Although Nexus is a legal obligation, it has a quite complex structure. Tax assessment can be a barrier to business growth by straining cash flow. Businesses that want to remove this obstacle have been looking for the right software in recent years to ensure compatibility. Avalara is one of the leading names that businesses come across during their search. David Lingerfelt, Senior Director of Tax Content at Avalara, answered our questions about tax compliance.
Could you tell ERP News readers about yourself and your role at Avalara?
I am the senior director of tax content at Avalara. In this role, I am responsible for sourcing, analyzing, and organizing the tax content that powers Avalara’s calculation and research product suite. My day-to-day job involves efficiently scaling and maintaining boundaries, rates, and taxability decisions. I work closely with the product, global returns, and engineering teams to meet our client’s tax calculation and research needs, so our clients do not have to worry about tax.
What’s one tax challenge you believe all SaaS/software companies should be aware of?
Nexus is the legal obligation to register and collect sales tax in a U.S. jurisdiction. A significant tax challenge for SaaS and software companies is determining where they have nexus.
SaaS and software companies commonly establish economic nexus. Economic nexus is created when a software seller meets a jurisdiction’s annual sales threshold or, in some instances, the transaction threshold. For example, Florida has a $100,000 annual sales threshold, while New York’s thresholds are $500,000 in annual sales and one hundred or more annual transactions. The differing ways states determine annual sales add to the complexity. Florida excludes exempt sales from the calculation, while New York includes exempt sales. There are no geographic boundaries for SaaS and software companies in the digital economy, so they have the complicated task of understanding economic nexus thresholds in all U.S. jurisdictions, and VAT implications for sales abroad.
SaaS and software companies lead the way with remote work. Furthermore, they engage in mergers and acquisitions (M&A) more frequently than other industries. As a result, SaaS and software companies typically establish physical nexus by hiring or acquiring employees or offices in new locations. This complicates tax compliance for the tax team as they must stay connected to everyone across an organization like the People and Culture and M&A teams.
Moreover, software and SaaS companies may create nexus by helping buyers avoid use tax. If the buyer uses the purchased software in various locations, the buyer may expect the seller to collect the applicable taxes in each jurisdiction. This prevents the buyer from having to assess and remit use tax. However, the seller must register and remit the sales tax collected even if the seller has no physical or economic nexus in the jurisdiction, which increases complexity for the seller.
Nexus is complicated, but non-compliance is not an option. The penalties and interest for non-compliance detected during an audit are significant. A tax assessment can strain cash flow, slowing growth. Furthermore, non-compliance discovered during M&A due diligence will result in purchase price adjustments.
What should SaaS/software companies expect to change from a tax compliance perspective in 2022?
I expect states to introduce legislation to modernize their statutes and regulations to extend the sales tax to SaaS and software products during the 2022 legislative sessions. One such example is the recent Mississippi legislation creating a commission to study the taxation of cloud computing.
The digitization of the economy continues to accelerate. SaaS and software companies are central to this transformation. Many jurisdictions have antiquated statutes and regulations that do not account for how businesses use SaaS and software to serve customers today. Currently, only 18 states tax SaaS, meaning that the majority of states are leaving additional tax revenue on the table.
Along with divergent tax treatment, there is a myriad of definitions that apply to SaaS and software companies. In Connecticut, tangible personal property includes “software that is electronically accessed or transferred.” Texas defines SaaS as data processing, and Arizona treats SaaS as a rental of tangible personal property. To say it is confusing is an understatement.
Technology, particularly SaaS and software technology, powered the economy through the recent pandemic. States took notice, and I expect them to respond by modernizing or investigating how to modernize their statutes and regulations to capture additional revenues from the sales of SaaS and software.
What should a tax management solution provide SaaS/software businesses to better monitor and manage ever-changing transaction tax laws and regulations?
Best-in-class tax management solutions have extensive libraries of tax content maintained by tax experts leveraging artificial intelligence to ensure the timeliness and accuracy of tax calculations. Tax technical expertise and machine-assisted intelligence are critical to monitoring thousands of jurisdictions for tax law and regulation updates.
