Digital Goods: An Ever Changing and Brave New World
Carolynn Kranz is the Managing Member of Industry Sales Tax Solutions, LLC, which offers a subscription database containing the sales and use taxability of software related transactions, digital content and cloud services; and the Managing Member of Kranz & Associates, PLLC, a boutique law firm specializing in state and local tax consulting.
Carolynn holds a law degree from Widener University School of Law and a Bachelor’s Degree from Widener University. Carolynn is a CPA, and a member of the District of Columbia and Pennsylvania Bar Associations. Carolynn is also a member of the advisory committee to Widener University’s Department of Taxation and Accounting, has served as a visiting professor at Widener University, and was an adjunct professor in Widener University’s Master of Taxation Program. She is also a member of the Advisory Board to NYU’s Annual Institute on State & Local Taxation, and is a member and officer to the board for the Streamlined Sales Tax Business Advisory Council. Carolynn was recognized by State Tax Notes in its monthly State Tax Spotlight, which regularly profiles a person or organization influential in the state and local tax world. She also authored LexisNexis’ State Tax Guide to Digital Content and Cloud Services, 1st – 10th Editions; and is a frequent speaker and author on state tax issues.
Russ: Carolynn, thanks for joining us today to talk about a complicated and rapidly changing area of taxation. In a recent interview with Richard Cram about Marketplace Facilitators he said that states are generally at least 10 years behind what is happening in the markets when it comes to updating their sales tax laws. Do you think that holds true in the world of digital goods?
Carolynn: No. I don’t believe this holds true in the world of digital goods. This is largely because the Streamlined Sales Tax Project took on the issue of digital goods early on – somewhere around 2010 – enacting definitions of specified digital products, digital audio-visual works, digital audio works, and digital books. In other words, addressing the emerging world of digital movies, music, and books. Other states followed suit. Thus, as the proliferation of these digital items were becoming largely available, the SSUTA states had already enacted provisions to address these commonly purchased items. That being said, there are many subtleties and nuances that were not necessarily addressed as part of this initial effort. Coming up with common definitions and administrative provisions requires that only the simplest issues get addressed; the complex issues become more highly debated and do not get incorporated into the final rules.
Since that time, we’ve also seen the entire digital landscape change, more so since the pandemic began, with more offerings in the digital space that do not clearly fit within the definition of specified digital products. Further, uniform rules have not been developed under the SSUTA; so each state continues to adopt their own treatment of products in this space.
Russ: Would you recommend SST do more work in this area?
Carolynn: This is a tough question. As someone who has been actively involved in SST almost since its inception, I have seen the project take on some really tough issues and make an impact that benefits both the states as well as taxpayers. However, when the Governing Board enacted the digital products definitions, which took years to develop, the end result was many states expanding their tax base to tax digital products, where these same digital products were not previously being taxed. Thus, as someone who has been involved in SST for almost twenty years, it is hard to believe that if SST took up other areas in the digital space, such as cloud services, that the end result would not be the same – more states expanding their base to tax the newly defined services. The fact is that today, most of the SSUTA states do not tax cloud services.
Russ: Given the rapidity and transformational nature of changes now in business models and what is being sold compared to when sales tax statutes were originally adopted, just how big a problem is this, for businesses, and for states?
Carolynn: It’s a huge problem. Particularly in the cloud services space. Sales and use tax laws were written during a manufacturing based economy. But for the area of specified digital goods, many states have
made minimal progress in addressing the taxability of cloud services offerings, and often resort to utilizing their existing and outdated provisions regarding prewritten computer software; attempting to fit new cloud based offerings into those existing definitions. This just doesn’t work from a practical perspective. In this space, the efforts of the states to tax cloud based offerings using their existing tax scheme is particularly problematic because sellers are faced with the challenge of following state tax policies which may not be supported by law, which could result in a potential class action lawsuit. Alternatively, without specific statutory guidance, a seller may utilize their own interpretation of state tax laws and bear audit risk and the potential controversy that comes with trying to convince the state that the seller’s interpretation is correct. The state’s unwillingness to provide clear legislative guidance in this space and to leave it to the interpretation of state taxing authorities is inherently unfair to taxpayers.
Russ: What are some of the most common misconceptions about digital goods and services?
Carolynn: That one size fits all. Certainly, there are certain digital products in which the taxability is easier to navigate – a digital good that has an almost identical tangible counterpart. For example, a digital book and a hard copy book; or a downloaded song with the right to listen in perpetuity. However, there are numerous subtleties to digital products that differentiate a digital product such that it does not fit squarely into a given definition, creating challenges – the most common of which is temporary versus permanent use, which is largely addressed by many states that tax digital products.
However, to demonstrate the other differences that can exist, consider the purchase of a digital magazine. A customer may be able to purchase a single issue of a magazine and read it in the same manner as you would the print version. However, a customer might also be able to subscribe to a magazine and have remote access to all the magazines that are issued during the subscription period. Alternatively, a customer’s subscription could allow access to all the magazines ever printed; while another subscription might allow the customer to use a “search” function to search past and present issues of the magazine. I have seen states characterize the single issue as a digital magazine, and the subscription to the same as a canned information service, given the customer has access to past issues. In this area, the devil is in the details, and the details can make all the difference in determining taxability.
