Category Archives for lawsuit

First, Class Actions, and Now Whistleblowers Penalties for Sales Tax Errors May Skyrocket                                  

Isn’t Staying in Business, Keeping the Customer Happy while Earning at least a Modest Profit, Hard Enough Already?

The Greatest Tragedy in Sales Tax
 
If a company even slightly overcharges sales tax to a customer, they run the risk, if there are many such customers, of a possible class action lawsuit. On the other hand, if they even slightly undercharge sales tax, they run the risk of that item being assessed in an audit with possible penalties and interest and paying that assessment out of their own pocket. We call this “The Greatest Tragedy in Sales Tax.” 
 
That’s why it’s always been important to be as accurate as possible in charging the right rates on the right products and services. New developments in New York and Illinois may mean the penalties for undercharging sales tax have just skyrocketed.
 
Troubling Developments in the Sales Tax World 
 
Now, when times are as tough as ever, companies are facing another threat. So-called “whistleblower” lawsuits are being used in Illinois and New York against companies allegedly undercharging sales tax. Illinois and New York are the first states where these whistleblower lawsuits are being filed, and there may be whistleblowers in more states waiting to pounce. Whistleblower lawsuits can cost a bundle both in terms of the actual judgment and of negative publicity. Such was the case with Sprint, which was recently sued by the Attorney General of New York for $300,000,000 of treble damages for allegedly slightly undercharging sales tax to its customers in the state, but the negative publicity stemming from the grand announcement by the A.G. may have led to a precipitous drop in Sprint’s stock price costing perhaps $500,000,000 in market cap. And all of that on top of the audit assessment. We’ll discuss that case in detail and also some even more troubling developments in Illinois. The bottom line?  Whereas in the past (the good old days?) you worried about sales tax audit assessments by the Department of Revenue with penalties and interest, now you have that worry plus treble damages and damaging publicity. 
 
Whistleblowers Not Bad Per Se, But Not Everything is Fraud
 
We’re not against the concept of whistleblowers. States have the laudable goal of eliminating fraud and wasteful spending. They can’t find all of it on their own, so they offer a bounty to people who do find it. We can all agree that when used as most people would assume, as in uncovering Medicare fraud or abuse, that these statutes are beneficial to everyone. We’ve all heard the stories of medicaid and medicare fraud in which companies send in claims for providing services to thousands of people who don’t exist. And we’ve heard of people who file a tax return on behalf of 1000 dead people and claim they each have 10 dependents and have the refunds sent to a bank in the Caribbean somewhere. These are clear cases of fraud that cost the government real money and most reasonable people can agree, this should be eliminated if possible. If the New York Federal Reserve uncovered manipulation of LIBOR, now that would be something to pursue. Uncovering and proving real fraud is real work, but it’s a real benefit to society also.
 
Fining companies who engage in truly fraudulent behavior in the form of trebling the damages seems justifiable. Treble damages can mean some big bucks and will certainly discourage bad behavior. But when the state offers a 25 percent bounty to find it, the urge might — and, in my opinion, has — created a monster. Like all programs where large sums of money are involved and the amount of work is small, the potential to push the envelope in terms of broadening what is called fraud can be extreme. And the sums of money are large while the amount of work needed is small in these sales tax cases. Additionally, fraud cases make great political theater for the A.G., who gets to make the big announcement. The result of this environment is that reasonable judgments on whether and to what extent an item is taxable can be seen as fraud.
 
Charging the Right Tax Should be Easy — In Theory
 
The “easy” answer to this new level of risk is to make sure you charge the correct amount of tax in every situation. Seems simple enough. But as we’ve heard others say: Sales tax isn’t rocket science — it’s not that easy. The taxability of products and services as well as the determination of rates is a moving target. In addition, each state and local taxing jurisdiction, of which there are more than 7,600 in the United States alone, may have their own rates or taxation rules. Sometimes company just make mistakes, but plenty of the time, the answer is just not clear and judgments must be made. As a result of all of this, it’s very common for companies to overcharge sales and use tax on some items and undercharge tax on others.
 
Whistleblower Lawsuits
 
I’m not an attorney nor do I play one on TV, nor do I try to play one in real life. So I’ve had to educate myself on the matter of the False Claims Acts in general. Please don’t assume I’m an expert on legal proceedings; what follows is my understanding, and I’m indebted to several authors who have written articles about these matters, who I will cite where appropriate. 
 