Also, the tax management solution must store and aggregate sales transactions to monitor for economic nexus exposure. Manually determining when economic nexus is triggered is extremely difficult for SaaS and software companies that can sell anywhere and be nowhere. The best tax management solutions fully automate economic nexus monitoring tasks.
A best-in-class tax management solution should seamlessly integrate exemption certificate management (ECM). SaaS and software sellers need to collect and store valid exemption certificates for sales for resale or sales exempted because the purchased software will have multiple points of use. Auditors always examine exempt transactions, so a failure to collect and store valid exemption certificates for exempt transactions is risky.
Additionally, SaaS and software companies should select a tax management solution that integrates calculation with return filing. Failure to timely file returns and remit taxes held in trust is an expensive proposition. The failure to file and pay penalties and interest are significant. The easiest way to ensure compliance is to have your tax management solution file and pay the taxes with the sales data used to calculate tax on clients’ invoices.
What can you say about the future of taxes impacting SaaS/software companies? What will be the greatest tax challenges software companies will face in the next decade?
I see two tax challenges for software companies over the next decade. The first one is where to source the sale of SaaS or software. In general, sales taxes are sourced to the location where the benefit of the software is consumed. However, SaaS is accessible anywhere from any web-enabled device, making it difficult to determine where the benefit is consumed. Today, sellers commonly use the purchaser’s billing address to source software and SaaS transactions. However, a billing address is not required to access a SaaS application. All that is needed is a credit card number and a web-enabled device. Where should a software seller source a purchase if the purchaser does not provide a complete billing address?
Two policy proposals offer a glimpse into the future of digital goods sourcing. The first is a draft rule by the Streamline Sales Tax Governing Board (SSTGB) allowing a seller to source a sale to the jurisdiction in the 5-digit zip code with the highest sales tax rate. The primary drawback to this proposal is that it will lead to the overcollection of tax.
Let us illustrate this issue using zip code 30316. Zip code 30316 includes the City of Atlanta in Dekalb County, Georgia. The Atlanta suburb of Gresham Park is also covered by zip code 30316. The Atlanta Transportation Special Purpose Local Option Sales Tax applies to sales sourced to the portion of zip code 30316 that includes the City of Atlanta in Dekalb County. However, the SPLOST does not apply to sales sourced to the suburb of Gresham Park.
As of June 1, 2021, the combined sales tax rate for sales sourced to the portion of zip code 30316 in the City of Atlanta is 8.9%. The combined sales tax rate in the suburb of Gresham Park is 8.0%. Under the SSTGB draft rule, the seller would over-collect tax for SaaS or software consumed in Gresham Park.
The second policy proposal is the Organization for Economic Co-operation and Development (OECD) draft nexus and revenue sourcing rules. The focus of these rules is on the allocation of global income taxes. However, there are sales tax implications. Under the draft rules, sales of digital goods, which includes SaaS and software, will be sourced as follows:
- The billing address of the purchaser,
- The user profile information of the purchaser,
- The geolocation of the device of the purchaser, or
- The device IP address of the purchaser.
Sellers of software and SaaS should watch these developments closely. The outcome could require costly ERP modifications or replacements to enable the collection and storage of additional transactional information to determine where to source SaaS and software purchases.
The second challenge facing SaaS and software companies in the next decade is how to classify and tax Web 3.0 digital products. Web 3.0 has many definitions, but at its core, it is about decentralization and three-dimensional interactive web experiences.
One example of Web 3.0 developments is a non-fungible token (NFT). An NFT is a link to a digital asset and a record of the asset’s ownership stored on the blockchain ledger. The token is non-fungible, which means it is unique and irreplaceable.
All the big fashion houses are getting in on wearable NFTs. You can buy an original Dolce & Gabbana NFT for your avatar to attend Decentraland’s fashion week events. Is the original Dolce & Gabbana wearable NFT software, clothing, or something different?
As previously mentioned, we will likely see jurisdictions modernize their statutes and regulations to better define SaaS and Software in the near term. However, modernization is unlikely to keep pace with the rapid Web 3.0 developments, creating more complexity for SaaS and software companies trying to determine how to tax Web 3.0 products in the absence of statutory or regulatory guidance.