To Tax or Not to Tax? Using the True Object Test to Assess Sales Taxability

Cloud computing

By: Betsy Tuck, State and Local Tax Manager at Aprio

At a Glance:

  • The Main Takeaway: In today’s growing, tech-fueled economy, it can be hard to distinguish a “service” from “software,” especially when it comes to assessing sales tax.
  • Impact on Your Business: A recent letter ruling out of Tennessee looks at this issue and applies the “true object” test to determine how a transaction should be classified.
  • Next Steps: This ruling can serve as a guidepost for businesses that operate within the service or software space, in terms of evaluating their sales tax liability.

Need help analyzing the taxability of your services or software? Contact Aprio’s experienced State and Local Tax (SALT) team today.

The full story:

Amid the growing service and software economy, the lines can easily blur between how states distinguish a “service” from “software” for sales tax purposes, particularly when there are elements to both in a single transaction.

In those cases, states typically apply a subjective analysis, known as the “true object” test, to determine whether the transaction should be treated as a license of software versus the provision of a service.  Depending on how a state taxes software and services, this analysis will impact a business’s sales tax obligations. A recent Tennessee letter ruling looks at this issue.[1]

The case in question

Tennessee’s ruling looks at a taxpayer who is in the business of providing web-based data analytics services. The taxpayer collects data from customers, located in Tennessee and other states, and then processes and aggregates data with other third-party data to create data sets for the customer. The taxpayer uses this data in various ways to provide a range of data analytics to its customers. For example, the taxpayer may provide its customer with a digital report summarizing the data and comparing it to the customer’s market and competition. This report is accessed by customers online or digitally — never in hard-copy.

The taxpayer also offers a web-based analytics dashboard for its customers to access online that allows them to perform searches or queries of the underlying data, as well as to create standardized or customized electronic reports. Lastly, the taxpayer offers consulting services to assist customers with data analytics and may provide reports or visualizations to customers through online or digital means.

Customers may be invoiced a single, all-inclusive fee, based on the amount of data processed, the length of access time and the reports/services requested. Alternatively, a customer may request to be charged on an itemized basis. However, in all cases, the taxpayer represented that the customer wants to obtain the data analytics services.

Assessing sales tax with the true object test

Tennessee’s sales tax statute is clear that prewritten software is taxable, whether it is delivered in tangible form, electronically or accessed remotely. However, the statute also states that the use of remotely accessed software “shall not be construed to impose a tax on any services that are not currently subject to tax under this chapter such as, but not limited to, information or data process services, including the capability of the customer to analyze such information or data provided by the dealer.”[1]

In this case, the ruling notes that the taxpayer is using software to provide nontaxable data analytics services, but that it is also providing potentially taxable software by giving customers the ability to use a web-based dashboard to access and view the data and reports. The taxpayer argued that the dashboard is of no value on a stand-alone basis and is not separate from the data analytics service.

When a transaction involves taxable and nontaxable components that are not separable, and the true object of the transaction is the taxable component, then the transaction is subject to tax. However, if the true object is not separately taxable and the potentially taxable items are “merely incidental” to the true object, then the transaction is not taxable.

The ruling agrees with the taxpayer that its sales are not taxable, stating that:

“Although software is used to give customers access to these reports, which may be accessed from locations within Tennessee, this method of delivering the results of the Taxpayer’s services is merely incidental to the data analytics services.”

In other words, although the ruling treated the dashboard as computer software, it is simply provided to view the end results of the data analytics services that the customer is purchasing.

The bottom line

These types of true object analyses are subjective, and two states may reach different conclusions on the same set of facts. Therefore, when a business is providing a service and the customer obtains access to software in connection with that service, it is important to review the guidance in each applicable state to understand how that state may treat the transaction for sales tax purposes.

Aprio’s SALT team has experience in this area and can help businesses analyze the taxability of software and services. Our assistance will help your business understand its sales tax obligations, ensure that you comply with those obligations and do not incur unexpected liability and penalty. In addition, in situations where the guidance is unclear, we can draft a private ruling request to the state to provide clarity and certainty.

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.

Contact Betsy Tuck, SALT Manager at betsy.tuck@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 March 2021 SALT Newsletter.

[1] Tennessee Department of Revenue Letter Ruling #21-01.

[1] Tennessee Code. Ann. 67-6-231.

Disclosure
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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