In seeking to eliminate fraud, states have enacted statutes that allow private people to bring civil actions against other people or companies in the state’s name for “defrauding” the state. These actions are referred to as qui tam or “whistleblower.” It’s important to understand that in a qui tam action, the party filing the lawsuit does not have to be the injured party. An attorney can file a lawsuit on behalf of the state, basically because the state is deemed to be the victim. Attorneys don’t even have to do all the work involved of chasing the ambulances or even compete with the other ambulance chasers to convince the victim to hire them. They just circle overhead until they become aware of possible undercharges of sales tax and then pounce. The powerful incentive of bounty fees meshed with the removal of the barrier of needing to find an injured party makes these whistleblower opportunities lucrative indeed — for the attorney and the state. They don’t even have to wait for an accident. They can just watch court cases. Anytime a DOR position is overruled and the result is that companies who followed the DOR are now undercharging tax, here come the lawsuits. Or, even easier still, they need only look for grey areas in the tax law — like dropshipping, taxation of cloud computing, or the taxation of telecom charges, just to name a few — where the laws are either difficult to apply or just barely evolving and where companies are all over the board in terms of how transactions are taxed, and they will find opportunities galore.
 
According to information published by the False Claims Act Legal Center, approximately 28 states, three municipalities, a county, and the District of Columbia have enacted their own False Claims Acts. Many of these statutes follow the federal False Claims Act, which excludes tax fraud. Some of these jurisdictions have false claims laws that apply only to fraud involving Medicaid or other state health care funds. Other jurisdictions have laws that apply to a broad range of state-funded programs. The states we are most concerned about are those that allow whistleblower actions for tax fraud. According to the article, New York’s Qui TamLaw: Jackpot Justice or Creative Tax Tool—or Both?, some of the states to be concerned about are California, Delaware, Florida, Illinois, Indiana, Nevada, New York, Rhode Island, and Texas.  It will be interesting to see how many more states amend their existing statutes to allow for tax fraud in the coming years.
 
A winning lawsuit could potentially involve treble damages. When it comes to sales tax, that means three times the back taxes, penalties, and interest owed plus attorney’s fees. The whistleblower could potentially receive up to 30 percent in certain cases.  This is quite an incentive and the lure of potential hundred-million-dollar-plus settlements in the sales tax arena means companies have to be more careful than ever to charge the correct tax.
 
Walmart Survives Class Action; Whistleblowers Spring to Action
 
We mentioned that businesses with many customers have to be careful not to overcharge taxes even by a little, lest they be the subject of a class action lawsuit. Walmart would be the type of company that would have to be very careful with something like this because of their deep pockets. It’s interesting, and more than a little ironic that the most recent spate of whistleblower lawsuits in Illinois seems to have had its beginning as a result of a class action lawsuit against Walmart. In 2009, the Illinois Supreme Court decided on a class action lawsuit by the name of KEAN v. WAL-MART STORES, INC. 919 N.E.2d 926 (2009), 235 Ill.2d 351. Kean vs. Walmart was originally filed in 2006. The plaintiff in the case claimed they were improperly charged sales tax on a shipping charge for a purchase on Walmart.com. They based this claim on prior Illinios DOR guidance.  In fact, sales and use regulations promulgated by the Illinois DOR, state that, “If the seller and the buyer agree upon the transportation or delivery charges separately from the selling price of the tangible personal property which is sold, then the cost of the transportation or delivery service is not a part of the ‘selling price’ of the tangible personal property which is sold, but instead is a service charge, separately contracted for, need not be included in the figure upon which the seller computes his Retailers’ Occupation Tax liability. Delivery charges are deemed to be agreed upon separately from the selling price of the tangible personal property being sold so long as the seller requires a separate charge for delivery…” (86ILAC 130.415(d))
Walmart basically claimed that there was no “separately contracted for” delivery option. While they offered different methods of delivery with separate charges, the purchaser on Internet transactions does not have a choice to not have the product delivered. Because delivery was a mandatory condition of the purchase, it could not be separately contacted and was therefore part of the purchase price and taxable.
The case eventually made its way to the Illinois Supreme Court, which ruled in late 2009 in favor of Walmart. In deciding for Walmart, I do not believe the court could have foreseen what the Law of Unintended Consequences had in store. Because the court ruled that Walmart, who had not followed Department guidance, was not overcharging sales tax, then that guidance must be invalid. Enter now the opportunistic, whistleblowing plaintiff’s attorney, circling above in the sky, ready to swoop in on the unsuspecting business. The whistleblower realizes that most companies would likely have followed the DOR’s guidance, and as as result could now be said to be undercharging sales tax. Aha! Fraud Alert! Actually, what really is happening is Aha! Huge Fee Opportunity! So, the Whistleblower sues in behalf of the state of Illinois and nails the “fraudsters.” Nevermind that the “fraudsters” were the ones who were simply following the guidance of Ilinois’ own DOR.
 
These Cases Should be Dismissed
We understand that in qui tam actions, the state usually has a process to dismiss these lawsuits. It has not exercised that right so far. In addition, the Illinois DOR is reviewing the regulation on this issue but as of now has not given any guidance on how to move forward. This illustrates the point of how tough it is to figure out the correct amount of tax when the state can’t even decide themselves how it should be taxed.
 