Russ: Early on people tended to focus on equivalency between tangible products and digital products when thinking about digital goods. Is it fair to say that the evolution of digital goods and its growth is now directed more toward unique digital goods and services?
Carolynn. Yes, that is true. I believe that the taxability of many of the digital goods where tangible equivalents exist (i.e., books, music, movies, photographs, greeting cards, etc.) have largely been addressed by the states. However, with respect to traditional services that are now being performed solely via e-commerce, there is a controversy. This is a question that is being vetted now in light of various Internet Tax Freedom Act (“ITFA”) challenges brought by taxpayers. As you know, Congress enacted the ITFA to establish a moratorium on the imposition of state and local taxes that would interfere with the free flow of interstate commerce over the internet and preempts state and local governments from levying taxes on internet access and multiple and discriminatory taxes on electronic commerce. As more state and local governments pass laws to tax digital goods and services, courts have had to address novel
issues concerning ITFA preemption. Generally, under the ITFA, a tax is found discriminatory if “similar” property, goods, services, or information are taxed when purchased electronically, but not taxed if purchased via traditional means. Therefore, these cases turn on the contentious issue of what constitutes “similar” property, goods, services, or information. This will be an area that we should expect to see developments over the next few years.
Russ: What states have done the best job in understanding digital goods and providing clarity in their taxation? And what about their approach makes sense?
Carolynn: I’m fairly certain you might be hoping for a response of Washington state. However, all kidding aside, if I had to point to one state that has the most detailed guidance in this space it would, in fact, be Washington state – largely due to the major legislative changes made in 2010 surrounding digital products, remotely accessed software, and digital automated services (“DAS”). What Washington did well when it took on this initiative is that it sought the input of the business community and enacted provisions that addressed the concerns of the business community. However, as we often see in the state tax arena, the Department’s interpretation of these provisions has changed over time. In the early years, it seemed that the exceptions to DAS were broadly interpreted by the Department, whereas now, these exceptions are very narrowly interpreted. But overall, I would say Washington has done the best job in providing guidance in the digital goods space.
Russ: How can the sourcing issues for digital goods be solved? To achieve certainty do we need a Federal Act along the lines of the Mobile Telecommunications Sourcing Act? Do you think a consensus for federal legislation is achievable? What are the main obstacles?
Carolynn: The simple answer for sourcing digital goods is the use of a billing address. However, due to the use of third party payment platforms, the necessary billing information is not necessarily passed through to the seller of digital goods, which can create real issues for sellers. Without this information, we see states utilizing alternative defaults, which creates a lack of uniformity, and from a practical perspective, creates issues for sellers when they attempt to program a sales tax system.
Certainly, a federal bill could help resolve some of the sourcing issues and create uniformity that all taxing jurisdictions would be required to follow. A federal bill has been repeatedly introduced to address issues in the digital goods space, including situsing – the Digital Goods and Services Tax Fairness Act. The first introduction was in approximately 2013, but as of today, there has been no real movement on this legislation.
(Note: The Streamlined Sales Tax Governing Board (SSTGB) currently has a work group looking at sourcing issues, especially for transactions without address information.)
Russ: Some states seem to worry that their sales tax will become unenforceable if digital goods or services are provided by international sellers. Is this a valid concern? How big is the universe of international suppliers? Do they present unique challenges?
Carolynn: Enforcement is not an issue that is specific only to international sellers. In fact, taxing jurisdictions face the same challenges of enforcing their sales and use tax provisions against domestic remote sellers. The issues that exist for international sellers in the digital goods space aren’t inherently that different than the issues that exist for domestic remote sellers. The typical state enforcement mechanism when a sales tax assessment goes unpaid is a tax lien. If the taxpayer has no property in the state, it is more difficult to place a lien in that state. In the case of a domestic seller, a state might have the ability to file a lien in another state’s court, but practically speaking, this doesn’t happen. Thus, states are left with the challenge of figuring out how to enforce a collection obligation against a seller, whether international or domestic, where they lack any real enforcement mechanism.
Russ: Are the states’ efforts to tax digital goods and services creating pitfalls for traditional merchants? For example, have you seen any “traditional service providers” who are surprised to find their previously non-taxable services are now being characterized by states as the sale of digital goods?
Carolynn: In our practice we have seen a number of states attempting to tax services that previously were unquestionably exempt from tax. Obviously, companies must stay current and relevant in today’s competitive business environment and have adopted technologies to complement and enhance their traditional service offerings, which remain largely unchanged. However, we often see the taxing jurisdictions homing in on the technology component of the service offering, and overlooking that the service offering itself has not changed. The true object of the transaction remains the traditional service. However, more often than not, if there is any underlying technology involved in the delivery of the service, the state will conclude that the technology taints the transaction, and an otherwise nontaxable service is now taxable.
Russ: Do you have advice for any new merchants that are starting to sell digital goods or services or for traditional merchants that are expanding into this area?
Carolynn: Companies that are just starting out or expanding into the digital goods and services space should spend time and resources upfront to understand the rules in the taxing jurisdictions where they are doing business. In my experience, companies are sometimes reluctant to hire outside assistance, based only on a simple cost benefit analysis. However, the cost of not complying properly up front adds up quickly and could be very costly down the road.