Dissecting Maryland’s Taxation of Digital Products: Part 2 – The Treatment of Software as a Digital Product

Earlier this year, the Maryland General Assembly enacted House Bill 932, which amended the state’s sales tax laws to make sales of digital products subject to tax. As noted in the fiscal policy note accompanying the legislation, the change in the law was needed to recoup lost revenue caused by consumers now buying products in digital form. In short, Maryland’s sales tax law needed to be modernized to keep pace with the digital economy.

Shortly after the Maryland General Assembly approved the change to make digital products subject to sales tax, the Comptroller published Business Tax Tips #29, which represents the Comptroller’s interpretation of the term “digital product.” Included in the scope of digital products, as described by the Comptroller, is electronically delivered software and Software-as-a-Service (i.e., SaaS). Depending on one’s reading of the law change, the inclusion of these software items in the term “digital product” is either a perfectly reasonable interpretation of the law or clearly at odds with the plain language of the legislation. The taxation of electronically delivered software and SaaS is nothing new. Approximately 20 states now tax SaaS, with an even larger number taxing electronically delivered (i.e., downloaded) software. However, most states have addressed software separately from other digital products, such as downloaded movies, music, books and streaming services.

Admittedly, Maryland’s sales tax law now defines “digital product” rather broadly as a product that is “obtained electronically or delivered by means other than tangible storage media using technology having electrical, digital, magnetic, wireless, optical, electromagnetic, or similar capabilities.”

However, the law goes on to provide that the term “digital product” includes the following:

• A work that results from the fixation of a series of sounds that are transferred electronically, including prerecorded or live music or performances, readings of books or other written materials, and speeches
• Audio greeting cards sent by e-mail
• A digitized sound file such as a ring tone, that is downloaded onto a device and may be used to alert the user of the device with respect to a communication
• A series of related images that, when shown in succession, impart an impression of motion, together with any accompanying sounds that are transferred electronically, including motion pictures, musical videos, news and entertainment programs, live events, video greeting cards sent by e-mail, and video or electronic games
• A book, generally known as an “e-book,” that is transferred electronically
• A newspaper, magazine, or periodical

Interestingly, the word “software” is not included anywhere in the list above. Further, software products do not seem to neatly fit into any of the products described above. Instead, the list above includes products and services such as downloaded music and movies, streaming music services, streaming television program services, ring tones, video games, and electronically transferred books and periodicals. It’s true that video games are a form of software. However, the sales tax law includes video games in the group of taxable digital products that impart “an impression of motion, together with . . accompanying sounds.” Clearly, this provision is not intended to treat all software products as being subject to Maryland sales tax. The vagueness in the law that potentially results in the term “digital product” being broader than the list above lies in whether the items listed were intended to be an exhaustive list of taxable digital products or merely examples. Clearly, as reflected in Business Tax Tips #29, the Comptroller believes it’s the latter.

Assuming that the Comptroller is correct, the general definition of “digital product” as being any “product that is obtained electronically or delivered by means other than tangible storage media” results in additional items, such as electronically delivered software, being subject to Maryland sales tax. Still, the Comptroller has arguably taken additional liberties by including items such SaaS and streaming services in its interpretation of a taxable digital product, as these items are likely never “obtained” by or “delivered” to a customer. It will be interesting to see if the Comptroller’s interpretation of the law is challenged. For now, despite the Comptroller’s interpretation of the law potentially being overly-broad, it would be prudent for taxpayers to defer to the guidance in Business Tax Tips #29.

As described in Business Tax Tips #29, Effective March 14, 2021, the sale of canned or commercial off-the-shelf (“COTS”) software obtained electronically by a buyer is treated as a sale of a digital product and is subject to Maryland sales tax. The Comptroller further provides that the sale of SaaS is also subject to the sales tax. However, customized software that is electronically delivered is not subject to Maryland sales tax. Compared to many other states that exempt customized software from sales tax, Maryland’s exemption, as interpreted by the Comptroller, appears to be rather broad.

Notably, an exempt sale of customized software includes a sales where the software must be customized, configured, or modified “to perform the functions required for the software to operate as intended.” Thus, sales of software that would otherwise be considered a taxable sale of canned or COTS software will be exempt from Maryland sales tax if the software must be configured or modified in order to work as intended on the customer’s computer systems. As explained by the Comptroller, a sale of software that does not “operate immediately as required by the buyer (i.e., out of the box)” is an exempt sale of customized software.

Thus, many software purchases made by businesses will be exempt from tax. For instance, Business Tax Tips #29 provides an example whereby an exempt sale of customized software includes a businesses’ purchase of a software product that needs to be configured before it can interface with the existing systems used by the business. Interestingly, there is no requirement that the configuration or modification be done by the seller of the software. The purchaser of the software can engage a third party to perform the configuration or modification, which will result in the purchase of the software from the seller not being subject to Maryland sales tax. So long as the purchaser provides notification to the seller of the software that the software will be customized, configured, or modified in order to operate as required by the buyer, the duty of the seller to collect sales tax is waived.

The Comptroller’s guidance on what constitutes a sale of customized is somewhat broader than other states that similarly do not impose sales tax on customized software or software customization services. The customization, modification, or configuration performed by the third party in the scenario above would not render the initial sale of a canned software product as exempt from tax in most states that impose their sales tax on canned but not customized software. For example, Massachusetts, New York, North Carolina and New Jersey would continue to treat the sale or license of the canned software subject to tax, but would treat the any customization services performed on such software as exempt from tax if the charge for such services are separately stated to the purchaser.

It’s certainly possible that the guidance issued by the Comptroller could be modified in the months to come. Thus, tax practitioners and sellers of software need to continue to monitor develops in this area. In part three of this blog series, Aprio will discuss the Comptroller’s controversial inclusion of certain education services as being taxable digital products. If you missed part one of the series, catch up here.

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