Summary: A Tennessee revenue ruling concluded that a business’ sale of its mobile healthcare solution was subject to sales tax because the true object of the transaction was the taxable sale of software.
States are increasingly viewing services delivered through software as a service (SaaS) or cloud platforms as taxable sales of software, rather than nontaxable services. The recent issuance of Revenue Ruling 25-08 by Tennessee’s Department of Revenue (the Department), highlights this notable trend by subjecting Tennessee sales tax on a taxpayer’s subscription fees for a mobile healthcare app, which tracks certain health metrics of an individual user, including blood pressure, pulse, weight, and activity level. The rationale was that the “true object” of the sale is the remotely accessed software (i.e., SaaS), not the service it delivers.
Software Delivery: Why are States Taxing SaaS?
With the shift in software delivery from physical media and downloads to cloud-based access, it’s no surprise to see an increasing number of states imposing sales tax on SaaS. To avoid losing sales tax revenue, many states have responded by expanding their definition of or interpretation of taxable “tangible personal property” or other computer-related services, or by enacting legislation that clearly imposes sales tax on SaaS.[1]
A Changing Tax Landscape
A state deciding to impose sales tax on cloud-based software accessed when it used to only tax software delivered on a disc or downloadable by the customer may have been a predictable change. From a policy perspective, the customer experience is often quite similar regardless of the delivery method. However, what is concerning is when states begin taxing services that were traditionally nontaxable, simply because of technological advances enables providers to offer those same services to be delivered through cloud-based software. Currently, there is no indication that this trend will slow. In fact, as more of the “services” we purchase become accessible over the Internet, we should expect that the application of sales tax to such services will only become more common.
The Role of Marketing and Agreements
How a service is marketed and the language used in license agreements can often influence whether a state considers it a taxable software. It’s common for digital services to be marketed as “platforms,” and customer agreements to explicitly mention a license of software. Of course, this doesn’t mean that service providers should change how they market their services or rewrite their customer agreements. In fact, it’s often advisable to avoid letting tax considerations drive decisions on effective marketing strategies and IP protection. However, providers need to be aware of the tax implications tied to these aspects of their businesses, including the risk of significant sales tax assessments if they fail to collect sales tax on subscriptions fees.
A Breakdown of Tennessee Revenue Ruling 25-08
Tennessee Revenue Ruling 25-08 involved a taxpayer who sold a mobile healthcare solution designed to promote improvements in heart health management. The Taxpayer’s customers were employers, who then offered access to the solution as part of their employees’, and their family members’ (participants), medical benefits. The participants were able to access the solution by downloading an application (app) onto their mobile device.
The digital subscription fees covered several components:
- A non-assignable, non-exclusive, nontransferable software license to use the app. The app included tools to track and understand blood pressure, pulse, weight, and activity levels; medication adherence tools; wellness tips to improve blood pressure over time; and the ability to download reports with heart rate data from the app.
- FDA-approved Bluetooth enabled blood pressure monitors for the participants to use, which only work in conjunction with the subscription.
- Enrollment engagement and ongoing technical support, which included marketing materials, such as emails, video, postcards, and posters to engage eligible and enrolled participants. In relevant cases, the Taxpayer can also reach out to participants via phone or text (with consent).
- Live enrollment support that included email, mail, and phone access when required, and onsite enrollment for certain larger customers/employers.
- Annual and quarterly dashboards where the employers could view engagement levels and population clinical parameters, such as hypertension levels.
All of the subscription features described above were sold for a single bundled price (i.e., there was not a separately itemized price for each item). In Tennessee, sales tax specifically applies to electronically delivered and remotely accessed software, whereas services are generally not subject to sales tax unless the service is specifically listed as taxable.
Understanding the Department’s Ruling
Due to the overall sale including both taxable and nontaxable elements, the Department proceeded to assess whether the transaction should be treated as a “bundled transaction” or a “mixed transaction.” While somewhat similar in nature, “bundled transactions” and “mixed transactions” are treated differently for sales tax purposes. The Department defines a “bundled transaction” as one that includes two or more standalone products sold for one non-itemized price. Under Tennessee’s rules, as well as several other states, when a bundled transaction contains at least one item that is subject to sales tax, the entire sales price is subject to sales tax.
In contrast, a “mixed transaction” is a sale of closely related taxable and non-taxable components that generally would not be sold as separate products. Rather than the taxable component automatically “tainting” the entire sale, as is the case in Tennessee with a “bundled transaction,” the Department provided that the taxability of a “mixed transaction” is determined by applying the true object test. The true object test, which can be viewed as somewhat flawed due to the inherent subjectivity, was described in the ruling as looking to the totality of the facts and circumstances to determine what “objective is really being accomplished by the transaction.” When the true object or integral element of the transaction is the taxable component, then the entire transaction is subject to sales tax regardless of how it is invoiced. If the true object is determined to be nontaxable components, then the sale is not subject to sales tax.
In Ruling 25-08, the Department concluded that the Taxpayer’s sales were mixed transactions because the components of the transaction were not sold separately and several of the components had little to no value without the others. For example, the blood pressure monitors only worked with the app, and an employer would have no use for the engagement materials or enrollment support without access to the Taxpayer’s software. Ultimately, the Department reasoned that the objective being accomplished by the Taxpayer’s transactions was to provide a health-related mobile app that tracks activity, blood pressure, and other information, and offers tools to help participants improve their blood pressure and overall wellbeing, all of which are performed by the software app (rather than by a medical professionals or other individuals). Therefore, the Department concluded that the true object of the transaction was the taxable sale of remotely accessed software.
Final Thoughts: Be Proactive on Sales Tax
The Tennessee ruling is just one in a series of similar decisions in recent years. It serves as a crucial reminder to service providers who sell their services online, through an app, or over digital platforms. Providers should proactively evaluate the sales tax implications of how customers access their services, the marketing strategies behind their offerings, and the way their service agreements define those offerings.
If any critical elements of your service offerings are delivered or accessed through software, it’s important to review your sales tax collection obligations and continue to monitor those obligations as sales increase and expand to additional states.
[1] For example, Texas takes the position that license fees for remotely accessed software are taxable as “data processing.” See e.g., Texas Private Letter Ruling No. 20180411151546 (Feb. 22, 2019).
