In the 2009 session, the Washington Legislature mandated big changes in the way that goods and services are taxed if those goods and services are delivered digitally. Under the new law, the notion that the sales and use tax primarily applies to tangible personal property is only a memory. On July 26, 2009, many sellers of internet-based products had to begin collecting sales tax from their customers. However, there is benefit. At the same time, some of these sellers’ business & occupation tax rate was cut by two-thirds, and their basis for apportioning income changed dramatically.
The Department of Revenue is still in the process of writing rules to flesh out the new statute and many details are still unknown. With the exception of digital books, music and videos, the Department recognizes that uncertainty in most situations is the common denominator. Consquently, the Department has said that in the early phases of implementation, it will help businesses comply rather than brow beat them for guessing wrong. Nonetheless, some of the biggest changes are clear.
Many Companies That Formerly Were Considered Service Providers Are Now Retailers and Must Collect Retail Sales Tax.
1. Digital Goods Providers. The quintessential digital goods are audio and video that is accessed electronically. A frequently cited rationale for the legislation was that when such goods were downloaded, a sales tax applied, whereas when they were merely streamed, no taxable transfer had occurred. This difference was eliminated. However, the legislation applies to far more than audio and video.
Under prior law, the provision of information in digital form was generally considered to be a service. Now sellers of database information, online legal research, financial information, and similar information will be considered retailers, though some sales are exempt from sales tax.
2. Digital Service Providers.
Providers of search engines, online gaming, and other services that are performed electronically using one or more software applications are now considered retailers
3. Providers of Web-based Software. Providers of web-based software applications, sometimes called “cloud computing” and called “remote access software” in this bill, will also become retailers under the new law. The fact that the provider does not transfer possession of the software does not change the analysis.
4. Exceptions. The new law is written broadly, but it also contains many exceptions. These can broadly be categorized as (1) exceptions to the definition of digital goods and digital automated services that maintain the current tax classifications for certain businesses, (2) sales tax exemptions that parallel existing law, and (3) sales tax exemptions unique to the new law.
The first category preserves existing tax treatment for certain goods and services. These include telecommunications, online classified advertising, internet access, electronic funds transfer and other automated financial transactions, online educational programs, travel agency services, data processing services, and payment processing services. Charges for allowing another person or entity to sell things on a website are also excluded from retailing, though the underlying sale is not.
Professional services, involving primarily human effort and performed pursuant to a customer request, are excluded from retailing, even if delivered electronically. Examples would include appraisal reports, legal research, and customer website development.
The second category parallels existing sales tax exemptions:
a. If a purchaser incorporates a digital good or service in goods or services that the purchaser markets or otherwise resells, the purchaser is entitled to use a resale certificate or, after January 1, 2010, a reseller’s permit, to avoid the sales tax.
b. If an entity makes digital goods or services available for free, no sales tax applies.
c. Goods created for a noncommercial purpose or internal use, such as e-mail, are not subject to tax.
d. Digital goods may qualify for the manufacturing and equipment exemption from sales tax under the same criteria as any other kind of goods.
The third category exempts certain digital goods and services from sales tax, despite their categorization as retail for B&O purposes:
a. Sales of data that is reported in a standardized format and for a business purpose, such as daily reports of stock prices for investment companies, are exempt. The business purpose must be documented with an exemption certificate.
b. Sales of electronic versions of newspapers are exempt if the electronic versions share content with the printed newspaper.
c. Radio and TV broadcasting is exempt except for pay-per-view programs.
d. Sales to entities that will use the digital goods or services both inside and outside Washington are exempt from sales tax, but the purchaser will be liable for use tax on value of the goods or services used in Washington.
The Change in Classification May Reduce B&O Tax for Washington-based Companies.
For the companies that are now reclassified as retailers rather than service providers, the B&O rate will decline from 1.5 percent to 0.471 percent. Just as importantly, the basis for apportioning income for B&O tax will also change from apportionment based on costs to apportionment based on sales. Cost-based apportionment tends to result in a larger amount apportioned to Washington for companies headquartered here. For digital goods and services providers that sell primarily outside the state, the amount of receipts subject to tax in Washington may decline significantly.
The New Law Will Affect Business Transactions.
The new law simply amends the current business and occupation and sales and use tax chapters, rather than creating a new chapter. As part of that existing architecture, there is no hint that business transactions involving digital goods or services would be analyzed any differently than those involving tangible personal property. Superimposing the existing analytical structure on digital goods is likely warranted. Although this sounds simple, there will undoubtedly be problems requiring further guidance from the Department.
Expect Further Changes in the 2010 Session.
The taxation of digital goods and services is a sweeping change that was enacted very quickly. The Department has already identified ambiguities and unintended consequences. Expect a technical corrections bill in 2010.