Tax Challenges Of The Software-Powered Economy

“Software is eating the world,” wrote Marc Andreessen in The Wall Street Journal in 2011. Eight years later, in a Forbes article, Peter Bender-Samuel observed that software may be eating the world, but services are now eating software. The “as-a-service” model has proven to be more efficient and productive than owning the software. Companies are increasingly opting to use software delivered in the cloud rather than building their own data centers. Initially, we had software as a service (SaaS), infrastructure as a service (IaaS), and platforms as a service (PaaS). Gradually, these concepts evolved into a single comprehensive option, “everything as a service”, also known as XaaS. XaaS refers to products, tools and technologies that are accessed as needed over the Internet rather than being provided locally to customers. The global XaaS market size was estimated at USD 436.82 billion in 2021 and is expected to reach USD 2,378.07 billion by 2029.

We’re now in an age where XaaS has become the most accessible and universally accepted software model in the industry. However, indirect taxes may have fallen short of supporting these software-enabled economy shifts. First, in some countries, the tax treatment of XaaS is much more complex than that of traditional business models. Second, double taxation may occur if countries disagree on where XaaS is taxable. Third, some countries are discussing applying import duties to digital transmissions. Let’s take a closer look at each of these issues.

Sales tax complexity

US sales tax laws are notorious for their complexity regarding the tax treatment of software and SaaS in particular. There is no unanimity to what SaaS is: some states view it as tangible personal property while others regard it as a service. Pennsylvania classifies the provision of software regardless of method of delivery as a sale of tangible personal property which is generally taxable. California does not tax software that is conveyed solely electronically or through the cloud because it does not consider it to be tangible personal property. Texas treats SaaS and cloud computing as taxable data processing services which are subject to a 20% exemption, so effectively, 80% of a company’s SaaS revenue stream is subject to local sales tax.

Factors like usage may also influence the taxability of SaaS. For example, in Connecticut, SaaS for personal use is taxed at full state rate, while SaaS for business use is taxed at 1%. Maryland does not tax the provision of software for business use at all. In contrast, Ohio collects sales tax on SaaS when used in business, but generally does not require sales tax on SaaS when intended for personal use. Tax calculations may become even more complex if cloud computing services are used in more than one state. If some users are located outside the state, the SaaS charge may have to be apportioned and the part of the charge representing out-of-state use may benefit from an exemption from local tax.

SaaS providers with customers in home rule jurisdictions where local governments administer their own sales tax are faced with an even greater patchwork of inconsistent rules. Home-rule jurisdictions may levy local sales tax on transactions that are exempt from state sales tax, or exempt sales that are subject to state sales tax. For example, Colorado exempts SaaS at the state level but many of its home-rule jurisdictions including Denver consider it taxable. Illinois doesn’t levy its retailer occupation tax on SaaS but Chicago applies its Personal Property Lease Transaction Tax to SaaS and other cloud computing services provided to users physically located in Chicago.

Double taxation risks

In countries that levy value added tax (VAT), the tax treatment of SaaS is much simpler than it is in the United States. As VAT is a broad-base tax that applies to all supplies of goods and services unless explicitly excluded, the provision of SaaS is generally taxable and subject to the standard VAT rate. However, the tax treatment of SaaS may become slightly more complex in countries that have implemented use and enjoyment rules. These rules shift the place of taxation of services from the customer or seller’s country to the place where the service is effectively used and enjoyed. Let’s illustrate this with a practical example.

A German business provides cloud computing services to another German business for use at its UK branch (which does not constitute a fixed establishment for VAT purposes). From the perspective of German tax law, the sale is subject to German VAT because services provided to other businesses are generally taxable where the customer is established. Germany does not apply any use and enjoyment rules to sales of digital services. However, the UK applies such rules and considers the sale to be taxable there, where the services are effectively consumed. This result is that the same transaction is subject to both German and UK VAT. This runs contrary to the purpose of the use enjoyment rules, which were designed to prevent double taxation and non-taxation. However, as countries do not apply them in a coordinated manner, the use and enjoyment rules may actually create the problem that they were supposed to prevent.

Import duties debate

Software can be transmitted electronically or carried on hardware when sold to customers in other countries. As customs duties are levied only on imports of tangible property (goods), there is no customs duty impact when software is transmitted electronically. In 1998, members of the World Trade Organization agreed not to impose customs duties on electronic transmissions. The 1998 Moratorium on Customs Duties and Electronic Transmissions is not set in stone but must be extended every two years, as it was most recently in June 2022.

Some countries, such as India, Indonesia and South Africa, have indicated a desire to end the moratorium and to impose customs duties on software delivered electronically. Their argument is that the digitization of previously physical goods has led to losses in customs revenue. Indonesia has already implemented new tariff rules for electronically transmitted software and products.

While revenue losses are a legitimate problem, a unilateral imposition of customs duties on electronic transmission may have a distorting effect on the growth of the digital economy and is very expensive and technologically infeasible to implement. While customs duties and import taxes on physical goods can be assessed when these goods enter a country’s territory, it is difficult to imagine how to collect customs duties on invisible data flows transcending national borders.

Conclusion

The world is increasingly driven and enabled by software. SaaS has disrupted product lifecycles and value chains across multiple sectors, allowing companies to be more agile and innovation-focused. Yet, at the same time the world of software taxability is highly complex and uncertain, and tax regulations at all levels of government have not managed to keep up.

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