It is distressing to say the least that a company could be targeted by a whistleblower for not charging tax on something for which even the Illinois DOR doesn’t have the answer, but that is the current state of affairs in Illinois.Your stomach may be already turning, but wait… in some respects, things may be even worse in New York.
New York Whistleblowers
New York has now jumped on the whistleblower bandwagon. On April 19, 2012, the New York Attorney General, filed the first New York Sate whistleblower tax fraud lawsuit against Sprint-Nextel Corp. under the amended New York False Claims Act. The suit alleges that Sprint deliberately under-collected and underpaid millions of dollars in New York state and local sales taxes on flat-rate access charges for wireless calling plans. Sprint disputed the claims, releasing a statement saying the case is “without merit” and on June 14, 2012, asked a judge to dismiss the lawsuit on the grounds the state was attempting to levy taxes on services that are legally excluded from sales tax.
 
The stakes are high. The state claims that the Sprint owes $100,000,000 of back taxes plus penalties and interest. Under the Act, if Sprint is found liable, they would have to pay three times that amount. That is what you call skyrocketing penalties. The whistleblower would score 25 percent of the bounty. In addition to the harsh monetary penalties, there is the negative publicity of being labeled a “fraudster” by the Attorney General. For example, according to news reports on the day of the big announcement made by the the New York A.G. at a celebratory press conference, Sprint’s Stock price dropped almost 5 percent with a hit to its market cap approaching $500,000,000. This is not good news for a company which lost nearly $2.9 billion last year on sales of $33.7 billion.
 
Check out what Ted Barac who writes about Sprint’s Sales Tax Blunder in his investment newsletter and website Seeking Alpha says about Sprint. It reflects much of the popular thinking on this:
 

“The state claims that Sprint did this to achieve a competitive advantage, but I doubt that customers are going to even notice such a marginal difference in sales taxes and it’s certainly not something that Sprint could advertise and market…  So why would Sprint take such actions when it seems clear that there were questions and grey areas in the tax law? The company didn’t get any extra revenues for themselves and it really offered them no significant competitive advantages. Conversely, as a result of these actions, they are now faced with back taxes, penalties, lawsuits, headline risks, general uncertainty, etc. All things considered, it really seems like an act of very poor judgment.”

 
This is unduly harsh in my opinion, but it comes from a non-tax professional, who doesn’t deal in the grey of state and local sales and use tax on a daily basis. But this is evidence of the damage that can be caused to a company’s reputation and public perception when a state Attorney General makes a grand announcement to a fawning press corps. Companies making tax judgments on grey areas of the law are being labeled fraudsters and tax cheats. It’s sobering.
 
To add insult to injury, because of the stock market price drop (which came on the heels of the A.G.’s press conference) Sprint’s Officers and directors have been sued by a Louisiana pension fund for a breach of fiduciary responsibility and for failing to oversee the company and subjecting it to a huge liability. 
 
Last but not least, the stakes may also have been raised for attorneys, CPAs, and others who may be termed co-conspirators if it can be shown that they have assisted in the development of the “tax avoidance strategy” or the filing of returns if they should have known that a return was false but did not because they deliberately ignored or recklessly disregarded the truth of the matter asserted. These provisions of the law make clear that intentional deception or proof of intent to defraud is not required. While no third party has been charged in this case, it is an issue to be noted.   
 
What Happened With Sprint?
 
We don’t have special inside knowledge about Sprint. They are not a client of ours, and if they were, we wouldn’t give away any inside knowledge we had. But we know and understand how these decisions are made inside corporate tax departments, and we have done our own research of documents publicly available in this case. This whole thing with New York and Sprint arises out of a taxability decision made by Sprint several years ago. Sprint came out with a flat-rate calling plan in which you can make all the calls you want for $39.99 a month. Sprint’s internal tax department had to make a determination on how to tax that monthy charge. Under the Mobile Telecommunications Sourcing Act (P.L. 106-252; 4 U.S.C. Secs. 116—126) and under the New York’s Chapter 85 of the Laws of 2002, which effective as of August 2, 2002, wireless carriers were required to collect and pay sales taxes on the entire amount they charge for monthly access calling fees. However, interstate calls separately stated are not taxed.
 
