Michigan Letter Ruling Addresses Sales Tax Treatment of SaaS

By: Tracey Stewart, SALT Associate

At a glance

• The main takeaway: A private letter ruling issued in Michigan re-affirms its position that the sale of remote access to software (SaaS) was not a taxable transaction.    
• Assess the impact: This ruling is an important reminder that while selling SaaS transactions may be nontaxable, when some software is downloaded, the transaction may be taxable depending on whether the software is incidental to the services provided.  
• Take the next step: Aprio’s State and Local Tax (SALT) team can assist your business to determine if your software transactions are subject to sales tax.

Schedule a free consultation today to learn more!

The full story:

On January 31, 2024, the Michigan Department of Treasury issued a letter ruling on the sales tax treatment of services accessed via remotely-hosted software as a service (SaaS) or through a free application that can be downloaded to various devices like a mobile phone or tablet.

A closer look at the case

The taxpayer is based outside of the United States and hosts software on servers located outside of Michigan. The taxpayer sells subscriptions to access information hosted in the cloud through a web portal or by a free downloaded application. The information is customized for each customer based on an algorithm that utilizes the customer’s responses to a series of questions. The ruling states that these services are “fundamentally Software as a Service, and the majority of [s]ervices are unattainable without access to the Internet.” The free application does offer some limited functions that are available to anyone that has downloaded it.       

Unpacking the ruling

In Michigan, sales tax is imposed on retail sales of tangible personal property, and the definition of tangible personal property includes prewritten computer software.^[1] Prewritten computer software is defined as “computer software, including prewritten upgrades, that is delivered by any means and that is not designed and developed by the author or other creator to the specifications of a specific purchaser.”^[2]

First, the ruling addressed the taxpayer’s SaaS (i.e., the services that the customer accesses directly through software hosted on the internet). The ruling relied on a prior Michigan Court of Appeals case that addressed a similar situation.^[3] In the Auto-Owners case, the court addressed software hosted on a third-party server that a user merely accessed through a website. The court concluded that the software was not taxable because it did not satisfy the definition of “prewritten computer software” since it was not “delivered by any means.” Based on this guidance, the ruling similarly concluded that for sales that do not involve any downloaded software, the taxpayer’s SaaS does not meet the definition of prewritten computer software and is therefore not taxable.

Second, the ruling looked at the taxpayer’s services that are used by customers through software that was download to a mobile phone or tablet. Again, it relied on guidance provided by the court in the Auto-Owners case. In that case, the court examined services where some software was electronically delivered to the user (i.e., a local client or desktop agent). The court explained that electronically delivered software is prewritten computer software, and therefore is taxable because it satisfies the definition of tangible personal property. However, since the transaction involves both a sale of taxable tangible personal property and a nontaxable service for one price, it is necessary to evaluate what the ruling refers to as the “incidental to service” test as was done in the Auto-Owners case.^[4]

The “incidental to service” test looks objectively at the entire transaction to determine whether the transaction is principally a transfer of tangible personal property or a provision of a service, and considers the following factors (none of which is dispositive):

1. What the buyer sought as the object of the transaction;
2. What the seller or service provider is in the business of doing;
3. Whether the goods were provided as a retail enterprise with a profit-making motive;
4. Whether the tangible goods were available for sale without the service;
5. The extent to which intangible services have contributed to the value of the physical item that is transferred; and
6. Any other factors relevant to the particular transaction.

Based on these factors, the ruling concluded that the downloaded application was incidental to the sale of the services, and therefore, this transaction constituted the sale of nontaxable services. The ruling noted that the taxpayer was in the business of providing services, the buyer sought those services, and the taxpayer charged for those services and not for the software. In addition, the software itself was not useful (outside of some limited functionality) without also paying for the services.

The bottom line

This ruling is important to taxpayers involved in selling SaaS and serves as a reminder that the state does not tax software when users merely access the software through the internet. When downloadable software is involved, the state will apply the “incidental to service” test to determine the overall treatment of the transaction. This is a subjective test, and different jurisdictions may reach opposite conclusions. Aprio’s SALT team has experience with these types of situations and can assist your business to determine its sales tax obligations so that you do not incur any unexpected tax liabilities and penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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[1] MCL 205.52(1) and MCL 205.51a(r).

[2] MCL 205.51a(p).

[3] Auto-Owners Ins Co v Dep ‘t of Treasury, 313 Mich. App. 56 (2015).

[4] In most other states, this is commonly referred to as the “true object of the transaction” test.