Friday, August 2, 2013

Sales Tax on Computer Design, Software Modification Services: Massachusetts Issues Initial Guidance, Yet Questions and Challenges Remain




On Wednesday, July 24th Massachusetts enacted H.B. 3535An Act Relative to Transportation Finance (“the Act”), which was passed by legislative override of Governor Deval Patrick’s veto.  The Act includes several significant tax provisions, such as the adoption of market-based sourcing for receipts from other than tangible personal property sales and an increase in the cigarette tax.


But perhaps the most significant tax provision in the Act is the expansion of the sales tax base to include Computer System Design and Software Modification Services.

Because this provision became effective on July 31, 2013 (just seven days after the enactment of H.B. 3535) businesses that provide computer system design and software modification services will not have much time to digest the new provision’s impact and implement procedures to insure they are compliant with the new law's requirements. Perhaps this is reason the Massachusetts Department of Revenue issued preliminary administrative guidance the day after the Act was passed.

Massachusetts Issues Technical Information Release (TIR) 13-10, Sales and Use Tax on Computer and Software Services Law Changes Effective July 31, 2013


In an effort to provide preliminary guidance on the sales and use tax impact of the Act on affected taxpayers, the Massachusetts Department of Revenue (“the Department”) issued TIR 13-10: Sales and Use Tax on Computer and Software Services Law Changes Effective July 31, 2013More specifically, TIR 13-10 provides initial guidance on the statutory change,  including an explanation of new and amended sales tax definitions, sourcing rules for determining when a sale or use is taxable in Massachusetts, transition rules for existing contracts, the calculation of use tax liability, information on electronic filing requirements, and the provision’s effective date and its impact on filings and payments.

The Act’s New and Amended Definitions


Effective on July 31, 2013, the Massachusetts sales and use tax will apply to certain computer services and software services. In order to clarify which services will be taxable, the Act adds a new definition for “computer system design services” and also amends the existing definition of “services” subject to Massachusetts sales and use tax by incorporating the newly taxed services.

Regarding the new definition of “computer system design services”, the Act adds that these are; “the planning, consulting or designing of computer systems that integrate computer hardware, software or communication technologies and are provided by a vendor or a third party.

Regarding services subject to sales tax, the new law retains much of the definition of “services” as under prior law, which are defined as, “a commodity consisting of activities engaged in by a person for another person for a consideration but which do not include activities performed by a person who is not in a trade or business of offering the same types of services to the public or services rendered to a member of a corporate affiliate (as defined under IRC Sec. 1504) by another member of the same affiliated group provided the service providing member does not sell the same type of service to the public, or to data access, data processing or information management services.” (TIR 13-10 notes that the latter types of services were not subject to sales tax prior to the law change, and continue to be exempt.)

The main modification to the services definition introduced by the Act can be found in the last sentence where the two new taxable services were added.  Thus, completing the definition of "services", the Act modifies the final sentence to read as follows: “The term services shall be limited to the following items: telecommunications services, computer system design services and the modification, integration, enhancement, installation or configuration of standardized software.” (Under prior law, only telecommunications services were listed as taxable.)

TIR 13-10 also notes that personal or professional services that do not themselves constitute computer system design services or software modification services and that are not directly related to a particular systems integration project involving the sale of computer hardware or software are not subject to tax.  For instance, consulting and evaluation services with respect to existing computer systems to identify deficiencies and needs, and services to prepare a business to use modified software, such as training, would be considered non-taxable personal and professional services.
 

How Massachusetts Defines Standardized Software: Revisiting the Computer Industry Services and Products Regulation, 830 CMR 64H.1.3


Because the TIR does not go beyond summarizing the definition changes just noted, it’s important to look to the existing regulations to more fully understand what services will be taxed.  For instance, to understand what the new law means by “the modification, integration, enhancement, installation or configuration of standardized software”, one needs to look at the definition of "standardized software" in the Massachusetts Computer Industry Services and Products Regulation830 CMR 64H.1.3. The regulation defines standardized software (which is also referred to as prewritten or canned software) as follows:

 “Computer software, including prewritten upgrades, which is not designed and developed by the author or other creator to the specifications of a specific purchaser.

