August 22, 2024 - Sales and use tax laws and guidance throughout the U.S. are regularly updated and revised to account for changes in technology and business practices over time. Additionally, certain local jurisdictions impose particular types of sales or transaction taxes that can materially deviate from those imposed at the state level. In this article, we highlight some of these developments and include a few reminders on particular topics which may cause compliance issues for further consideration and analysis.

A few recent examples of these issues and developments include:

1. Illinois amends its sales tax laws to impose tax on leases of tangible personal property by lessors and codifies previous administrative guidance related to software licenses.
2. Chicago imposes a 9% Personal Property Lease Transaction Tax (”Lease Tax“) on leases of tangible personal property, including licenses of software, hardware, database access via software or software as a service (”SaaS“).
3. The New York Tax Appeals Tribunal and Division of Tax Appeals issue important decisions clarifying that software or SaaS should be subject to tax when combined with other nontaxable services in most circumstances.
4. New York Court of Appeals agrees to hear case examining the taxability of certain digital advertising services that are prevalent in today’s e-commerce world.
5. South Carolina imposes tax on certain SaaS and online information services despite not having clear statutory authority for doing so.

Illinois to begin imposing tax on leases of tangible personal property

Currently, Illinois law requires lessors to pay the sales or use tax on the purchase of tangible personal property that will be leased by the lessor rather than imposing tax on the lease charges to the lessee. However, effective January 1, 2025, the imposition of sales tax will be shifted to the lease stream of payments instead of the acquisition of the tangible personal property to be leased. Importantly, the new law applies to leases “in effect, entered into, or renewed” on or after January 1, 2025. Leases that are subject to a local home rule lease tax, such as the Chicago Lease Tax, are exempt from the new Illinois sales and use tax requirement.

Purchases of tangible personal property for subsequent leasing by lessors will now be treated as sales for resale and therefore not subject to sales or use tax. However, this resale change only applies to purchases of property on or after January 1, 2025. Therefore, there is a significant risk that lease payments made on property subject to sales tax upon acquisition by the lessor prior to 2025 would still be subject to sales tax as of January 1, 2025. This creates a form of double tax or tax-pyramiding that is usually avoided in sales and use tax contexts.

Finally, Illinois has also codified a current regulatory sale and use tax exemption for certain software transferred to a lessee under a restrictive license agreement which:

1. Is evidenced by a written agreement signed by the licensor and the customer;
2. Restricts the customer's duplication and use of the software;
3. Prohibits the customer from licensing, sublicensing, or transferring the software to a third party (except to a related party) without the permission and continued control of the licensor;
4. Has a policy of the licensor providing another copy at minimal or no charge if the customer loses or damages the software, or of permitting the licensee to make and keep an archival copy, and such policy is either stated in the license agreement, supported by the licensor's books and records, or supported by a notarized statement made under penalties of perjury by the licensor; and
5. Provides the customer must destroy or return all copies of the software to the licensor at the end of the license period. This provision is deemed to be met, in the case of a perpetual license, without being set forth in the license agreement. Ill. Admin. Code § 130.1935(a).

While the above requirements apply to the exemption for downloaded or electronically delivered software, SaaS is currently not subject to Illinois sales or use tax. This is the case regardless of whether the SaaS license at issue satisfies the criteria enumerated above.

Important reminder on Chicago Lease Tax — especially for cloud computing services

Charging sales tax on leases of tangible personal property may be a new concept in the state of Illinois, but Chicago has imposed the Lease Tax on leases of personal property since the 1990’s. The current Lease Tax rate is a flat 9% and the tax applies to certain database and data processing services in addition to most cloud computing services, including SaaS, platform as a service (“PaaS”), and infrastructure as a service (“IaaS”). The Chicago Lease Tax code and related administrative guidance provide a host of different exemptions and clarifying guidance on how to source certain lease revenue streams.

The Lease Tax is to be collected by lessors that have physical or economic nexus (derive $100K in revenue) with Chicago. In addition, companies based in Chicago or those that have employees working remotely in Chicago may also have a Lease Tax liability if their suppliers do not charge them tax on otherwise taxable leases or licenses.

New York Tribunal issues key rulings on taxability of SaaS combined with other nontaxable services

On May 2, 2024, In the Matter of the Petition of Beeline.com, Inc., the New York Tax Appeals Tribunal (“Tribunal”) upheld a 2023 ruling of the NY Division of Tax Appeals (“DTA”) which determined that a taxpayer’s fees charged for its vendor management system that matches customers needing temporary workers with the suppliers of temporary labor was subject to sales tax. The vendor management system is a web-based application that helps to manage and procure staffing services from requisition through billing. The company argued that its fees are not taxable because “the primary function” of its service was to act as a “matching” agent for suppliers of temporary labor and customers needing such labor and not the license of software.

The Tribunal determined that the licensing of the software/SaaS was not incidental or inconsequential as compared to the nontaxable services provided by the taxpayer. Therefore, the primary function test does not apply since that test is only used when taxable and nontaxable services are bundled together. However, when tangible personal property, such as software/SaaS, is bundled with nontaxable services and the software/SaaS is not incidental or inconsequential to the transaction, sales or use tax should be imposed.

