Tax in the Bluegrass
Technology and state taxes
October 28, 2019
By Mark A. Loyd, JD, CPA
Technology has a significant impact on taxes. As technology evolves, so do taxes, although technology evolves first and much more rapidly than taxes, while taxes evolve in response and at a comparatively slower pace.
Remote seller sales tax collection
The evolution of remote sales companies parallels the evolution of technology over the past fifty-plus years. In 1967, remote retailers made sales by sending catalogues to potential customers and taking orders by phone or mail. It is no wonder that in National Bellas Hess v. Illinois, 386 U.S. 753 (1967) the United States Supreme Court held that a “physical presence” was required for a state to require a remote seller to collect and remit sales tax on sales to customers in the taxing state. Twenty-five years later, remote sellers were still sending catalogues to potential customers and taking orders by phone or mail but they were also sending them floppy disks with software to facilitate taking orders transmitted via dial-up modems, when the Court took up the issue again in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). The Court upheld the “physical presence” test based on the Commerce Clause, but made it possible for Congress to legislate a solution by overruling Bellas Hess to the extent that it was based on the Due Process Clause.
After Quill, remote sellers added the internet channel to the model, which became the dominant channel for communicating offerings to potential customers and taking orders from them. Meanwhile certain states came together and entered into the Streamlined Sales and Use Tax Agreement (SSUTA) to try to simplify not only sales tax bases and rates but also the administration of sales taxes, including centralized administration of local taxes. Ultimately, the Supreme Court in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080; 201 L. Ed. 2d 403 (2018), overruled the “physical presence” test and upheld South Carolina’s tax scheme, which: applied an economic nexus safe harbor; did not retroactively seek to impose collection obligations prior to the Wayfair decision; and, had adopted SSUTA simplification.
Now, many remote sellers must use technology and the internet to comply with the almost universal adoption by the states (with some notable exceptions) of the South Dakota sales tax scheme.
Software as a service
Most states have historically imposed their sales taxes – most of which have been in place for over fifty years – on all non-exempt tangible personal property and certain specifically enumerated taxable services. State sales tax statutes often define tangible personal property to mean personal property which may be seen, weighed, measured, felt, or touched. Software does not come within this definition.
As the use of personal computers became widespread by individuals and businesses, so did the use of application software like word processing and spreadsheet software as well as computer games. While sales tax clearly applied to computer hardware and operating software pre-loaded onto computers, it did not apply to software. So, states seeking to tax software amended their definitions of software to encompass it; typically, states tax prewritten computer software, since custom computer software is generally considered to be the embodiment of a nontaxable service, like a will prepared by a lawyer.
With the advent of the internet, property that sellers previously sold on tangible mediums, like music, books, art, photographs, periodicals, newspapers, magazines, greeting cards, and video and electronic games, began being sold as digital property, which is neither tangible personal property nor software. So, states seeking to tax digital property amended their sales tax laws to tax it.
Some internet businesses also allow users to subscribe to access software (which typically performs some type of electronic service) as a service (SaaS) over the internet, without transferring the software to the user. Notably, CPAs preparing tax returns often use a SaaS solution to prepare tax returns, and tax research is often done using a SaaS solution. Because there is no transfer of tangible personal property, e.g., no physical medium (like a CD, DVD, or thumb drive) or download of software, there may not be a taxable transaction, depending on the state’s sales tax laws. There must be some statutory basis to subject such an access fee to sales tax; otherwise, it is not taxable. Roughly half the states tax SaaS, and half the states do not.
Single sales factor and market based sourcing
Almost three quarters of a century ago, when the Uniform Division of Income for Tax Purposes Act of 1957, commonly known as UDITPA, was drafted, large multistate manufacturing concerns dominated the U.S. economy. Service businesses were small by comparison and often operated within one state or maybe regionally. Unsurprisingly, UDITPA focused on manufacturers, adopting a three-factor apportionment formula to apportion corporate income comprised of the average of a property factor (in-state percentage of property), payroll factor (in-state percentage of payroll), and a sales factor (in-state percentage of sales). That apportionment percentage was used to carve out a state’s share of a corporation’s income tax “pie”. Although a few states have had single sales factors for decades, such as Iowa, which survived a challenge in Moorman Manufacturing Co. v. Bair, 437 U.S. 267 (1978) under the Due Process and Commerce Clauses, states have moved consistently over time to abandon the property factor and the payroll factor and to adopt a single sales factor. Today, the single sales factor is the most common apportionment method.
