Income tax considerations for software providers
Like state sales tax, there are several state income tax considerations for software providers.
Considerations include:
- Nexus
- Apportionment formula
- Sourcing of sales
Income tax nexus
For state income tax purposes, a software provider may establish nexus in one of three ways:
- Physical presence
- Economic nexus
- Factor-presence nexus
Physical presence
Physical presence nexus is generally triggered in the same way as nexus for sales tax purposes.
In relatively few jurisdictions, such as Delaware, state income tax nexus can only be triggered by physical presence.
Economic nexus
Economic nexus standards for income tax arise from jurisdictions’ deriving income from this state income tax nexus provisions.
While deriving income from this state is generally not a defined term, jurisdictions have been using the Wayfair case as a foothold to take the position that if a software provider lacking physical presence in a jurisdiction has economic nexus for sales tax purposes, then economic nexus is likely triggered for income tax purposes.
Factor-presence nexus
Finally, states such as California and Colorado utilize a factor-presence standard to determine nexus for income tax purposes.
Typically, factor-presence nexus is established by having a specified amount of property, payroll, sales, or a certain percentage of worldwide property, payroll, or sales in a taxing jurisdiction.
Public law (PL) 86-272 and state income tax
PL 86-272 is a federal statute that exempts out-of-state businesses from the imposition of state or local income tax if the business' only activity in the state is soliciting orders of TPP that are approved at and fulfilled from points outside the taxing state.
This is applicable to software providers, including SaaS providers, because several jurisdictions, such as Massachusetts and Pennsylvania, consider the provision of software, regardless of method of delivery, to be a sale of TPP.
Other jurisdictions, such as New Jersey, also find the sale of software, but not the provision of cloud-based access to software such as SaaS, to be a sale of TPP even if delivered electronically. Therefore, as held in the New Jersey case Accuzip, Inc. v. Division of Taxation, PL 86-272 protections would apply to most software providers, except cloud-based software providers. However, a determination of the sale as TPP is of utmost importance because sales other than TPP such as royalties, rentals, and services, are not protected by PL 86-272.
Solicitation
The term solicitation can vary slightly on a jurisdiction-by-jurisdiction basis, however, it’s understood to mean the presence of employees or representatives in a taxing jurisdiction for the purpose of making sales of TPP, for which orders are sent outside the taxing jurisdiction for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the taxing jurisdiction.
Generally, activities that go beyond the solicitation of orders for the sale of TPP, such as providing maintenance on premises to the property sold, installing the property on premises, conducting training on premises, or providing technical assistance on premises, may cause a software provider to lose PL 86-272 protection and subject itself to a jurisdiction’s tax on net income.
Multistate tax commission (MTC)
The MTC recently refreshed its statement of PL 86-272 with updated considerations for telecommuting and activities conducted via the Internet.
While not binding on its own, MTC compact member taxing jurisdictions generally incorporate these statements into their tax guidance. New Jersey issued a Technical Bulletin expanding the protected and unprotected activities under PL 86-272 to mirror that of the MTC’s new statement. Furthermore, New York has finalized regulations that adopt the MTC’s new statement retroactively.
California was the first to respond to the MTC’s updated guidance by issuing a Technical Advice Memorandum that mirrors the MTC’s refreshed statement. However, the San Francisco Superior Court recently voided the memorandum, stating that the guidance constituted regulations that were required to be adopted
With regards to telecommuting, the MTC opines those activities performed by an employee who telecommutes that go beyond solicitation will terminate PL 86-272 in the taxing jurisdiction where the employee sits.
Turning to Internet activities, the MTC provides that Internet sellers of TPP generally require the same analysis with respect to persons that sell TPP by other means. However, some additional considerations arise, such as the placement of Internet cookies to gather customer information, which can terminate PL 86-272 protection in the taxing jurisdictions where the Internet seller’s customers are located.
Nuances of navigating PL 86-272
First and foremost, PL 86-272 applies only to net income taxes. This means tax regimes such as the Washington B&O tax, which is a tax on gross receipts, and the Texas Franchise Tax, a tax on profit margin, aren’t bound by PL 86-272.