INTERstate calls are not taxable but INTRAstate calls are taxable. In a flat-rate plan, how much of it is interstate vs. intrastate? Should Sprint collect tax on the whole charge each month or just on the portion that’s interstate in nature? And what does it mean for something to be “separately stated?” For example, my cell phone bill (not Sprint) includes detailed records separately identifying each call, interstate and intrastate. Is that enough to meet the “separately stated” requirement?  Would a footnote on the bill saying that 25 percent of the billing is for interstate calls constitute “separately stating” an amount? How should Sprint have done it? Hindsight may be 20/20 in many cases, but I’m not sure even in hindsight one can say for sure how it should have been done. The statute and regulations may seem to be pretty clear that lump sum billing is taxable, but there must have been some other support for Sprint choosing to tax it at 75 percent instead. I can only guess what factored into the decision. Some commentators have said that maybe they should have gotten a ruling from the New York DOR before proceeding. But how did that help companies in Illinois, when the courts ruled the Illinois DOR’s ruling to be incorrect? No one is surprised that New York would want to tax the whole charge if any part of it was intrastate in nature, but just because a person at the New York DOR says it’s taxable, that’s not always the final answer, as tax professionals know. That’s just one answer — it’s an important answer, no doubt, but not necessarily the only or maybe even the correct answer. 
 
Was this a Mistake or Judgment Error or Neither?
 
Companies and their advisors make mistakes. Sometimes we just miss things. But this situation can’t be a simple mistake because they are taxing 75 percent of the charges. A mistake could be taxing 100 percent, or none of it, but not 75 percent. Therefore, some consideration, at some level, must have been given to how to tax it. Maybe they were worried about class action lawsuits. It’s certainly a valid concern that if Sprint taxed the whole thing, a class-action attorney would sue them for overcharging tax by arguing that Sprint was, in fact, separately stating interstate calls by detailing them on their customer invoices. Seems like a stretch, but it could have been one of their concerns. Or, it could have been something else that convinced them to tax it at 75 percent. I certainly do not know, but I do know for sure that this is not fraud.
 
I feel confident the tax department just wanted to get the answer right and charge their customers correctly. It appears they did some analysis of actual phone calling data by people on those plans. Evidently they found that approximately 25 percent of the calls made were interstate. So they made the decision to charge tax on 75 percent of the $40 per month charge. Does that sound so bad? Does that seem like fraud? 
 
If you’re the Attorney General, eager to make a splashy announcement, or an attorney looking to score big fees, a company can be made to look pretty sinister. When the initial press conference was called by the NY A.G. and Sprint was assailed for its “fraudulent” actions, much of the press seemed negative toward the company. Notwithstanding the views of many other commentators on this, I have my own take on what happened here, and I come down on the side of Sprint and Sprint’s tax department. I see it much differently. And I emphasize we have no inside knowledge on this, but does making what I would call a good faith effort to tax your customers correctly under New York’s different laws, regulations, court cases, administrative decisions, and policies (which many times themselves conflict) constitute fraud? If this is fraud, then every tax professional in the U.S. that is called upon to make a judgment on how to tax transactions are in on it too. 
 
Keep in mind that Sprint made a decision to charge its customers less tax. By doing so, Sprint took on the risk of having to pay that tax themselves out of their own pocket later on if it was ultimately held that the total charge is taxable. There’s no allegation in this case that Sprint kept any of the money they charged to the customer, only that they didn’t charge their customers enough. One way to look at this is that the New York Attorney General apparently doesn’t think New Yorkers pay enough tax on their phone bills, and is suing Sprint in order to force them to collect more tax from New Yorkers. There’s no fraud in the sense that Sprint taxed people and put that money in its own pocket, but there’s got to be fraud somehow, right? They had to come up with something, or there’s no big announcement and no fat bounty fee. 
 
So How is Sprint Committing Fraud Then?
 
To prove fraud here, the Attorney General had to twist this into a “scheme” in which Sprint made a conscious and deliberate decision to undercharge the tax. Maybe not to enrich themselves on the actual taxes, but to give themselves a competitive advantage against the other carriers. Now that is a stretch! And by the way, just how much tax are we talking about here to each customer each month? Even that’s not an easy answer, but let’s talk in round figures. Let’s say the combined state and local rate in New York is 8 percent. That means that the tax on the monthly fee would be $3.20 if Sprint taxed it in total. But they only taxed 75 percent, so they collected $2.40 instead, or $0.80, less per customer per month under their so-called “scheme.” I find it hard to believe that the $0.80 less a month gives them a competitive advantage. In fact, I think it’s outright ridiculous. I can’t imagine a scenario where a marketing department would even make a pitch that a $0.80 cents per month would give them a competitive advantage. And certainly no tax department would go out on such a limb and expose their company to such a risk on their own. The Attorney General’s argument is ridiculously weak — it would be laughable if the consequences weren’t so dire.
 
When everyone was coming out with these plans basically at the same time, how did Sprint know exactly how their competitors would tax it? Did Sprint even advertise that their taxes were lower than their competitors? How critical is it to a prospective wireless customer what rate of tax they will be charged? Do people even think about that when looking at wireless carriers? Don’t most customers focus on coverage, roll-over minutes, equipment offered, and other services? How in the world is this fraud?
 
