Sales and Use Taxes on Digital Products and Services
In 2011, the US Congress enacted The Digital Goods and Services Tax Fairness Act. This law provided a federal framework for digital taxes, but didn’t go far enough in providing guidance and direction for the individual states.
- There are 28 states that tax digital products.
- There are 23 states that do not tax digital products.
- 4 states do not have a retail sales tax at all; these include: Delaware, Montana, New Hampshire and Oregon.
- For the states that tax digital products, the tax rate varies from 1% to 7%, depending upon the state and the type of digital goods.
We have a section on our site which focuses on online selling. Please feel free to review it here - https://htj.tax/category/online-selling/
In the US, generally only tangible personal property and enumerated services are subject to sales and use tax. In this article although we focus on digital goods and services, it important to keep in mind that the same considerations apply whether the good / service is tangible or digital.
When a sale includes both a product and a service, some states use a true object test to determine the taxability of the transaction. If the main purpose of the transaction (the true object) is the sale of taxable property or equipment, the entire transaction is subject to sales tax. If the main purpose of the transaction is instead the sale of an exempt service, the entire transaction is generally exempt.
Some examples of services that are usually taxed are services to tangible property, services to real estate, business services, personal services, professional services and amusement / recreation services.
Following a US Supreme Court decision in June 2018 many states have implemented new rules to require out-of-state sellers to collect and remit sales tax even without having a physical presence in that state.
Sellers that do not have a physical presence in the US are also subject to these laws if they meet the sales volume thresholds — there is no treaty or other protection, equally included are sellers in other States of the US (so state to state).
It is apparent that a majority of states have moved to tax digital goods e.g., e-books, downloaded movies, digital audio products. These are generally tax substitutes for goods previously sold only in tangible (otherwise taxable) form.
Some states — New York, Florida, California and a few others — do not tax such products currently.
From a tax perspective, there are 6 types of digital goods:
- Online data processing services.
- Downloaded software.
- Downloaded books, such as eBooks and Kindle.
- Downloaded music, digital audio files such as iTunes and podcasts.
- Downloaded movies or digital video, such as Netflix and Amazon Prime.
- Other downloaded electronic goods.
1 This is the result of 2018 US Supreme Court decision South Dakota v. Wayfair, which overruled an earlier court decision prohibiting states from imposing a sales tax collection obligation on a seller unless the seller had a “physical presence” in the state. 2 This is the result of 2018 US Supreme Court decision South Dakota v. Wayfair, which overruled an earlier court decision prohibiting states from imposing a sales tax collection obligation on a seller unless the seller had a “physical presence” in the state. These rules may also apply in jurisdictions where local governments administer taxes as well (e.g., Louisiana, Alabama).
HTJ has found that complexities lay in defining/classifying items and sourcing to the place of use. There has been an increase as well in taxing streaming services, i.e., digital goods that are not downloaded to user’s device. Fewer states do so than tax downloaded digital goods.
Advice must be taken as the greatest challenge is that states take varying approaches to imposition which can substantially increase risk.
We believe that sales and use tax is due where you are outside of the territorial US and where you are selling from State to State. This, we think is applicable to digital goods and services (e.g., digital media, downloadable music, streaming media, fonts and graphics), as well as to more traditionally defined services or goods (e.g., tangible goods or tangible services).
We have also seen uneven taxation of “cloud” products and services; approaching half of the states that tax SaaS (software as a service) — without necessarily defining what is SaaS.
Typically, every person or entity that is engaged in such business ― even if resident outside of the territorial US or doing such business from state to state, must register with the state to obtain a sales tax license, permit or certificate before making sales or providing services.
The alternative to this seems to be that if a seller does not collect tax, the purchaser owes USE tax which is complementary to the sales tax, which would catch the mischief where a seller does not register, collect and remit tax to the particular US state.
What counts as engaging in business varies from state to state.
States have also passed “marketplace facilitator” legislation that requires a marketplace facilitator to collect, report and remit taxes for sales through a marketplace. Generally, a marketplace facilitator is a person that operates or owns a marketplace who contracts with marketplace sellers to facilitate sales of their products (e.g., drop shipping arrangements and other intermediary arrangements.
“Marketplace” often defined to include a physical or electronic place, including an internet website. Consideration for the service of facilitation may or may not be required. ― What it means to “facilitate sales” can vary widely.
