US taxation of digital economy is confusing and inconsistent among states
Mark Mirsky & Jamie Baker
by Mark Mirsky & Jamie Baker
Foreign companies venturing into the United States digital economy face a complex tax landscape. Taxation of digital economy services at the federal level is confusing at best, and the 51 states (including Puerto Rico) each have their own tax laws that may be very different from federal rules.
Moreover, tax liability at the state level is determined by a complex and inconsistent web of factors that add up to “nexus”. Nexus is the term used for whether a company must pay taxes in a certain US state. Once nexus is established in a specific state, the corporation must pay a variety of taxes, including income tax, sales tax, excise tax, and, if there are employees in that state, payroll taxes.
Determining tax liability at the federal level may be simpler. Once a foreign corporation meets the federal standard of “permanent establishment”, it’s liable for US federal taxation on its taxable income derived within the country.
Defining the digital economy
For the purposes of this article, we will focus on the tax situation of a European corporate entity selling software or software as a service (SaaS) in the US.
A key reality to bear in mind when it comes to state taxation of the digital economy in the US is that the laws are changing rapidly. Many states have not yet put in place coherent tax policies or laws related to sales of cloud-based software or SaaS, but they are working on it. State policymakers understand the digital economy is growing rapidly, and they want a piece of that pie.
The mode of software delivery is the most important factor in determining tax liability in US states. Whether a software product or service is delivered electronically through download or is cloud-based matters in determining taxation. In the case of SaaS, which is cloud based, whether it’s delivered under a service contract or a license agreement determines whether some states consider it taxable. If it’s a service, it may not be taxable; if licensed, it’s considered software and subject to tax. It's crucial to engage a US-based tax advisor knowledgeable about nexus issues and taxation across all 51 states and territories because of varying state rules.
If a company provides computer services, such as data processing, web hosting or other services besides software, it’s important to know how many states currently consider those services taxable.
Is it custom software or off the shelf? In most states, custom software is not taxable, but prewritten software is taxable. However, the definition of customisation can change from one state to another. While a minor change in a software package may qualify as customisation in one state, another state may require significant changes to consider the software customised.
Tax exposure also depends on where a company’s customers are, and, more importantly, where its employees are. If a foreign company hires employees in the US, the company will have established nexus in whatever state(s) the employee(s) live in, meaning there is potential liability for income, sales, and payroll taxes. If an employee is hired as a contractor and is just selling (not developing) software, it may not trigger nexus and definitely does not trigger permanent establishment at the federal level.
Different types of taxes
Once tax liability is established, there are many different types of taxes, including income, sales, excise, and payroll taxes. To complicate matters further, each different tax is subject to its own criteria of nexus standards. Consequently, a business may be subject to sales tax in a certain state, but not income tax. In certain states, companies may be subject to franchise tax, which is usually based on a percentage of revenue derived in that state, or a gross receipts tax.
While taxation at the federal and state level is complicated enough, there are many local jurisdictions that have the authority to impose their own regulations and administer their own taxes. For instance, while the state of Colorado does not tax software delivered electronically, its cities do tax it if the software is delivered to an address within their borders. When municipalities are taken into consideration, there are approximately 11,000 taxing authorities within the US, each with its own set of rules.
Taxation in the US is vastly more complex than in most other countries. It’s essential for corporations doing business in the US digital economy to work with a tax provider with expertise in nexus and the software industry.
KRD Ltd is a Chicago area, Certified Public Accounting firm offering a full range of accounting, tax, and consulting services. Our highly trained CPAs and advisors strive to uncover unrealized opportunities as your business changes and grows.
GGI member firmKutchins, Robbins & Diamond, Ltd. (KRD)Chicago (IL), USAT: +1 847 278 4350
Advisory, Auditing & Accounting, Corporate Finance, Fiduciary & Estate Planning, Tax
Mark specialises in multi-state and international taxation, advising on startups, mergers, acquisitions, and multiple sectors including technology, healthcare, and real estate. Contact Mark.
Jamie serves as KRD's State and Local Tax (SALT) Director in KRD's Tax practice. She is an expert in multi-state, local tax compliance, and specialises in S-corporations and partnerships. Contact Jamie.