Taxation is Tough for Everyone, Especially Telecom Providers
 
The New York State Public Service Commission website page lists all the taxes and other fees that apply to telecom providers. If you’re the Sprint tax department you not only have to decide how much of the monthly call volume is interstate in nature, but which taxes and other fees apply and which of those they owe out their own pocket and which they must collect from their customers. Here’s a list of the taxes and fees applicable to telecom providers in NY: 
  • State and local sales tax,
  • Federal excise tax,
  • E911 surcharge,
  • Public safety communications surcharge,
  • Municipal surcharge,
  • New York State gross revenue tax surcharge,
  • FCC subscriber line charge (SLC) 2, 
  • Federal universal service fund recovery charge,
  • MTA tax surcharge,
  • Local number portability surcharge (LNP),
  • New York City franchise fee,
  • and more!
Can we give the telecom providers a break here? Rocket scientists are welcome to weigh in. Just complying with the laws is nearly impossible. When laws change and judgments have to be made as to whether a given charge is taxable in part or in whole, isn’t it possible that fraud is not involved even if the judgment is later deemed to be incorrect? 
 
Keep in mind that this is just one state. Every other state requires a similar, but distinctly baffling array of taxes of telecom companies. I can imagine that when this calling plan came out from the marketing department. The Sprint tax department had to scramble to figure out how it should be taxed all over the nation, wherever it was offered. I’m willing also to bet that at the time the plan was offered, the law wasn’t crystal clear in every jurisdiction, including New York. So, it’s very easy to understand how they came to this conclusion. I’m not saying whether I agree or disagree with their conclusion, but I can see how they got there.
 
Every Other Carrier in N.Y. is Vulnerable Here
 
According to the A.G., all the other big cell carriers were or are taxing these calling plans 100 percent. If the A.G. wins this lawsuit, the carriers may not be at risk on this specific issue, but because of the complexity of telecom taxation, other issues where they are at risk of undertaxing customers are bound to exist. But on a more ironic twist, let’s say that Sprint is able to fight back and win a court decision that they taxed it correctly in the first place. Then, suddenly, all of the other carriers are at risk to class action lawsuits for overcharging the tax. Is this good for encouraging rational tax policy that reasonable, law-abiding companies can follow? 
 
How to Minimize the Risks
 
So what do we recommend on how to avoid these type of lawsuits against your company? Good question. I guess the best we can say is, be extra careful. We all have to be careful to charge the right rate of tax on the right items. Some ways we can increase our diligence are:

 

  1. Education – A big part of being diligent is to continuously educate ourselves. Sales tax is not static and neither should our knowledge base be. We should also be vigilant in watching for important court cases and how they may affect what we do.
  2. Don’t Assume – Your normal CPA is probably very knowledgeable when it comes to income taxes and other issues that affect your business. However multi-state sales tax issues are complex and many CPAs often do not have the bandwidth to stay abreast of all the changes. Ask your CPA how comfortable they are with multi-state issues and what they do to keep themselves educated. The same goes for your employees. Make sure they are staying current.
  3. Be Agile – Once changes are spotted we have to be agile enough to implement the necessary adjustments in a timely fashion.
  4. Be Proactive – The attitude of “we have always done it this way and have never had any problems” should be banished from our organizations’ mindsets. We don’t have to experience the problem ourselves prior initiating adjustments to how we operate.
  5. Utilize Third Parties – There are a handful of firms that concentrate on sales tax. At  Peisner Johnson and Company, we focus entirely on state and local tax issues.
The merits of the different state False Claims Acts and whether they create unnecessary litigation when it comes to tax issues can be debated. Our position is firmly on the side of the taxpayer. In Illinois we believe that the Act clearly creates unnecessary litigation. In New York, although much remains to be discovered, we believe the fraud action to be far too drastic an option. Sprint and New York would have ultimately worked out their differences either voluntarily or in court. However, at least for the time being, qui tam or whistleblower lawsuits are potential sales tax nightmares that need to be taken seriously.

Our Prayer to Lawmakers
As it currently stands, it seems like companies take great risks if they mistakenly overcharge the tax because of class action lawsuits. But at least in Illinois and New York — and maybe in more states as time moves on — companies may be in even worse shape if they undercharge the tax because of the whistleblower and fraud lawsuits they may face. We hope that as this issue comes up more frequently, lawmakers will step in to change these false claims acts and leave the enforcement of the tax laws with the various Departments of Revenue. Generally, Departments of Revenue have done a creditable job over the years of developing policy, training taxpayers, and enforcing the law. Remedies for disputing how the laws are interpreted are well-developed and widely used. Companies have a realistic expectation that they will be treated fairly by Departments of Revenue. Although the system is far from flawless, the system works quite well, overall. As for fraud, there are provisions for dealing with sales tax fraudsters. Fraud does occur when it comes to sales tax, but it usually involves knowingly collecting tax and not remitting it. Fraud should not include a scenario where a company relies on a DOR’s written policy and does not collect tax, or when a company makes a reasonable judgment that part or all of a given service it provides is not taxable. We hope that lawmakers will act to change these false claims laws such that these unnecessary and ridiculously punitive provisions of treble damages are removed. We hope that lawmakers will remove the bounty fees being paid to uninjured attorneys. We do not advocate underpaying or overpaying tax, but we know it happens for a variety of reasons most of which never involve a scintilla of fraud.  

