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How tax rules apply to your software

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Last Updated

How tax rules apply to your software

Anrok | Streamlined sales tax for SaaS

If you’re a producer of software, it’s essential to know how tax authorities in states across the country 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.

One example of such evolution is the creation of Software as a Service, known widely as SaaS, which is software that customers access remotely via the internet and pay for on a subscription basis. However, it can be difficult to make the distinction between what is SaaS and other types of software. Read on to learn the biggest differences between them.

Primary differences between SaaS and traditional software

  • Location and accessibility: If your software is SaaS, then anyone, anywhere with a connection to the Internet can access it. This means that multiple organizations can access the software hosted on the same network at the same time. By contrast, on-prem software is hosted on hardware physically accessible to the customer and only available on devices that have access to that local network.
  • Licensing and payment methods: Another major difference between SaaS and traditional software is the way that people purchase it. SaaS is a subscription-based service; customers pay a service fee for access to that software. Meanwhile, traditional/on-prem software is typically purchased up-front through a licensing agreement.
  • Ownership: The provider of SaaS software remains the owner of all hardware and software and is also responsible for maintaining and updating the software over time. With SaaS, the customer owns only their own data in the system. With on-prem software, on the other hand, the customer owns all aspects of the solution: hardware, software, and data. All maintenance and updates are also the responsibility of the customer.

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Anrok | Streamlined sales tax for SaaS

What you should know about sales tax in 5 key states

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How taxes apply to data processing services

Another type of digital product outside of SaaS and traditional software is data processing services. Every state has its own definition of data processing, but most states define it as manipulating, processing, acquiring, or storing data furnished by a customer and delivered by electronic transmission with the main purpose of the transaction being the processed data or information. The taxability of data processing services also varies by state. For example, data processing services are not taxable in Washington, but Texas clearly states that SaaS is included as a data processing service and both are taxable.

Why is it important to know whether your product is SaaS or not?

Knowing whether your product is SaaS or not is important for your sales tax management process because states might tax various types of software differently.

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 a 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.

Not only do states 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 taxes in the right places.

An automated sales tax engine like Anrok can help substantially, making the process as easy as clicking a button. With digital help like that, you can rest easy knowing you’re charging taxes in line with the latest state regulations, no matter what kind of software you sell.

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