Second, while PL 86-272 protections may apply, some jurisdictions may still require the filing of a zero return or informational report, while others may still require the payment of a minimum tax.
Apportionment of receipts for income tax purposes
Apportionment is the allocation of a business' taxable income or in the case of a gross receipts tax, gross receipts, to a particular taxing jurisdiction for purposes of determining a business' taxable base.
The apportionment of receipts is achieved through several different methodologies, all of which result in a fraction — the apportionment factor — which is multiplied against the business' federal taxable income, after adjustments for jurisdiction-specific addbacks and deductions, to arrive at the tax base.
Single sales factor
The most common apportionment methodology is the single sales factor. Under this methodology a fraction is created with the software provider’s worldwide gross receipts as the denominator and gross receipts attributable to a particular taxing jurisdiction as the numerator.
Three-factor apportionment formula
The former most common apportionment methodology is the three-factor apportionment formula.
Under this methodology, a business' sales, payroll, and property each create individual fractions with figures placed in the denominator and figures attributable to the taxing jurisdiction in the numerator. These fractions are averaged together to create an overall apportionment factor.
Jurisdictions such as Alaska, Hawaii, and Kansas still use the three-factor apportionment formula. A handful of jurisdictions use variations of the three-factor apportionment formula such as the double-weighted sales formula — New Hampshire — and the triple weighted sales formula — Tennessee. Under these methodologies, the sales factor of the three-factor apportionment formula is simply duplicated or triplicated, creating a five- or six-factor apportionment formula.
Before considering the above, software and SaaS providers should consider how their business activities are treated for income tax purposes, incremental to sales tax purposes, which may have a direct effect on the type of apportionment methodology used. This issue arose in the Massachusetts Appellate Tax Board case Akamai Technologies, Inc. v. Commissioner of Revenue, where a SaaS provider was determined to be a manufacturer for income tax purposes. The provision of SaaS is a sale of TPP in Massachusetts, thereby allowing the SaaS provider to use the single sales factor apportionment methodology available to manufacturing corporations, as opposed to the less preferential — for a Massachusetts-based taxpayer — three-factor formula.
Sourcing of receipts for income tax purposes
The sourcing of a software provider’s sales is relevant for states that impose economic presence or factor-presence nexus standards for state income tax purposes. To the extent a software provider’s sales represent the sale of TPP, receipts are almost always sourced to where the software is being used.
If a software provider’s sales represent the sale of services, the two general methodologies for sourcing sales are market-based sourcing and cost-of-performance-based sourcing.
Market-based sourcing
Under market-based sourcing, receipts are sourced to the state where the benefit of the service is received or where the customer is located.
In the context of SaaS providers, the source state is likely going to be the state where the customer uses the software but may be the state where the customer maintains a billing address. Most states, such as California and Oregon, implement market-based sourcing.
Cost-of-performance sourcing
States that implement the cost-of-performance approach, such as Arizona, source receipts to where the income-producing activity takes place, either wholly within the state or in the state where the greatest cost of performing the service occurred. This approach is likely most problematic for SaaS providers because the income-producing activity could occur at the location of servers that host the software, or where the software is developed or maintained, or in some cases, both.
Specific to software and SaaS, taxing jurisdictions generally don’t have specific carve-outs in their codes and regulations for sourcing beyond classification as either the sale of TPP, intangible personal property, or services.
However, applicable to taxing jurisdictions using the cost-of-performance sourcing approach, some taxing jurisdictions, such as Florida, may interpret the income producing activity, such as cost of performance, for sales of software or the provision of SaaS to be the customer’s location rather than where the software is developed or maintained, or where the servers are.
Texas is also unique, as per the recent Texas Supreme Court holding in Sirius XM Radio, Inc. v. Hegar, which instructs taxpayers to apportion receipts based on where the work was performed as opposed to where the end-product act occurs, which was an argument of the Comptroller for market-based sourcing, for Texas Franchise Tax purposes, which is a complex analysis.