The Massachusetts Computer Industry Services and Productions Regulation adds that:

 "Prewritten [standardized] computer software includes software designed and developed by the author or other creator to the specifications of a specific purchaser when it is sold to a person other than the specific purchaser. Where a person modifies or enhances computer software of which the person is not the author or creator, the person shall be deemed to be the author or creator only of such person's modifications or enhancements. Prewritten computer software or a prewritten portion thereof that is modified or enhanced to any degree, where such modification or enhancement is designed and developed to the specifications of a specific purchaser, remains prewritten computer software; provided, however, that where there is a reasonable, separately stated charge or an invoice or other statement of the price given to the purchaser for such modification or enhancement, such modification or enhancement shall not constitute prewritten computer software." (But as I explain in a minute, a portion of this section of the Regulation is now made obsolete by the new law.)

In essence, the standardized software mentioned in the new law is the same prewritten/canned software defined in the Computer Industry Services and Products Regulation. You see, prewritten (i.e., standardized, canned) software was subject to sales tax under the prior law, and continues to be subject to sales tax under the new law - regardless of the method of delivery.

But here's the big difference. Prewritten (i.e., standardized, canned) software that was modified or enhanced to any degree to the specifications of the user (i.e., customized), and which was separately stated on a customer's invoice was not subject to sales tax under prior law, but is subject to sales tax under the new law even if the charge for customization is separately stated.

As you can see, for a taxpayer that is not familiar with the Massachusetts sales tax regulations, understanding whether their service offering will be subject to sales tax can be challenging - especially where their service offering is bundled with non-taxable personal or professional services.  But even if a taxpayer knows to look at the existing regulations, this could also cause confusion as the Computer Industry Services and Productions Regulation has not been  updated to reflect the new law changes. For this reason, the TIR notes that the Department will issue further guidance as deemed necessary or appropriate, including an amendment to the Computer Industry Products and Services Regulation and invites input via comments or suggestions at: rulesandregulations@dor.ma.us. (Note, I also blogged about and explained the history of this regulation in my February 11th blog post, “Sales Tax on Cloud Computing, SaaS and Related Business Solutions: Massachusetts Issues Draft Directive, Provides Criteria for Establishing Taxability”.)

Sourcing Rules – When is the Sale or Use Taxable in Massachusetts


Assuming then that a vendor provides taxable computer design or software modification services, what amount of Massachusetts sales tax should be charged? In other words, how much of a service contract should be "sourced" to Massachusetts and subject to the 6.25% sales tax?

Sourcing deals with whether and to what extent the sale of computer services or software modification services are subject to Massachusetts sales tax. Not surprisingly, the sourcing rules can be quite complex especially where the computer/software services are concurrently available for use in more than one state or jurisdiction. 

The general rule regarding sourcing is that unless the purchaser has given a vendor a Multiple Points of Use (MPU) certificate (explained in a bit), the computer/software services vendor must collect Massachusetts sales tax from the purchaser of such services if the sale is sourced to the Massachusetts customer according to the following hierarchy: 
  • If the purchaser receives the service at a business location of the vendor, the retail sale is sourced to that business location of the vendor.
  • If the vendor knows the location where the service is received by the purchaser based on instructions for delivery as provided by the purchaser, tax is due based on that location, when use of this address does not constitute bad faith. 
  • If the purchaser does not specify a location for the service to be delivered, the vendor must collect tax based on the purchaser’s address that is known to the vendor as provided by the purchaser or based on information known to the vendor (e.g., as collected to complete the sale), such as address information from a payment instrument or credit card, when use of this address does not constitute bad faith.
  • If neither the delivery location nor the purchaser’s address can be determined, then the vendor must collect tax based on the address of the vendor from which the sale was made.
To assist with this concept, TIR 13-10 provides an example in which a vendor makes a sale of customized software to a purchaser located in Massachusetts.  The purchaser does not give the vendor a MPU certificate (explained in next section).  In this situation, the vendor would first determine if the purchaser received the software at the vendor’s location, and if so, the sale would be sourced to the vendor’s location. (If the vendor is located in Massachusetts, then the entire sale would be sourced to Massachusetts. But if the vendor is not located in Massachusetts, then none of the sale would be sourced to Massachusetts).

