Arizona Rules on Taxability of Transaction Processing Services through Computer Software

Arizona ruled a transaction was a non-taxable service instead of taxable software because the taxpayer’s client did not have sufficient control or use of the software.

By Tina Chunn, SALT senior manager

Online transaction (i.e., payment) processing services delivered through the use of computer software can present challenging issues for business when it comes to determining taxability for sales and use tax purposes. [1] Any time remote computer software, or SaaS, is involved in a transaction these days, there is the question of whether the state will classify the overall transaction as SaaS (and then determine taxability based on that classification) or whether it will classify the transaction as a service that involves, to some extent, the use of remote access software (and then determine the taxability based on the particular service classification). [2] Thus, the challenge for taxpayers is not really the issue of taxability; it is the issue of how to classify the transaction in the first place. States take into account different factors regarding these transactions which must be analyzed to assist in determining the treatment on a state-by-state basis.

Recently, Arizona issued a ruling in which it determined that the transactions at issue were not taxable under the personal property rental classification of the state’s transaction privilege tax, which is the classification that the state uses for taxable SaaS transactions. [3] Arizona’s transaction privilege tax differs from traditional state sales and use taxes as it is a tax on the privilege of conducting business in the state of Arizona. It is levied on the seller (who can legally pass on the economic expense of the tax to the purchaser) and is imposed under 15 separate business classifications including the personal property rental and retail classifications. [4]

The taxpayer is a subscription billing and reoccurring payment provider located outside of Arizona, but with clients within the state. The taxpayer assists with the processing of electronic payment transactions on a time-determined basis on behalf of its clients for the products and services that its clients sell to consumers. The taxpayer’s clients offer products and services such as content site subscriptions, newsletter fees, club dues or even recurring donations.

Both the taxpayer and its client use the software. The taxpayer stores the end user customer payment data on its servers after it is uploaded by the client to the taxpayer’s servers via an application program interface (“API”) which is cloud-based, and uses that information to request payment through third-party payment processors. [5] The taxpayer updates information on a web-based portal so the client may see the status of payments processed and other analytical information. The client can access the status of payments and may also make changes to update its customer payment data as needed. Clients pay the taxpayer based on the dollar amount of successful payments generated and not as a fixed amount or based on software usage.

Arizona ruled that although the API and web-based portal may be considered software, the client is not provided the right to use the software for a perpetual duration, and therefore, the transaction cannot be considered taxable under the retail classification. [6] Further, Arizona ruled that the client does not gain sufficient control and use of the software to classify the transaction under the personal property rental classification. In support of that conclusion, the state notes that the taxpayer is based on successful payments generated and not based on a fixed amount or on software usage. As such, Arizona determined that the taxpayer is providing a non-taxable service for Arizona transaction privilege tax purposes. It is worth noting that the fact that the agreement between the taxpayer and its clients that refers to the transaction as a software license was not definitive.

Since all online transactions involve computer software to some extent, it is important for sales and use tax purposes to distinguish between true remote software access services (or SaaS) and other services vendors provide that are accomplished through the use of software. This distinction can be difficult to draw sometimes, but is crucial in order to determine whether or not a transaction is subject to sales tax.

Aprio’s SALT team is experienced at reviewing these transactions and assisting our clients in making these types of determinations on a state-by-state basis. We continually strive to keep our clients advised of important issues and developments in state and local taxes in order to help them address their specific tax situations. We will continue to monitor these and other significant tax developments and include any updates in future issues of the Aprio SALT Newsletter.

Contact Tina Chunn at tina.chunn@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the April 2017 SALT Newsletter. Click here to view the full newsletter.

[1] These services are sometimes referred to as software-as-a-service or SaaS by the states.

[2] Generally, if the transaction is classified as SaaS, taxability will depend specifically on whether or not the state views SaaS as taxable. If the transaction is classified as a service, the transaction is likely to be treated as non-taxable unless the state rules specifically identify such service as taxable.

[3] State of Arizona Taxpayer Information Ruling LR16-011, Sept. 23, 2016.

[4] These classifications are similar to sales and rental transactions subject to sales tax in other states.

[5] The taxpayer is not a payment processor. Payment processing services are provided separately by a third party unrelated to the taxpayer contracted by the taxpayer’s client.

[6] The access to the API and web-based portal are discontinued if the client does not continue to make agreed-upon payments.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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