Missouri DOR Rules on Software Delivered Through “Load and Leave” Method

Back in October of 2010, we published an article entitled Missouri Policy on Software Load and Leave is Ruled Out Is Software Even Taxable in Missouri Now? The article was in response to an administrative hearings decision that held that software delivered through a “load and leave” method was not taxable because it was not tangible property.

But, as we said then, this decision seemed to throw the whole question out in the open. Is software even taxable at all regardless of how it is delivered? Is the means of delivery completely superfluous and is it all about the true object of the transaction? That certainly seems to be the reasoning underlying the ruling. Consider this: the AHC stated that while it was true that precedents from the Missouri Supreme Court have applied to sales of software, the prior cases did not squarely address the issue of whether software is tangible personal property. In fact, tellingly, the AHC compared the sale of software on a disk to the sale of a share of stock. The sale of stock is not taxed because it is intangible in nature. Yes, it is represented on some fancy parchment stock paper, but the value of the paper is inconsequential to the value of the ownership interest it represents. It could certainly be argued using the reasoning in this case that in Missouri all software is intangible by nature and whether it is transferred electronically, by load and leave, or by tangible medium does not matter.

We said this issued should be watched in Missouri. And we have been watching.

The Missouri Department of Revenue has now issued a detailed ruling outlining its policies on software. Unfortunately, they do not go as far as to conclude that all software is exempt because it is not tangible property, but they do affirm all other aspects of the administrative hearing referenced above. According to the DOR, the taxability of canned software depends totally on how it is delivered. If by tangible personal property that remains at the purchaser’s location, then it is taxable. Below is the entire text of the ruling for your reading pleasure.

We still believe that this distinction is shaky at best. In sales/use tax, form often trumps substance and we understand that. But this treatment by MO strains all credibility. For example, let’s say a company in MO buys 10,000 licenses to MS Office for use by its employees all over the world. According to this ruling, if the software is installed electronically on the company’s server in MO and then subsequently downloaded and installed by employees in and outside MO, no, MO tax is due. However, if even one CD is part of the “originally delivery” of the software, then all licenses would be taxable in MO. That seems to be a huge stretch. If this comes up on audit and an assessment is made, I would expect someone to fight this and the issue of whether software is even tangible property will be raised again.

For now, though, at least we have some definite policies on software taxability in Missouri. Here is the ruling in its entirety.

Letter Ruling No. LR 7001, Missouri, (Jan. 27, 2012)

LR 7001

Taxability of Canned Software, Custom Software, Software Licenses, Mandatory & Optional Maintenance Agreements, Non-Downloadable Software Kept by Vendor & Load and Leave

January 27, 2012

Dear Applicant:

This is a letter ruling issued by the Director of Revenue under Section 536.021.10, RSMo, and Missouri Code of Regulations 12 CSR 10-1.020, in response to your letter dated October 14, 2011.

The facts as presented in your letter ruling request, your previous letter, and through telephone conversations with Legal Counsel Eva Vlachynsky are summarized as follows:

Applicant purchases canned and customized software programs, licenses to use canned software programs, and mandatory and optional software maintenance and support for the software programs from a variety of vendors. Applicant purchases licenses to use original canned software programs that are downloaded to Applicant’s local servers electronically through the internet. In the alternative, Applicant sometimes purchases an original canned software program that is downloaded from a tangible format. Once a software program is downloaded onto Applicant’s local servers that are located in Missouri, the software is copied onto Applicant’s other computers electronically according to the number of licenses purchased by the Applicant.

The maintenance and support that Applicant purchases provide updates, upgrades, or modifications to the software programs. Certain vendors will include the mandatory maintenance and support for a set period of time with the Applicant’s software program purchase or license agreement. Support services provide the ability to speak with a representative via telephone or the ability to look up answers to a problem via website. Examples of maintenance and support materials are instruction manuals and troubleshooting information. Support service contracts may include software updates referred to as “patches.” Patches repair problems or allow additional functionality based upon problems with the software after its release date. Maintenance and support materials are distinguishable from any part of the actual software. The costs for the maintenance and support, whether mandatory or optional, are stated separately on the vendor’s invoice or are billed as a separate invoice.

