If you’re a business selling software, it’s essential to know how tax authorities in US states and countries around the world will classify your products. Software is a particularly complex category in tax law, in part because it’s a relatively new type of product and continues to evolve in ways that tax departments have difficulty keeping up with. The same goes for other digital products like streaming video, gaming, and NFTs.
From a tax perspective, it can be difficult to make the distinction between digital products, especially SaaS (Software as a Service) and other types of software. But knowing how your product is classified is important for your sales tax and VAT management process because each jurisdiction might tax various types of software differently.
The wild world of digital product taxability
Making sure you’re compliant with sales tax and VAT regulations starts with understanding your product’s taxability, everywhere you have customers or employees. But that’s no easy feat, given that each jurisdiction has its own specific rules for taxing digital products—and they rarely agree on the definitions of different types of software.
In the US, for example, there are some states, such as Tennessee, New Mexico, and South Dakota, that levy sales tax on all sales of software, no matter which kind. But most states have more complex rules.
States might distinguish between “canned” software, which is standardized software customers buy “off-the-shelf,” and custom-made software that is particular to the customer. In each of those cases, the state may distinguish whether those types of software are delivered on physical property or are made to be downloaded. Some states distinguish between canned software, custom software, and canned software that has been customized. SaaS is typically seen as separate from any of those scenarios and has its own tax rules.
To give you an idea of how different states’ rules can be, check out these examples:
- Virginia exempts software, whether custom or prewritten, when the software is transferred electronically to the customer.
- California only taxes software that is canned and is delivered on or includes a physical medium.
- Texas considers SaaS to be a data processing service, which is taxed at 80%.
- Washington taxes SaaS but considers data processing to be a non-taxable service.
Internationally, classifications also vary widely. Some countries provide specific definitions for which digital good and services tax applies to—for example, in Europe a product is typically considered a digital good or service if it:
- is delivered over the Internet or an electronic network
- is essentially automated and involves minimal human intervention
- would not exist without technology
- is not a physical good
But other countries, like Australia and New Zealand, simply apply tax to all remote services provided to customers in their countries.
Not only do states and countries differ in their laws governing software, but those laws can and frequently do change as authorities work to keep up with changes in digital product delivery. It can be extremely challenging for software companies to ensure they are charging the right amounts of sales tax and VAT in the right places.