Sales Tax Treatment of a Single Offering Containing Multiple Products/Services

As traditional products such as software move to a more service-based approach through hosted environments, it is increasingly difficult to answer the basic question of whether a sales transaction is a product or service offering.

As new products and services are constantly being introduced into our economy, it can often be difficult to determine whether something will be subject to sales tax in each state.  Many times the state may not have addressed that service or product specifically in their governing regulations, which can often lead to differing interpretations from state to state.  Further, as traditional products such as software move to a more service-based approach through hosted environments (i.e. cloud computing), it is increasingly difficult to answer the basic question of whether a sales transaction is a product or service offering.

Many states use a “true object test” to determine whether the invoiced item should be treated as a product or service in determining if an item is subject to sales tax.  The true object test is applied when physical items are included in a service offering to help determine the main purpose of the transaction (the true object).  If the main purpose of the transaction is the purchase of property or equipment and only secondarily the services to support those goods, then the entire transaction is treated as a sale of a product and is subject to sales tax.

Conversely, when you provide a physical product with a service, but the product is secondary to the service, taxability is based on the real object of the transaction which is the service provided.  For example, when a lawyer drafts a contract or an accountant prepares a tax report, although the client receives a document that constitutes tangible personal property, the transaction is considered to be a sale of a service rather than a sale of property because the client’s true object is the lawyer’s or accountant’s service.  The test may also be applied when multiple services are provided, some of which are taxable and some are not.

Not all states formally adopt the true object test, although those that don’t often use other similar measures to determine how a transaction should be categorized, such as whether one product/service is incidental to another or whether one product/service is the primary offering among multiple offerings.  New York, which does not formally adopt the true object test, has recently issued two Advisory Opinions addressing the sales and use tax implication of certain transactions by utilizing these alternative approaches.

The first Advisory Opinion addresses the treatment of a taxpayer’s cloud computing product offering for sales tax purposes. [1] The offering provides customers with computing infrastructure over the Internet, using virtual servers (the server is not specific to a customer; rather the customer is granted access to portions of a server as determined by the quantity of memory and storage requirements they have purchased) to run applications or host a website.  As part of the offering, the taxpayer provides software and other content to customers at no extra charge.  This software content includes specific operating systems (similar to Windows) and programing kits to enable ease of use on these servers for the customers to build their own programs in this environment.  At issue was whether the cloud computing offering constituted the sale of prewritten software, which is subject to sales tax in New York.  New York determined that the primary purpose of the offering was to provide customers with computing power to run applications and that any use of prewritten software was incidental.  Since providing a customer with computing power is not a taxable service in New York, the entire cloud computing product offering was not taxable.

The second Advisory Opinion required New York to examine the treatment of a drop shipment service for sales tax purposes. [2]  In this opinion, a company is providing a drop ship master service to major retailers in the Internet retail industry. This service combines advisory services, networking and data processing capabilities that connect e-commerce retailers to third-party manufacturers and distributors who can fulfill the retailer customer orders. The service allows the retailers to offer products on their websites without the costs and logistical issues of actually warehousing or stocking such products themselves; rather, orders can be shipped to customers directly from suppliers’ inventory warehouses. Certain advisory and technical services are also provided, including the formulation of a drop shipment strategy and operational procedures. This service requires the transmission and processing of data for the purposes of connecting these retail orders to the supplier locations for shipment.  Upon review, New York ruled that the primary function of the service is not the transmission of the data (which is a taxable service in New York) but the processing of the data (which is not taxable in New York) between the retailer and supplier systems in order to complete the customer’s order and have it shipped to their location from the supplier. Thus, the service is not subject to sales tax in New York.

As you can see, when a company’s single offering consists of multiple products and/or services, it is not always clear how the entire offering should be categorized for sales tax purposes.  These are often fact-sensitive analyses that look at the written agreement between the parties, the way the offering is invoiced and other relevant factors.  At HA&W, we strive to keep our clients advised of these important rules in order to help them address their specific tax situations.  As always, we will continue to monitor these and other significant sales and use tax developments, and include any updates in future issues of the HA&W SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of HA&W’s SALT practice, for more information.