Businesses in Massachusetts that use computer software or provide computer services are generally aware of the expansion of the Massachusetts sales and use tax to certain computer software and services, and of the controversy it has generated. Since its revision and the widespread fierce criticism that arose, the Massachusetts Department of Revenue (DOR) has made repeated attempts to clarify the expansion of tax.
The new legislation, which took effect on July 31, 2013, requires the 6.25% sales and use tax to be applied to:
- Computer system design services, defined as: “the planning, consulting or designing of computer systems that integrate computer hardware, software or communication technologies,” and
- Software design services, defined as: “the modification, integration, enhancement, installation or configuration of standardized software.”
Initially, the DOR issued Technical Information Release 13-10 to provide guidance on the expansion of the tax. However, the Release did not address many concerns of software purchasers and service providers and there remained much confusion over the application of the new law. Subsequently, the DOR released a series of frequently asked questions (FAQs) and their responses to provide further guidance and fact-specific advice. Most recently, the DOR has also released Working Draft TIR 13-XX: Further Guidance Regarding the Scope of Sales and Use Tax on Computer and Software Services. The accompanying commentary to the draft TIR states that once adopted, it will supersede any previously issued FAQs that conflict with it.
A review of the FAQs reveals the following:
The DOR’s FAQs allow a business to draw a “bright line” test of taxability with respect to the “software design services” portion of the tax based on whether services are provided to modify or adjust “pre-written software” (or “off-the-shelf” or “canned” software) and “custom software.” However, this bright line test may be of little value as it is likely a small number of taxpayers who will have only custom software. In all likelihood, most taxpayers will use or interface with pre-written software. The DOR’s distinctions between “custom software” and “pre-written software” mean more for identifying what is NEWLY taxable, rather than what is taxable. Sales or licenses of software (custom or pre-written) have been taxable for years (see 830 CMR 64H.1). Only custom software that is not sold or licensed (e.g., developed on an hourly basis for the customer), is not taxable (FAQ 36).
What is taxable? The new tax on computer/software services has two components, which are being treated by the DOR as “distinct and having a different scope,” but clearly overlap. The first relates to the modification, integration, enhancement, installation, or configuration of standardized/prewritten software and the second relates to computer system design services.
Examples of taxable modifications include the installation or update of pre-written software, the creation of a local area network (LAN) with the installation of an operating system, the set- up and implementation of a new server system sold by a third party, and the installation of firewalls with continued monitoring.
Examples of taxable services include, the consulting, customization, or design services related to modification of pre-written software, the design of a server system, creation of macros or plug-ins that operate in conjunction with pre-written software, and the design of a website using pre-written software.
What is not taxable? According to the Release, the new tax won’t apply to personal or professional services that do not themselves constitute computer services, and that are not directly related to a particular systems integration project involving the sale of computer hardware or pre-written software. Examples of non-taxable services noted in the Release include: (a) consulting and evaluation services used to identify deficiencies and needs for existing computer systems, (b) services that prepare a business to use modified software, such as training or support, (c) website hosting, (d) data storage and cloud-based disaster recovery services, and (d) data conversion. It is important to note, however, that none of these examples require any use of the software or hardware (other than perhaps the disaster recovery services, which may then become taxable).
What is not yet known:
The FAQs leave some open questions, such as:
- FAQ 10 overtly acknowledges that the DOR has not yet determined how website design services are to be treated.
- FAQ 15 acknowledges that a vendor does not need to collect the tax on design or consulting services that “do not result in a sale of a computer system that integrates computer hardware, software or communication technologies.” It is unclear, however, what the vendor’s obligation to collect the tax will be if at a later point (even the next tax year) the buyer purchases the system from that vendor. The draft TIR indicates that the sale of taxable pre-written software does not need to occur at the same time or from the same vendor in order for the services to be taxable. Will the designer have to collect the tax at the time of the sale of the system on the cost of the system and the design services previously rendered or partly upon the provision of services? Even if the vendor fails to properly collect the tax at either the time the services were rendered or at the time of the sale of the system, the purchaser would be required to pay the use tax on both the design services and the system purchase at the later time of the system purchase as the design services were provided with regards to the system.
- Another conundrum is how to bill for a combination of services. FAQ 39 lists a series of activities typically involved in the introduction of new software into a business, and identifies which are taxable (the sale of the software and the installation) and which are non-taxable (training, data conversion, editing reports or queries that do not require altering the pre-written code).The requirement is that the charges for the non-taxable services must be “separately stated, reasonably allocated charges.” However, while separately stating the charges may reduce the taxes, it may lead to a missed opportunity to avoid them altogether: FAQ 45 posits a situation where a vendor is integrating a third-party’s software into the customer’s software and notes that the exception where taxable services are bundled with nontaxable services, and the value of the taxable services is inconsequential within the meaning of 830 CMR 64H.1.1, that is, valued as less than 10% of the total sale, the services will not be taxed if (1) the value is determined in good faith and (2) the service provider is not the vendor of the taxable prewritten software or product being integrated into the customer’s software. As a result, it may be advisable to only separately state the charges where the taxable services exceed 10% of the total invoice.
Next Steps. While the FAQs are not “official” public written statements of the DOR, the positions taken are unlikely to be reversed or altered significantly. However, until the bill is amended or further official clarification is provided, caution should be taken. Vendors and purchasers should review their service contracts to ensure that they adequately specify the services being provided, which of those services will be taxed, and the amount of tax that the vendor is obligated to collect. To alleviate the tax burden, vendors should determine if their contract fees can be more heavily weighted toward non-taxable services.
To determine whether you, as a vendor or a purchaser, are impacted by the new sales and use tax, and what you can do to mitigate your risks, please contact the authors of this alert: John F. Bradley and Serge Béchade. You can reach John at 617 456 8076 or firstname.lastname@example.org and Serge at 617 456 8016 or sbechade@PrinceLobel.com.