Applicant also purchases access to non-downloadable software programs through vendors’ internet web sites. The non-downloadable software programs are not downloaded onto Applicant’s local servers in Missouri but are merely accessible for Applicant’s use via each vendor’s web site.

Occasionally, Applicant will enter into a single agreement to purchase several products. In these instances, some products are downloaded electronically through the internet and some are delivered in tangible format. The vendor will separately state each item on a single invoice.

ISSUE 1:

Are Applicant’s purchases of canned software downloaded electronically over the internet subject to sales or use tax?

RESPONSE 1:

No. Applicant’s purchases of canned software downloaded electronically over the internet are not subject to sales or use tax.

Section 144.020.1, RSMo, imposes a sales tax upon retail sales of tangible personal property and certain enumerated services. Section 144.610.1, RSMo, imposes a use tax “for the privilege of storing, using or consuming within this state any article of tangible personal property.” Missouri Code of State Regulations 12 CSR 10-109.050(1) provides that “the sale of canned computer software programs is taxable as the sale of tangible personal property.” A “canned program” is defined as a standardized program “purchased ‘off the shelf’” or is a program “of general application developed for sale to and use by many different customers with little or no modifications.” 12 CSR 10-109.050(2)(A). A computer program may be a canned program “even if it requires some modification, adaptation or testing to meet the customer’s particular needs.” Id.

Missouri Code of State Regulations 12 CSR 10-109.050(3)(A) further provides:

Tax applies to the sale of canned programs delivered in a tangible medium which are transferred to and retained by the purchaser. Examples of canned programs delivered in a tangible medium would include coding sheets, cards, magnetic tape, CD-ROM or other tangible electronic distribution media on which or into which canned programs have been coded, punched or otherwise recorded. 12 CSR 10-109.050(3)(A). If a purchaser does not receive a tangible medium of the original canned software, there is no sale of tangible personal property under Section 144.020, RSMo.

Here, the software is downloaded directly from the internet at the time of installation. Applicant never takes possession of any tangible personal property. Therefore, the purchase of the software downloaded electronically from the internet is not subject to sales or use tax.

ISSUE 2:

Are Applicant’s purchases of customized software programs downloaded by tangible format or electronically through the Internet subject to sales or use tax?

RESPONSE 2:

No. Applicant’s purchases of customized software programs downloaded by tangible format or electronically through the internet are not subject to sales or use tax. But purchases of canned software by tangible format that by has been adapted for Applicant’s use is not custom software and is subject to sales or use tax.

Missouri Code of State Regulations 12 CSR 10-109.050(1) provides:

In general, the sale of canned computer software programs is taxable as the sale of tangible personal property. The sale of customized software programs, where the true object or essence of the transaction is the provision of technical professional service, is treated as the sale of a nontaxable service.

Missouri Code of State Regulations 12 CSR 10-109.050(3)(C) provides:

Programming changes to a canned program to adapt it to a customer’s equipment or business processes, including translating a program to a language compatible with a customer’s equipment, are in the nature of fabrication or production labor that are a part of the sale and are taxable.

Here, if the software is custom software and not canned software that has been adapted for a customer’s use, whether Applicant purchases the customized software program in a tangible format or in an electronic format, the sale of customized software is treated as a nontaxable service. Therefore, Applicant’s purchases of customized software programs are not subject to sales or use tax.

ISSUE 3:

Are Applicant’s purchases of licenses to use canned software, when the original software was downloaded electronically through the internet to Applicant’s server and afterward individual users download copies based on the number of licenses purchased, subject to sales or use tax?

RESPONSE 3:

No. Applicant’s purchases of licenses to use canned software, when the original software was downloaded electronically through the internet to Applicant’s server and afterward individual users download copies based on the number of licenses purchased, are not subject to sales or use tax.

Missouri Code of State Regulations 12 CSR 10-109.050(3)(B) provides:

Tax applies to the entire amount charged to the customer for canned programs. Where the consideration consists of license fees or royalty payments, all license fees or royalty payments, present or future, whether for a period of minimum use or for extended periods, are includable in the measure of the tax.

License fees are taxable if the original purchase of the canned program was subject to sales or use tax. A purchase of canned software that is downloaded through the internet is not taxable. If Applicant purchases licenses to use canned software that was originally downloaded through the internet, the purchases are not subject to Missouri sales or use tax.

ISSUE 4:

Are Applicant’s purchases of mandatory software maintenance and support delivered electronically through the internet subject to sales or use tax if delivery of the initial software occurs electronically through the internet?

RESPONSE 4:

No. Applicant’s purchases of mandatory software maintenance and support delivered electronically through the internet are not subject to sales or use tax if delivery of the initial software occurs electronically through the internet.