However, if the vendor did not provide the software at a specific location but instead delivers it by disk or electronic leave and load, then the sale would be sourced to the customer’s location.  (In this case, the entire sale would be sourced to Massachusetts since we know the purchaser is located in Massachusetts).

If neither of these scenarios applies, and the customized software was downloaded to the customer’s server, then the sale would be sourced to the customer’s address in the vendor’s books and records regardless of where the server was located. (Thus, the sale would only be sourced to Massachusetts if the customer's address in the vendor's books and records is in Massachusetts.)

Sourcing Rules Where Purchaser Provides a Multiple Points of Use (MPU) Certificate


Before explaining how a Multiple Points of Use (MPU) certificate impacts sourcing, it’s important to understand what a MPU is.  A handful of states allow a purchaser of computer services and/or software that will be used concurrently in more than one state to provide their vendor with an "exemption" certificate which transfers the burden of sales tax collection and remittance from the vendor to the purchaser. A MPU does not make the transaction sales-tax exempt as use tax is still owed on the transaction. However, instead of the vendor being responsible for collecting the sales tax, the purchaser becomes the party responsible for remitting the use tax. This also allows the purchaser the ability to determine what proportion of use should be sourced to Massachusetts which in turn determines the amount of use tax the purchaser must remit to the state.

TIR 13-10 addresses sourcing where a MPU is provided and notes that a purchaser will not necessarily source software modification services in the same manner as they would computer system design services.  For instance, sales of software modification services relating to prewritten (i.e., standardized) software should generally be sourced in the same manner as the software to which the services relate. A purchaser may use a method of apportionment reasonably designed to reflect the location of use of the modified software by the purchaser, where such method is consistent and uniform and is supported by the purchaser’s books and records.

On the other hand, even though a purchaser is also allowed to use a reasonable apportionment method for sourcing sales of computer system design services, these services should be sourced to reflect the location of use of the computer system. In general, the location of use is based on where the business utilizes the computer system and is typically limited to the purchasing company’s headquarters or the location where the services were performed.

Transition Rule for Existing Contracts, Filing and Remittance Requirements


Massachusetts sales tax is not due on services related to a contract for computer design services or software modification services that was entered into prior to July 31, 2013 as long as the services relating to the pre-July 31st contract were performed prior to July 31st.  This is the case even if the pre-July 31st services are billed after the law’s effective date.  On the other  hand, any services performed on or after July 31st, even if they relate to a pre-July 31st contract, are subject to sales tax.

Regarding filing and remittance deadlines, the TIR notes that in accordance with Massachusetts' mandatory electronic filing requirements, taxpayers will need to file and pay via the Massachusetts Webfile for Business on-line portal.  The sales tax for services performed on July 31st, or during the month of August 2013, can be reported and paid together by the September 20, 2013 due date for filing electronic Form ST-9, Monthly Sales & Use Tax Return. Taxpayers who will self-report and pay the use tax will report and pay their Massachusetts use tax on their electronically filled Form ST-10, Annual Business Use Tax Return, which will be due on April 15, 2014 for calendar year taxpayers.

Sylvia’s Summation


On July 31, 2013, Massachusetts became one of only four states in the country to impose its sales tax on computer design services (Hawaii, New Mexico, and South Dakota are the other three), as well as software modification services.  Not only is this a significant tax provision, but because the provision was effective just seven days after H.B. 3535 was enacted, vendors/providers of computer system design and software modification services will have to quickly assess the new law’s impact on their business and their sales tax registration, collection and remittance requirements. For some vendors this will represent the first time they will need to deal with sales tax collection responsibilities. And although the Department has issued preliminary guidance in TIR 13-10 and produced a Frequently Asked Questions (FAQ) document (see resources below), as of today’s date, August 2nd, the language in the official site of the Massachusetts General Laws has not been updated to reflect the definition changes made by H.B. 3535.
  
