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Annette Nellen
Do You Know What Is Now Subject to Sales Tax?

Sales-tax changes continue to expand the checklist needed for proper compliance. Lessons from recent sales tax developments.

April 14, 2011
by Annette Nellen, CPA, Esq.

One certainty in tax practice is that sales-tax rules are never constant. Changes, and even potential changes, often require action on the part of sellers, buyers and their tax advisers. This article highlights a few recent changes in state sales-tax rules and actions to take to ensure proper compliance and planning. The actions are presented in the form of items for a sales-tax compliance checklist.

The Tax Base

Customer charges: A complicating factor in sales-tax compliance is knowing exactly what is subject to tax. For example, are shipping and other transaction charges part of the tax base? At issue in Rent-A-Center East, Inc. v. Lincoln Parish Sales & Use Tax Comm. (La. Ct. App. 2nd Cir., No. 46,054, 2011), was whether "liability damage waiver" charges that some renters of tangible personal property agreed to pay were included in the tax base. The court found that the waiver charges were part of "gross proceeds derived from the lease or rental of tangible personal property" and thus subject to sales tax. Under the "real object" test, the waiver charge would not exist without rental of the tangible personal property. Since the damage waiver is incidental to the property rental, the entire monthly amount charged to customers was found to be subject to tax. The taxpayer was also held liable for penalties and attorney fees.

The Texas Comptroller’s March 2011 Tax Policy newsletter reminds readers that fuel surcharges, commonly added to customer bills when fuel prices are high, are subject to sales tax even if separately stated on the bill. Under Texas law, such charges are considered a delivery charge and part of the taxable item delivered.

Tangible vs. Intangible: Nortel Networks, Inc. v. State Board of Equalization, Cal. Ct. App., Dkt. No. B213415 (2011), involved application of special rules for "technology transfer agreements" (TTAs). Nortel sells both hardware (telephone switching equipment) and software to operate it. At issue was how the rules applied to Nortel's prewritten software as well as its "switch-specific programs" (SSP) designed for particular switches. An SSP makes the switch operational for a particular customer and involves significant programming time to create.

The software at issue was shipped to a customer on tangible storage media that cost about $55,000 to produce. Nortel licensed the software to the customer for about $402 million. The Board of Equalization (BOE) determined that sales tax was owed on the entire transaction and Nortel objected. A trial concluded that the SSP licensing fee was not taxable, but the charge for prewritten software was. The BOE appealed the ruling.

California law (Rev. & Tax. §6011 and §6012 and Reg. 1507) on TTAs exempts amounts charged for intangible property transferred with tangible personal property if the TTA "separately states a reasonable price for the tangible personal property." After review of the nature of the software and patents involved and the relevant law, the court concluded that the transfer of the prewritten software and SSP was a TTA because the programs were subject to a patent or copyright. The court also held that to the extent Reg. 1507(a)(1) "excludes from the definition of a TTA prewritten computer programs that are subject to a copyright or patent, the regulation exceeds the scope of the Board's authority and does not effectuate the purpose of the TTA statutes" and is invalid.

The court found that the "software licensed by Nortel is exempt from sales tax under the [TTA] statutes because it:

  1. Is copyrighted,
  2. Contains patented processes and
  3. Enables the licensee to copy the software, and to make and sell products — telephone calls — embodying the patents and copyright."

    Exemptions: Issues also arise in interpreting laws defining the tax base and exemptions as evidenced by recent rulings in New York. Advisory Opinion TSB-A-11(4)S (February 18, 2011) addressed a food exemption. New York Tax Law §1115(a)(1) exempts “food, food products, beverages, dietary foods and health supplements, sold for human consumption." Taxpayer sold "ready-to-drink beverages, liquid concentrates, powdered-drink mixes and chews" marketed as dietary supplements. Per the product labels, the supplements were "not intended to diagnose, treat, cure or prevent any disease.”

The Department of Taxation and Finance found that the taxpayer's products were exempt under the statute and related regulation 20 N.Y.C.R.R. §528.2(c). Taxpayer labeled the products such as to highlight a dietary effect. The products served as a dietary supplement or substituted for natural foods. The opinion contrasts earlier rulings that found Red Bull Energy Drinks and Sugar-Free Shots to be taxable. These products did not serve as substitutes for natural foods or dietary supplements. In addition, their product labels did not note any dietary properties.

Checklist
  What comprises the amount(s) charged to customers? How does the state statute and "real object" test apply to determine the taxable amount?
  Is any portion of a transfer considered non-taxable intangible property or services? Are there special rules for technology transfers?
  Have the details of exemptions been reviewed using the statute, regulations and rulings to determine if any apply or could apply after appropriate clarification of the transaction specifications?
  If any law defining the tax base is unclear in its application to a seller, consider obtaining a ruling from the state.