States have also begun to abandon the original UDITPA cost of performance methodology of assigning gross receipts from rendering services or arising from intangible property (e.g., licensing fees) to a state for sales factor purposes and instead adopting market-based sourcing. As a general premise, the cost of performance methodology assigns sales to the state in which the service is performed or the management of the intangible takes place, whereas the market-based sourcing methodology assigns sales to the market state; of course, the detailed rules are much more complex…. As with the single sales factor, today, market based sourcing is the most common method for assigning sales to a state.
Mobile phone 911 charges
Can you remember when you had to make calls on a house phone? Can you remember your first mobile phone? Have you ever used a pre-paid phone? The evolution of telephone service was front and center in Virgin Mobile U.S.A., L.P v. Com. ex rel. Commercial Mobile Radio Serv. Telecommunications Bd., 448 S.W.3d 241, 243 (Ky. 2014), wherein the Kentucky Supreme Court recited the history of both developments in telephone service and levies on such service to fund 911 emergency services.
For many years the General Assembly has provided a mechanism for taxing telephone service to provide funding for the state’s system of 911–emergency service. In 1984, the legislature authorized local governments to impose a special tax upon telephone service to finance local 911–emergency systems. Of course, at that time virtually all telephone communications were conducted through wires strung between poles, and the 911–emergency service systems were designed accordingly. They were not compatible with the new technologies for wireless cellular telephone service.
In 1998, with the burgeoning popularity of wireless and mobile cellular telephone service, the General Assembly directed the collection of a Commercial Mobile Radio Service (CMRS) service charge of $0.70 per month per CMRS connection.
This statutory scheme for assessing and collecting the CMRS service charge was obviously designed and intended to integrate seamlessly into what was then the only mode of selling mobile telephone service to consumers: a CMRS service provider such as AT&T Mobility or Sprint entered into a fixed contract with a customer to provide mobile phone service for an extended period, typically two years. The customer was assigned a mobile telephone number and was billed each month at the contract rate. Adding the CMRS service charge of $0.70 per month as a separate item on each monthly bill was a simple, almost natural, way to collect the service charge.
It was against this statutory backdrop that Virgin began doing business in Kentucky as a CMRS provider in August 2002. Unlike the conventional providers of mobile telephone service, Virgin structured its service on a new business model, marketing its service to a customer base with different abilities and needs. For all of those consumers, Virgin developed a pre-paid mobile telephone service, selling telephones with pre-paid phone service in retail outlets like Walmart.
In 2006, Governor Fletcher publicly called upon the legislature to close the “tax loophole on prepaid cell phones” by amending the CMRS service charge statutes. As a result, the General Assembly amended KRS 65.7629(3), effective July 12, 2006. The 2006 amendments expressly stated that prepaid mobile phone service was subject to the CMRS service charge, and it prescribed alternate methods by which the service charge for prepaid CMRS service should be collected and remitted.
Notice the evolution of the telephone industry and the charges that fund 911 service. These are a classic example of technological innovations followed by changes in the law.
Motor fuel taxes
Until recently, motor vehicles had not changed much since the Model T; they all ran on gasoline or diesel fuel. Now, there are hybrid gas and electric vehicles, and electric vehicles that do not use fossil fuels. Roads are financed by a combination of taxes on motor vehicles and motor fuel, typically charged on a cents per gallon basis. But what happens when motor vehicles are primarily electric cars? States are now facing this evolution in technology. What will they do?
“Skynet has become self aware. ” The Terminator in Terminator 3: Rise of the Machines (2003).
As technological change accelerates and as technologies like blockchain and artificial intelligence become mainstream, if the past is any indicator of the future, we can expect taxes and tax administration to evolve as well.
About the author: Mark A. Loyd, JD, CPA, is a partner of Bingham Greenebaum Doll in Louisville and chairs its Tax and Employee Benefits Department. He chairs the Society’s Editorial Board and Tax Committee. He can be reached at MLoyd@bgdlegal.com; 502.587.3552.