the content of this article, please contact your own tax advisor or attorney.