Cover Your SaaS – Issue II

Welcome to the second edition of Cover Your SaaS, your new favorite(ish) semi-regular publication from HMB Legal Counsel’s State & Local Tax team. Far from accepting a sophomore slump, this edition boldly delves into SALT developments in the digital products sphere, the importance of separately stating charges, and the dangers of straying into taxable telecommunications. As before, we organize the stories by jurisdiction, give you the headline, the context and explain why the story matters. If you have follow-up questions, please let us know.

Illinois

The Headline

• Chicago’s controversial “Netflix Tax” heads north to the suburb of Evanston

The Authority

• Evanston Proposed Ordinance 55-O-20 (Introduced May 26, 2020)
• https://www.cityofevanston.org/home/showdocument?id=57514

The Context

• Chicago imposes an amusement tax, dubbed the “Netflix Tax,” on streaming services. This tax was challenged as violating certain Illinois home rule laws, the Illinois constitution, and the federal Internet Tax Freedom Act (ITFA) but was ultimately upheld by an Illinois Appellate Court in 2019. Evanston’s proposed ordinance closely tracks Chicago’s amusement tax ordinance and would expand Evanston’s existing amusement tax to include a 5% tax on online gaming as well as video and audio streaming

Why It Matters

• Evanston, home of Northwestern University and thousands of students for whom Netflix binge watching is an invaluable procrastination technique, is taking notes from Chicago on how to replace declining revenues from telecommunications taxes. Although Evanston shares a border with Chicago, the lesson that at least one Illinois court has upheld amusement taxes on streaming services may travel much further
• On a similar note, the Rhode Island Division of Taxation recently held that an anonymous taxpayer’s app-based television streaming service was subject to sales tax as subscription television. Rhode Island Department of Revenue, Case No. 19-T-056 (Feb. 27, 2020)

Illinois Bonus

The Headline II

• Illinois federal court dismisses proposed class action against an Apple subsidiary alleging it improperly charged Illinois sales taxes

The Authority II

• Florodora Inc. v. Claris International Inc., 2020 U.S. Dist. LEXIS 84345 (N. Ill. 2020).

The Context II

• Florodora, a Chicago fashion boutique, filed a class action against Claris International, Inc., an Apple subsidiary, alleging that it improperly charged Illinois sales tax on a license of Filemaker Pro software. The court dismissed Florodora’s suit, holding that the license was subject to Illinois sales taxes despite Florodora’s argument that a specific exemption applied. The court further held that Florodora could not show any harm because the license was subject to the 6.25% Illinois sales rate, rather than the 9% Chicago Personal Property Lease Transaction Tax (“LTT”) rate that would otherwise have applied

Why it Matters II

• Illinois generally imposes sales tax on canned software licenses but exempts “true licenses” that satisfy a five-part test. Chicago’s LTT applies to most software licenses within the City’s jurisdiction, including “true licenses” that are not subject to Illinois sales tax. So even if a taxpayer is successfully able to avoid Illinois sales tax on its software, it will not be able to avoid Chicago’s LTT if the software is used in Chicago

Arkansas

The Headline

• Arkansas confirms sales tax due on certain digital products

The Authority

• Arkansas Department of Finance and Administration, Opinion Number 20180921 (Issued March 16, 2020)
• https://www.ark.org/dfa-act896/index.php/api/document/download/20180921.pdf

The Context

• An anonymous Arkansas taxpayer sells educational video courses on time management as well as digital planners and worksheets for its customers to download and print at home. In a requested opinion, the Department explained that gross proceeds from sales of the educational video course and digital planners are subject to sales tax, but gross proceeds from the digital workbook sales are only subject to sales taxes if the downloaded workbook pages are digitally bound together in an order that is essential to their purpose. The relevant Arkansas’ sales tax applies to digital works that are generally recognized in the ordinary and usual sense as “books.” The order of a book’s pages is essential to its purpose so digital planners bound in chronological order are taxable as “digital books,” but interchangeable worksheets are not

Why It Matters

• State sales tax, much like baseball and shuffleboard, is a game of inches in which small distinctions make the difference. Knowing the definitions of a state tax’s terms enables savvy taxpayers to differentiate their products and potentially prevent the tax from applying

Maryland

The Headline

• Maryland bill seeks to impose gross receipts tax on digital advertising services

The Authority

• Maryland House Bill 732
• https://legiscan.com/MD/bill/HB732/2020

The Context

• After months of dipping their figurative toes into the waters of controversy, the Maryland legislature took the plunge and passed a special gross receipts tax on “digital advertising services.” This tax is imposed on businesses with at least $100 million in annual global gross receipts and at least $1 million of Maryland gross revenues from digital advertising services (subtly targeting certain FANG companies). The bill was vetoed by Maryland Governor Larry Hogan, but the legislature is expected to override it

Why It Matters

• Digital Services Taxes (DSTs) are on their way, with four states (Maryland, Nebraska, New York and West Virginia) proposing legislation this year. There are significant constitutional questions surrounding these taxes, but cash-strapped states seem willing to accept the risk of litigation