In a similar decision issued by the New York DTA on May 9, 2024, the same conclusion was reached in the context of a facilities management service which involved the use of a remotely accessed software platform. See In the Matter of the Petitions of FacilitySource, LLC & FacilitySource Northeast Services, LLC.

In FacilitySource, the facilities management services at issue consisted of 24/7 call-in transaction center access, web-based portal access, work order management, vendor management, electronic invoicing, and data analytics. As part of the “integrated facilities management” service sold by the taxpayer, customers received access to a remotely accessed software platform that enabled users to enter facility work requests, dispatch work orders, allow for general tracking of all work orders, and create facility reports. Here again, since the taxpayer’s service involved a SaaS portal which was not incidental or inconsequential to the sale, the primary function analysis does not apply and sales tax should be charged.

In summary, any service being provided to a customer based in New York which involves or is delivered via SaaS should likely be subject to sales or use tax when the SaaS is not completely incidental or inconsequential to the underlying service. And of course, the determination of SaaS being incidental or inconsequential is extremely fact sensitive.

New York Court of Appeals to consider taxability of certain digital advertising and consulting services

New York’s highest court, the Court of Appeals, has agreed to consider the Appellate Division’s decision In the Matter of Dynamic Logic, Inc., which concerned the taxability of certain advertising data and consulting services provided by the petitioner. These services are aimed at measuring the effectiveness of advertising campaigns on behalf of ad agencies and publishers.

One such example at issue in the case is a research tool called AdIndex, which surveys consumers or internet users who have seen the advertisement and compares the results to responses of those who have not seen the advertising content. Once the survey data is collected and the results compiled, the petitioner provides its clients with a report that analyzes those results. Those reports compare a client's advertising campaign results to industry-specific benchmarking data from a database called MarketNorms, which contains anonymized and aggregated results from the standardized questions contained in AdIndex studies. As part of the service, petitioner also provides advice and recommendations for improving advertising effectiveness.

The Appellate Division determined that despite the services at issue involving recommendations and consulting, the primary function of the services was the data that was compiled, aggregated, and shared with clients as part of the AdIndex analysis and benchmarking tool. Accordingly, the service was correctly classified as a taxable information service by New York.

Furthermore, since each report incorporated MarketNorms data, the Appellate Division determined that the petitioner could not successfully advocate that the information at issue is excluded from tax on account of the data/information not being incorporated into reports made available to others.

Compare this conclusion with the holding in In the Matter of IT Works Marketing, Inc., where the New York DTA considered another similar digital advertising tool which measured and analyzed sales and customer data, but there was only a relatively small overlap and incorporating of non-client-specific data. In IT Works Marketing Inc., the NY DTA concluded that the service at issue was not a taxable information service.

As e-commerce and digital marketing platforms and channels continue to multiply, the prevalence of digital services similar to those at issue in the above-referenced New York cases will only continue to expand to every industry and region. Therefore, it is critical to understand how these services are delivered and used in order to properly evaluate the appropriate sales and use ramifications and compliance requirements.

South Carolina imposes tax on SaaS and online information services as taxable communications

Although South Carolina sales tax laws do not clearly authorize a tax on SaaS or information services, the South Carolina Department of Revenue (the “SC Department”) has issued guidance which indicates that sales or use tax may be due depending on the exact facts and circumstances involved. Specifically, SC Department Private Letter Ruling No. 20-1 dealt with the taxability of charges for cloud-based software that collects and stores customers’ billing and revenue data and provides inventory management and reporting analytics. In concluding that such charges were subject to sales and use tax, the SC Department explained that it is the State’s position that charges by an Application Service Provider (ASP) which allow a customer to access the ASP website and use the software on that website are taxable as communications services.

The SC Department defines an ASP as a company that provides customers access or use of software on the company’s website. While the SC Department’s guidance should cover most SaaS services, software that is downloaded or electronically delivered to customers continues not to be subject to sales and use tax in South Carolina.

In addition to SaaS provided through an ASP’s website, taxable communications services also include database access transmission services (on-line information services), such as legal research services, credit reporting/research services, and charges to access an individual website. Data processing services, on the other hand, should not be subject to SC sales and use tax. Data processing is defined in the law as follows:

The term “data processing” means the manipulation of information furnished by a customer, through all or part of a series of operations involving an interaction of procedures, processes, methods, personnel, and computers. It also encompasses electronic transfer of, or access to, the processed information. Some examples of data processing include computing, extracting, retrieving, sorting, and sequencing of information, and the use of computers. S.C. Code Ann. § 12-36-910.

These distinctions and clarifications provided by South Carolina guidance and policy are confusing, but essential for those purchasing and selling SaaS and online information/data services. Making matters even more complex is that the rules for South Carolina sales and use tax in the software and digital services contexts deviate from State income tax concepts and the sale and use tax rules employed by South Carolina’s neighboring states of North Carolina and Georgia.

How Citrin Cooperman can help

For more information on how Citrin Cooperman’s State and Local Tax Practice can assist with these developments and reminders, please contact Jaime Reichardt or your Citrin Cooperman advisor.