Cloud Computing

As more transactions, such as use of software and various services, move to the "cloud," guidance is needed on how (and if) sales tax applies to the transaction. The guidance has been slow in coming with occasional rulings from states. For example, Pennsylvania Ruling No. SUT-10-005 (PDF) (November 2010) addresses various web-based services including remote access to one's own computer, the ability for technicians to access a computer remotely and participation in online meetings. Customers pay on a per-user subscription basis and need to download a free "applet" (a small application that performs one specific task and runs within a larger program often as a plug-in) in order to connect to Taxpayer's website and proprietary system. Customers cannot access or change the applet. Taxpayer's data centers are located throughout the world, but none are in Pennsylvania.

While canned software is taxable in Pennsylvania, accessing software through the Internet is only a taxable transfer if the server or data center is in the state.

Checklist
  Evaluate cloud computing transactions (whether as the vendor or customer) to determine their nature and how existing law applies. Consider obtaining a ruling if the law is not clear.

Tax Rate

Sales tax rates at both the state and local levels may be increased for budget needs or decreased for economic stimulus or other reasons. Some rate changes are temporary and some change mid-year. For example, a one percent sales tax increase enacted in California in 2009 expires July 1, 2011, unless extended.

States may have different rates for different items. For example, West Virginia has had a three-percent sales-tax rate on food since mid-2008 (the state rate is 6%). HB 2971 (PDF) (2011) further lowers that rate to two percent starting in 2012.

Tax Holidays

Some states have sales-tax holidays during which for a specified, limited time period, no sales tax is owed on certain items. Maryland recently enacted a sales-tax holiday for
energy-efficient equipment.

Checklist
  Be sure software systems are updated monthly for rate changes and the effect of any sales-tax holidays.
  Re-evaluate sales-and-marketing strategies for any applicable sales-tax holidays. (The Federation of Tax Administrators maintains a list of sales-tax holidays.)

Amnesty

Some states have implemented limited amnesty periods to help generate revenue and increase the number of compliant taxpayers. Amnesty periods are often announced within weeks of their effectiveness. In March 2011, Ohio announced its Use Tax Education Program, which includes a limited offer for certain businesses to register and pay past use-tax liabilities. The incentive is that liabilities will not extend to more than three years of past liabilities (rather than seven years).

Checklist
  Follow news on amnesty programs and for each, evaluate whether the taxpayer has liabilities that can be remitted under the plan. Where no amnesty program exists, determine whether the state has any type of voluntary-disclosure program that might limit liabilities, interest and penalties.

Nexus

Legislation: States continue to consider and enact laws to broaden their nexus reach. For example, in March 2011, Illinois enacted HB 3659 (PDF), the so-called "Amazon law," similar to what New York enacted in 2008. South Dakota enacted SB 147 (PDF) broadening nexus to reach affiliate relationships where an Internet vendor with a specified ownership connection and a similar product or business name to an in-state entity will have nexus. South Dakota also enacted a law similar to what Oklahoma enacted in 2010 (HB 2359) to require certain remote vendors to provide information to buyers about use-tax compliance (SB 146 (PDF)).

In January 2011, a federal district court in Colorado granted a preliminary injunction requested by The Direct Marketing Association (No. 10-cv-01546-REB-CBS (PDF)). The litigation was in response to legislation enacted in 2010 that required certain remote vendors to provide information to Colorado customers about the use tax and to issue annual reports on sales activity to buyers and the states (see HB10-1193 (PDF) and Colorado FYI Sales 79).

Questionnaires: When a state discovers that a nonfiling vendor has customers, employees or property in a state, it will likely send a nexus questionnaire to the vendor to help in determining whether the vendor has tax obligations in the state. Barr Laboratories v. Michigan, Dkt. 291968 (Ct. Appeals Mich. 2010), serves as a reminder of the importance of completing nexus questionnaires correctly. In Barr, the questionnaire was treated as evidence that oral testimony did not supersede.

Checklist
  Follow nexus legislation and litigation to determine whether new collection and reporting obligations arise in any states.
  Have one person be the point person for responding to all nexus questionnaires to ensure accuracy and consistency.
  Implement procedures to ensure that the tax department has regular interaction with the sales, marketing, purchasing and human resources departments to keep abreast of any changes that affect nexus.

Future Changes

Legislators and governors regularly establish commissions to study state taxes and make recommendations. In recent months, the following commission reports were released:

The reports include various sales tax proposals, most notably to reduce exemptions.

Checklist
  Follow the work of state tax commissions and provide input as appropriate.

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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.