There are three scenarios:
- States using their own definition - In addition to the general categories listed above, many states have their own definition of digital goods and services. These include: Arkansas, Connecticut, Georgia, Illinois, Iowa, Kansas, Louisiana, Maine, Michigan, Minnesota, Mississippi, North Carolina, Ohio, Oklahoma, Texas and West Virginia.
- States not using any definition at all - There are 18 states (Alabama, Arizona, California, Colorado, D.C., Florida, Hawaii, Idaho, Maryland, Massachusetts, Missouri, New Mexico, New York, Pennsylvania, South Carolina, South Dakota, Utah and Virginia) that do not specifically define digital goods.
- States using a standard definition - The remaining states utilize a standardized definition of digital goods: Indiana, Kentucky, Nebraska, New Jersey, Nevada, North Dakota, Rhode Island, Tennessee, Vermont, Washington, Wisconsin and Wyoming. This definition is called the Streamlined Sales Tax (SST) Definition of Digital Goods; further information about this is available online, e.g. on the Streamlined Sales Tax Governing Board, Inc.’s website.
Sellers (wherever located) must therefore be alive to the following key challenges:
- Ensuring proper registration i.e. tracking movement of employees and property for purposes of determining “physical presence” or tracking volume of sales for purpose of determining “economic nexus” presence.
- Properly characterizing “what” is being sold — this is particularly difficult in the area of digital goods and products, streaming content, software, software as a service, infrastructure as a service and technology related services.
- Properly capturing data to determine where a sale should be sourced and to apply the correct tax rate for the location where a sale is sourced.
- Dealing with issues such as “caps” (i.e. only a certain amount of the sales price of an item is subject to tax), “thresholds” (i.e. clothing with a sales price of less than US$250 is exempt), and “sales tax holidays” that may last on specific items for specific time periods (i.e. back to school).
Every state taxes services in its own way
- Five U.S. states (New Hampshire, Oregon, Montana, Alaska, and Delaware) do not impose any general, statewide sales tax, whether on goods or services. Of the 45 states remaining, four (Hawaii, South Dakota, New Mexico, and West Virginia) tax services by default, with exceptions only for services specifically exempted in the law.
- This leaves 41 states — and the District of Columbia — where services are not taxed by default, but services enumerated by the state may be taxed. Every one of these states taxes a different set of services, making it difficult for service businesses to understand which states’ laws require them to file a return, as well as which specific elements of their services are taxable.
Categories of taxable services
No two states tax exactly the same specific services, but the general types of services being taxed can be divided roughly into six categories.
- Services to TPP: Many states have started to tax services to tangible personal property at the same rate as sales of TPP. These services typically improve or repair property. Services to TPP could include anything from carpentry services to car repair.
- Services to real property: Improvements to buildings and land fall into this category. One of the most commonly taxed services in this area is landscaping and lawn service. Janitorial services also fall into this category.
- Business services: Services performed for companies and businesses fall into this category. Examples include telephone answering services, credit reporting agencies and credit bureaus, and extermination services.
- Personal services: Personal services include a range of businesses that provide personal grooming or other types of “self-improvement.” For example, tanning salons, massages not performed by a licensed massage therapist, and animal grooming services can be considered “personal services.”
- Professional services: The least taxed service area, in large part because professional groups have powerful lobbying presences. Professional services include attorneys, physicians, accountants, and other licensed professionals.
- Amusement/Recreation: Admission to recreational events and amusement parks, as well as other types of entertainment. Some states that tax very few other services, like Utah, still tax admission charges to most sporting and entertainment events.
Purchasers (considering use tax where sales tax is not collected) must also be alive to the following key challenges:
- Ensuring sales tax was collected at the correct rate and the correct jurisdiction on taxable purchases, more sellers are registered to collect tax in multiple jurisdictions, but it does not necessarily mean that those sellers are properly calculating sales tax.
- Ensuring no tax was collected on exempt purchases
- Where sales tax is erroneously collected, purchasers must pursue claims for refund from the taxing authority. In some jurisdictions, the purchaser must pursue the claim through the seller that collected tax — in other jurisdictions, the purchaser can pursue the claim directly.
At HTJ, we can help provide the context for your business to assess overall risk related to collecting and remitting these varying transaction taxes. All in all your business can benefit from the best practices specific to your transaction profile.
<https://home.kpmg/xx/en/home/insights/2018/10/united-states-indirect-tax-guide.html> Accessed 25 August 2021