North Carolina

The Headline

• Customization fees for licensed software exempt from sales tax if the charge is separately stated

The Authority

• North Carolina Department of Revenue, Private Letter Ruling SUPLR 2020-0007 (Issued March 5, 2020)
• https://files.nc.gov/ncdor/documents/files/SUPLR-2020-0007.pdf

The Context

• An anonymous taxpayer sells standardized web software modules that are customized to meet a customer’s needs and then populated with the customer’s information. In a letter requested by the taxpayer, the Department explained that the gross proceeds from sales of modified pre-written software are subject to sales tax unless the modification charges are separately stated on the invoice. The taxpayer in this instance properly invoiced applicable modification charges as a separate line item so no sales tax was due on these fees

Why It Matters

• Sales tax exemptions for “customized” pre-written software often require modification charges to be both reasonable and separately stated. As customers become more price-conscious in a recession, it may be tempting to fold charges into a single lump sum but continuing to separately state customization and modifications charges on invoices is an opportunity to lower a client’s sales tax bill

South Carolina

The Headline

• South Carolina reaffirms the longstanding position that SaaS subscription fees are subject to sales tax

The Authority

• South Carolina Private Letter Ruling No. 20-4 (Issued May 18, 2020)

The Context

• An anonymous taxpayer provides enterprise cloud computing software to automate workflow and services within a company. In a letter requested by the taxpayer, South Carolina stated that the taxpayer’s SaaS offerings are subject to sales tax and reiterated its longstanding position that almost all SaaS is a taxable communication service. This is not a unique position, but South Carolina takes the road less traveled to reach this result, relying on Department guidance from 2003 and a 2002 regulation to determine that any company that provides access to use software on the company’s website is an Application Service Provider whose services are taxable as “on-line information services”

Why It Matters

• South Carolina is a good example of a state whose cloud computing position is based on older laws that have been creatively interpreted by the Department of Revenue to apply to contemporary products and services like cloud computing. Cloud product providers in states like South Carolina should be wary that cloud products may be subject to sales tax even though the relevant law does not use the words “cloud computing” to describe taxable software

Texas

The Headline

• Texas PLR states that service fee imposed on customers who buy lottery tickets via an app is subject to sales tax

The Authority

• Texas Comptroller Private Letter Ruling No. 20190912081126 (Feb. 18, 2020)
• https://star.comptroller.texas.gov/view/202002033L?q1=202002033L

The Context

• An anonymous taxpayer offers a mobile app allowing Texas-based users to purchase lottery tickets. The app functioned by scanning a physical lottery ticket using optical character resolution (OCR), adding a customer-specific watermark barcode, and then storing the ticket image on the app for users to access. In a letter requested by the taxpayer, Texas stated that the service fee charged to app users is subject to sales tax because OCR scanning and image storage constitute a taxable “data processing service”

Why It Matters

• Texas, like South Carolina, shoehorns most cloud products into the taxable category of “data processing services.” In addition to conjuring images of 1960s-style mainframes, the term conjures a false sense of safety for software providers who consider themselves to be in the business of connecting people or businesses

Washington

The Headline

• Washington imposes an additional 1.22% Business & Occupation (“B&O”) tax on “select advanced computing businesses”

The Authority

• Revised Code of Washington § 82.04.299

The Context

• Washington imposes the B&O tax on virtually all business activities conducted in Washington. This additional surcharge applies to a “select advanced computing business,” defined as any entity which is not a financial institution and is part of an affiliated group in which (1) at least one member engaged in “advanced computing” and (2) the group has total worldwide gross income in excess of $25 billion. “Advanced computing” is defined broadly to include designing, developing and modifying computer software or computer hardware

Why It Matters

• The additional 1.22% surcharge was originally drafted with the intent of taxing only Amazon, Facebook, Google and Microsoft but may apply to many more businesses due to the broad definitions of “advanced computing” and “advanced computing business” and the law’s inclusion of affiliated groups’ total worldwide gross income

West Virginia

The Headline

• West Virginia proposes a “data mining service tax” on commercial data operators

The Authority

• West Virginia House Bill 4898 (Introduced February 11, 2020)
• http://www.wvlegislature.gov/Bill_Status/bills_text.cfm?billdoc=HB4898%20INTR.htm&yr=2020&sesstype=RS&i=4898

The Context

• West Virginia introduced legislation imposing a new tax on “commercial data operators,” defined as any online service provider or data broker that generates a “material” amount of revenue from using, collecting, processing, selling or sharing of user data, and has more than 10,000 unique monthly visitors in West Virginia for a majority of months during the previous twelve-month period. The proposed tax would be 1% of the commercial data operator’s revenue

Why It Matters

• Deftly pivoting from one form of mining to another, West Virginia is following a potentially rich vein of revenue as companies increasingly seek to monetize their user data. New York is also moving in the same vein, having introduced bills A. 9112 and S. 6102, which propose a 5% tax on the gross income of corporations deriving income from data shared by New York residents. Look for other states to implement creative taxes in the digital space as the need for new revenue streams deepens