Is Vendor-Hosted Software Taxable? A New Rhode Island Ruling Offers Clarity to Providers

For sales tax purposes, when classifying a transaction as taxable software or a nontaxable service, states will often apply the “true object” test, and if the software is actually providing the service, then the state is likely to characterize the entire transaction as taxable software.

By: Kristen Mantilla, State & Local Tax Associate at Aprio

The Rhode Island Division of Taxation (which we’ll refer to as the “State”) recently issued a declaratory ruling pursuant to a request from a company (referred to as the “taxpayer”) regarding the taxability of its vendor-hosted, prewritten computer software, which it uses to provide customers with access to its services.

The ruling can serve as an example for other providers — particularly those located in Rhode Island — in determining what is and isn’t considered a nontaxable service.[1]

Unpacking the details of the ruling

The taxpayer electronically provides marketing analytics services using proprietary software and an online dashboard to help its customers develop advertising strategies and evaluate the effectiveness of advertisements and advertising campaigns. The taxpayer provides multiple services through its software, which it describes as follows:

1. Media Measurement: Customers obtain real-time advertising data to monitor and evaluate the reach and frequency of their advertisements, and can use the software to compare their data metrics with competitors’ metrics.
2. Attribution: Customers can measure the influence of their ad campaigns against business outcomes (i.e., how their ads drive website visits, product page visits, sales, etc.). In addition, customers can retrieve metrics from the software to measure the online conversion events that matter to consumers and discover how television is contributing to their business outcomes in real-time.
3. Marketing Stack Integration: The taxpayer’s software can integrate with customers’ existing marketing technology tools, allowing them to upload and combine different third-party data sources into the platform to further refine their marketing analytics.
4. Professional Services: The taxpayer provides custom reports and analyses, powered primarily by its software. The taxpayer typically delivers these services by third-party software licensed as a software as a service (SaaS) product, an installed software product or a customer’s Excel report, on either a weekly or monthly basis.

The services described above are accessible through the online dashboard that is provided on the taxpayer’s website, which allows customers to view, download and filter the taxpayer’s metrics. The taxpayer does not provide any electronically downloaded software to its customers. Instead, customers pay a license fee that allows them to access the software, which provides the services. The fees may either be separately stated by service or as a component of the purchase price.

The argument for assessing the software’s taxability

For Rhode Island sales tax purposes, charges for remotely accessed software are taxable because the term “sale at retail” includes “vendor-hosted, prewritten computer software.”[2]  However, the taxpayer argues that the software and the services provided via the software are distinct and identifiable products sold together for one subscription fee and that the real object of the software is to obtain the services. In other words, the taxpayer’s customers are purchasing nontaxable data processing and information services, and the software is merely incidental to the provision of those services.

The State disagreed with the taxpayer’s assertion and determined that the software and the services it provides are clearly intertwined and inseparable; one cannot exist without the other, and the software is what provides those services through its various functions. Therefore, the State concluded that the real object of the taxpayer’s transaction is the software, and since the software is taxable, the entire transaction is taxable.

The bottom line

For many software providers, it’s not always clear whether a transaction should be treated as the provision of the software or as a service for sales tax purposes. In some cases, it may be advisable for providers to seek a ruling from the state in which they do business to provide clarity.

Aprio’s State & Local Tax (SALT) team has experience addressing these issues for a multitude of different businesses, including software providers. We can assist your business with determining the proper treatment of your transactions so that you remain compliant with your sales tax obligations and do not incur unexpected liabilities and penalties. If appropriate, our SALT team can also draft ruling requests and work with your state to obtain clear guidance.

As a team, we constantly monitor these and other important state tax topics, so that you’re constantly up-to-speed on the changes and rulings that matter most to your business. Keep an eye out for significant developments on this topic in future issues of the Aprio SALT Newsletter.

Contact Kristen Mantilla, SALT Senior Manager at kristen.mantilla@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 February 2021 SALT Newsletter.

[1] Rhode Island Ruling Request No. 2020-03, December 29, 2020.

[2] R.I. Gen. Laws § 44-18-8.