Arkansas Addresses the Sales Tax Treatment of Bundled Computer Services

Bundling taxable and non-taxable goods/services can give rise to unfavorable sales tax consequences that can catch a seller by surprise and create unexpected tax liabilities.

When analyzing the sales tax consequences of a transaction, the formalities of the arrangement (e.g., what the contract states or doesn’t state, how the invoice is presented, etc.) may often outweigh the substance or intention of the parties.  Thus, when structuring a transaction, particular attention should be paid to the documentation and actual dealings between the parties.

One example of that is the treatment of bundling, which is basically providing two or more products and/or services for one non-itemized price.  While the intention of the parties and the substance of the transaction is that multiple products/services are provided (some of which are taxable and some of which are not), if the documentation is prepared in such a way that the transaction is treated formally as a bundled transaction, then the parties could be facing unexpected sales tax consequences.  On May 7, 2018, Arkansas issued a letter opinion explaining its treatment of a bundled transaction in connection with computer/software services.[1]

The taxpayer provided technical software support to its customers at a flat monthly rate. All software provided as part of that support was downloaded electronically, and most of the support services were provided remotely. In addition, if the customer purchased computer hardware from the taxpayer, any installation was included in the flat monthly price set forth in the agreement.  The service agreements also included a section for out of scope services in which the client was separately billed.

In Arkansas, the “service of initial installation, alteration, addition, cleaning, refinishing, replacement and repair of electronic devices is a service subject to sales tax.”[2] Thus, the initial installation of any computer hardware under the agreement is a taxable service.  Charges for technical support of software are not subject to Arkansas sales tax.[3]

Additionally, a bundled transaction is defined as the “retail sale of two or more products where the products are otherwise distinct and identifiable, and the products are sold for one non-itemized price.”[4]  Sales tax must be collected on such sales if any product in the bundle would be taxable if sold separately.[5]

There are exceptions to the classification as a bundled transaction.  First a transaction is not considered a bundled transaction if one service/product is provided exclusively in connection with a second service, is essential to the use or receipt of the second service, and the true object of the transaction is the second service.[6]  In that case, the transaction is treated solely as the second service, and sales tax is collected if the second service is taxable.

Second, a transaction will not be treated as a bundled transaction if the taxable item is de minimis, which means that the seller’s sales price or purchase price of the taxable item is no more than 10 percent of the total purchase price or sales price of all items.  For purposes of determining whether the taxable item is de minimis, the seller must use the full term of a service contract, and it may use either sales price or purchase price, but cannot use a combination.[7]

Based on these rules, the taxpayer’s transaction will be a taxable bundled transaction due to the taxable computer hardware installation component unless either (1) the computer hardware installation service is provided exclusively in connection with and is essential to the receipt or use of the nontaxable software support services, and the true object of the transaction is the nontaxable software support services, or (2) the taxable computer hardware installation service must be de minimis.

In this case, the taxpayer’s service agreements did not state or demonstrate that the installation of computer hardware is provided exclusively in connection with the service of software support. Thus, the true object test is not met. Additionally, the agreement did not provide the purchase price or sales price of the taxable computer hardware installation service, so there was no evidence to show that the de minimis exception was met. Thus, the taxpayer did not meet either of the exceptions, and the entire charge is subject to Arkansas sales tax.

This ruling demonstrates (i) the importance of understanding the sales tax treatment of a transaction when more than one product/service is being provided and (ii) that advanced planning may have been able to change that sales tax treatment (i.e., provide the appropriate information in the agreement or separately charge for each item).  Aprio’s SALT team is experienced in understanding these complex and often formalistic state sales tax rules, and we can assist you to ensure that you are in compliance and do not incur unexpected sales tax exposure.  We constantly monitor these and other important state and local tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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

This article was featured in the June 2018 SALT Newsletter.

[1] Arkansas Letter Opinion No. 20170703 (May 7, 2018).

[2] Ark. Code Ann. § 26-52-301(3)(B)(1)(i)(g); Ark. Regs. GR-25(D).

[3] Ark. Regs. GR-25(H)(1).

[4] Ark. Code Ann. § 26-52-103(2)(A).

[5] Ark. Regs. GR-93(A).

[6] Ark. Regs. GR-93(D)(1).

[7] Ark. Regs. GR-93(D)(2).  For purposes of determining whether the taxable item is de minimis, the seller may use either sales price or purchase price, but cannot use a combination.

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.