Data Processing Services – SaaS and Software Licenses

By Doug Duffie, CPA-Fort Worth

Computer software as a service (SaaS) constitutes a software application delivery model where a vendor develops a web-native software application and hosts and operates (either independently or through a third party) as an application for use by its customers over the internet. Access to SaaS stored in the cloud has been considered a taxable data processing service by multiple Texas court decisions where 80 percent of the SaaS sales price is subject to Texas sales tax.

Conversely, software licenses issued via discs and/or stored on taxpayer hard drives or file servers in Texas are subject to Texas sales tax based on 100 percent of the software license’s sales price. (See Texas Sales Tax Rule 3.308(c) Computer Hardware and Programs.)

Based on trends, more SaaS is being sold and stored in the cloud, which reduces Texas sales taxes legally due on software services as prices subject to Texas sales tax drop from 100 percent taxable to 80 percent taxable.

Cloud-Based SaaS – Used in Multiple States

For taxpayers headquartered in Texas, but also having significant business operations outside Texas, the sales tax benefits for cloud-based SaaS can be even more significant.

As an example, if a taxpayer receives bills for cloud-based SaaS at their Texas headquarters location, software service providers frequently presume ALL of the software service fees are subject to Texas sales tax based on 80 percent of the sales price as a taxable data processing service.

However, when the same cloud-based software service is “used” by a taxpayer in multiple states, the tax savings are more significant since the software service can be allocated between benefits received inside Texas and benefits received outside Texas.

As an example, if a cloud-based software service was used by a large retailer with retail stores in roughly 30 states, Texas Sales Tax Rule 3.330 Data Processing Services, (g) Determining the incident of the tax allows the software service to be allocated between benefits received inside Texas and outside Texas, thereby limiting the price of the software service subject to Texas sales tax.

If a cloud-based SaaS was billed for $1,000,000 to a retailer headquartered in Texas, the software service provider often presumes all of the software service will be used in Texas based on the billing address, which results in $800,000 (80 percent of $1MM) being subjected to Texas sales tax as a taxable data processing service. If the large retailer had 50 stores in Texas where the cloud-based software service was used, as well as another 50 stores in states OTHER than Texas where the same software service was used, the benefits received in Texas decline to 50 percent versus 100 percent of benefits presumed to be received in Texas by the software service provider (i.e., the collector/remitter of sales tax).

For this reason, the sales price of the cloud-based software service subject to Texas sales tax can be allocated for benefits received inside and outside Texas and Texas sales tax computed as follows:

1) Initial cloud-based SaaS sales price = $1,000,000

2) multiplied by 50 percent benefits received in Texas (using a reasonable allocation method, such as a retailer’s store count in Texas/total store count in ALL locations that used the same software service)

3) multiplied by 80 percent as a taxable data processing service in Texas, resulting in a price subject to Texas sales tax = $400,000 * 8.25 percent sales tax rate = $33,000 tax due.

If a taxpayer with business operations in multiple states overpaid Texas sales taxes on a cloud-based SaaS to a vendor(s), a retroactive Texas sales tax refund claim can be filed for up to four years after the software service was invoiced and paid and Texas sales tax was paid in error (i.e., directly through the software service provider or directly through the Comptroller when a taxpayer is permitted for sales tax).

Prospectively, a taxpayer can issue an exemption certificate to the software service provider and agree to be responsible for paying sales taxes on cloud-based software services used in multiple states based on a reasonable allocation method for benefits received inside/outside Texas.

The vast majority of states that impose a sales tax do not subject data processing services to sales tax, but it is highly recommended to verify how, and at what tax rate, cloud-based SaaS may be subject to sales tax in states outside Texas.

Technical Support

Texas Sales Tax Rule 3.330 Data Processing Services, (g) Determining the incident of the tax

Texas Sales Tax Rule 3.308(c) Computer Hardware and Programs

References to Texas Hearings regarding treatment of Software as a Service (SaaS)

Summary

As computer software services become more expensive and more frequently stored in the cloud, it is very important for taxpayers to consider options that may significantly lower prices of cloud-based software services subject to Texas sales tax while also verifying proper sales tax treatment of cloud-based SaaS used outside Texas.