Similarly, the Massachusetts Computer Industry Services and Products Regulation, 830 CMR 64H.1.3 has yet to be updated - thus making portions of the regulation obsolete. (I will note that updating a Regulation is often a longer process as amendments may first be issued in a working draft and comments solicited.  And indeed, TIR 13-10 states, “The Department also anticipates that there will be opportunity for public comment on a working draft of the regulation amendment before it is formerly proposed.”) The point, however, is that for taxpayers/vendors that must comply with the new law immediately, guidance is currently limited, scattered or in conflict with the new law.

But vendors of computer system design and/or software modification services are not the only taxpayers that will need to understand the new law. Purchasers who are not assessed the Massachusetts sales tax by a vendor or who provide the vendor with a MPU certificate are required to self-assess and remit the use tax on the amount sourced to Massachusetts.  Which brings up another point, where the computer system design services or software modification services are concurrently used in multiple jurisdictions and the purchaser gives the vendor a MPU, the purchaser will need to apply a reasonable apportionment method to determine the proportion of use that will occur in Massachusetts, which in turn will impact the amount subject to Massachusetts use tax (an amount that could be subject to future audit). 

And if you think the new law will only impact Massachusetts based vendors, think again! The impact of the new law will also apply to out-of-state vendors of computer design services and/or software modification services that have “nexus” to Massachusetts and a requirement to collect and remit Massachusetts sales tax.

That’s right! Out-of-state computer design/software modification service providers with nexus to Massachusetts will need to collect and remit on Massachusetts contracts to the extent the sale is sourced to Massachusetts unless the Massachusetts customer provides a MPU to the out-of-state vendor.

A recent blog post by The Tax Foundation, a tax policy think-tank, noted that, While a well-designed sales tax taxes services as well as goods, Massachusetts’s change is not well-designed. Computer services are the only service thrown in, and because business-to-business services are not exempted, it will lead to a lot of unintended ‘pyramiding’— taxes on taxes, rather than just on final sales. The bill’s definition of computer and software services is quite broad, perhaps overly so.”  (See “Massachusetts to Have Second Highest Cigarette Tax, Rare Tax on Computer Services, Higher Gas Tax”, by Joseph Henchmen, VP – Legal and State Projects, July 26, 2013) I agree with the Tax Foundation's assessment.  Sadly this is yet another example of State Legislators enacting a tax provision without truly understanding its impact on businesses.   

Back on February 7th, the Department issued Working Draft Directive, 13-XX, in which the Department provided criteria to assist taxpayers in determining whether a transaction is a taxable sale of pre-written software or a non-taxable personal or professional service. I blogged about the Working Draft in my February 11th blog post, “Sales Tax on Cloud Computing, SaaS and Related Business Solutions: Massachusetts Issues Draft Directive, Provides Criteria for Establishing Taxability”.  In that post I noted that the Department had issued the working draft in response to the numerous requests for private rulings from taxpayers seeking additional guidance on Cloud/SaaS based transactions – in particular those that included both a software component and personal and professional services. I anticipate that the Department will be similarly inundated with private ruling requests from providers of computer system design and software modification services that seek more clarity. The Department will also need to update its Cloud Computer/SaaS Working Draft Directive prior to it being issued in final form to coordinate its guidance with the new law changes.     

This is complex change requiring that sales tax be charged on computer system design and software modification services performed on or after July 31st even if those services relate to contracts entered into prior to July 31, 2013.  Additionally, sales tax due must be reported and remitted as soon as September 20th, the August 2013 sales tax filing deadline for taxpayers on an monthly filing frequency.  Once again, there is not a lot of time for impacted taxpayers to prepare.

If the new law has implications for your business you’ll want to seek the assistance of a qualified CPA or attorney, preferably one who is knowledgeable with Massachusetts’ sales tax laws. (Such as your author here, wink!)  All joking aside, if you need assistance with determining how the new law will impact your business, with a ruling request, with whether your (out-of-state) business has nexus to Massachusetts and a requirement to collect on Massachusetts contracts, or simply have questions, please don't hesitate to call me. 


Resources/Links:  Although I have linked to most of these resources in the above post, I've also listed them here for easy reference:

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