Traps for the Unwary: Taxation of Digital Products

Recently, I presented at a webinar hosted by Strafford Publishing on the subject of sales and use tax on digital products and services.  It almost goes without saying that the interstate sale of digital products—whether books or software—is complicated, if for no other reason than it requires analyzing the sales and use tax consequences of such transactions based upon forty-five states’ (and the District of Columbia’s) sales tax laws, which were adopted long before the advent of the digital age.  For example, the starting point for sales tax analysis in most states is whether the transaction involves the sale of “tangible personal property.”  Is a digital product such as a digital book that is downloaded by the customer tangible personal property?

The states do not provide for uniform treatment of the taxability of digital products from state to state, nor are all digital products taxed similarly within a given state.  Colorado, for example, taxes digital books and music, but does not tax digital software.  Twenty-five states tax digital books, music and videos, while thirty states tax prewritten software.

What makes analysis in this field even trickier are the different methods of delivery of digital products and the various pricing plans under which such products are sold.  For example,  under one delivery method, the seller provides the buyer an electronic access code to permit the buyer to download the digital product at the buyer’s convenience.  For a sale such as this, in addition to analyzing whether the underlying product is taxable, the seller must also determine whether the sale of the access code is taxable at the time of such sale.  The SSUTA, of which there are 24 member states, treats the sale of a “digital code” that entitles the purchaser to download a taxable digital product as a taxable transaction.  See Section 332(G).  But not every state, of course, is a member of the SSUTA and non-member states do not always follow this principle.  For instance, the non-member states of Texas, New York, and Illinois treat the sale of such access codes as tantamount to selling a gift card.  These states treat the sale of a gift card or access code as the sale of an intangible.  It is only when the gift card is redeemed that a taxable sale of tangible personal property has occurred.  See, for example, Ill. General Information Letter ST 10-0052-GIL (June 4, 2010).

Tennessee Ruling Provides Another Wrinkle for Cloud Computing Services

A recent ruling by the Tennessee Department of Revenue (Ruling #12-11) illustrates some of the anomalies and pitfalls in properly taxing cloud computing services. The request for ruling concerned a service that provided Tennessee users access to software maintained on remote servers located outside of Tennessee. This is otherwise known as an SaaS service. In addition, the charge for the service permitted users access to certain databases, including certain reference materials such as dictionaries and encyclopedias. It would appear that the users did not download the references to their computers.

One of the anomalies in the ruling is that the Department stated that the SaaS portion of the service was not taxable, but access to the databases was taxable because the Department deemed the access to include the right to license and use digital books. As of January 1, 2009, the right to license and use digital books is taxable pursuant to an amendment to the Tennessee sales and use tax statute adopting the Streamlined Sales and Use Tax Agreement (“SSUTA”).

The Department’s basis for this distinction in taxability appears to be that access to software is not taxable because “title, possession, and control” of the software always resides outside of Tennessee. On the other hand, the taxability of digital books is predicated on the following underscored clause from Tenn. Code Ann § 67-6-233(a), which provides for the taxation of digital books when there has been the “retail sale, lease, licensing, or use of specified digital products transferred to or accessed by subscribers or consumers in this state.” (emphasis added). Section 67-6-231(a), providing for the taxation of software, includes only “software transferred by tangible storage media or delivered electronically,” but does not include access to the software. The difference between the two statutory provisions is subtle. On the one hand, digital books are taxable if the consumer in Tennessee has “access” to the books, without being required to download them. On the other hand, computer software is not taxable, even if the consumer has access to the software, so long as the consumer does not download the software to his or her computer in Tennessee.