Missouri Code of State Regulations 12 CSR 10-109.050(3)(E) provides:

Program installation, training, and maintenance of software services are taxable under the following circumstances:

1. The purchase of the services is mandatory under the terms of an agreement to purchase software[.]

Under the regulation, the Director assumes, if the original purchase of the software was subject to sales or use tax, then program installation, training, and maintenance of software services are taxable if these services are mandatory under the terms of the purchase agreement. Here, although Applicant’s purchases of the software maintenance and support are mandatory, the original software was not subject to tax because it was not purchased in a tangible format, but downloaded through the internet. Therefore, Applicant’s purchases of mandatory maintenance and support downloaded electronically are not subject to Missouri sales or use tax when the original software was downloaded electronically.

ISSUE 5:

Are Applicant’s purchases of optional software maintenance and support delivered electronically through the internet subject to sales or use tax if delivery of the initial software occurs electronically through the internet?

RESPONSE 5:

No. Applicant’s purchases of optional software maintenance and support delivered electronically through the internet are not subject to sales or use tax if delivery of the initial software occurs electronically through the internet.

Missouri Code of State Regulations 12 CSR 10-109.050(3)(F) provides:

Program installation, training and maintenance of software services are not taxable under the following circumstances:

1. The purchase of the services is not mandatory under a software purchase agreement and the services are separately stated on the purchase invoice from software or other items purchased; or

2. The services are purchased separately from software or other tangible personal property.

Applicant’s purchases of the software maintenance and support are optional. If an optional maintenance and support fee is separately stated on the invoice, it is not subject to sales or use tax. Applicant’s purchases of optional software maintenance and support downloaded electronically through the internet are not subject to sales or use tax when the initial software was downloaded electronically through the internet or if the optional software maintenance and support is separately stated on the invoice and does not include software updates.

ISSUE 6:

If Applicant purchases canned software originally delivered in electronic format, licenses to use the canned software, mandatory and optional maintenance and support with delivery of some items occurring in tangible form and delivery of others occurring electronically, which products are subject to sales or use tax when the vendor separately states each product on a single invoice?

RESPONSE 6:

Purchases of canned software delivered electronically, licenses to use canned software when the initial software was delivered electronically, and mandatory and optional maintenance and support delivered electronically when the initial software was delivered electronically are not subject to sales or use tax when the vendor separately states each product on a single invoice. See Responses 1, 3, 4, and 5. However, any portion of these items delivered in a tangible format will be subject to sales or use tax.

ISSUE 7:

If Applicant purchases canned software originally delivered in tangible format, licenses to use the canned software, mandatory and optional maintenance and support with delivery of some items occurring in tangible form and delivery of others occurring electronically, which products are subject to sales or use tax when the vendor separately states each product on a single invoice?

RESPONSE 7:

Purchases of canned software in a tangible format, licenses to use the canned software when the initial software was in a tangible format, and mandatory maintenance and support when the initial software was in tangible format are subject to sales or use tax when the vendor separately states each product on a single invoice. Optional maintenance and support is also subject to sales or use tax when the initial software was in a tangible format. See Responses 1, 3, 4, and 5.

ISSUE 8:

Are Applicant’s purchases of access to non-downloadable software housed on vendor internet web sites on servers located outside of Missouri subject to sales or use tax?

RESPONSE 8:

No. Applicant’s purchases of access to non-downloadable software housed on vendors’ Internet web sites on servers located outside of Missouri are not subject to Missouri sales or use tax if Applicant does not receive a tangible form of a software program that will allow it to access the non-downloadable software. See Response 1.

ISSUE 9:

Are Applicant’s purchases of software programs subject to sales or use tax when the programs are installed by the vendor using a tangible storage media at the Applicant’s web site and the tangible media is taken by the vendor after installation?

RESPONSE 9:

No. Applicant’s purchases of software programs are not subject to sales or use tax when the programs are installed by the vendor using a tangible storage media at the Applicant’s web site and the tangible media is taken by the vendor after installation.

Applicant does not take possession of any tangible media because the software is downloaded by the vendor from tangible media at the Applicant’s web site and the tangible media is taken by the vendor after installation. Therefore, the purchase of the software is not subject to sales or use tax. See Response 1.

This letter ruling is binding upon the Department of Revenue with respect to Applicant for three (3) years from the date of this letter and is subject only to statutory changes by the General Assembly and to changes in the interpretation of law by the courts or administrative tribunals. If a change occurs, the taxpayer who relies upon an outdated interpretation may be subject to additional taxes, interest and penalties, which may be imposed prospectively from the date of the change. For this reason, the interpretation set forth above should be reviewed on a regular basis. Please note that any change in or deviation from the facts as presented will render this ruling inapplicable.

Should additional information be needed, please contact Legal Counsel Eva Vlachynsky, General Counsel’s Office, Post Office Box 475, Jefferson City, Missouri 65105-0475 (phone 573-751-0961), or me.

Sincerely,

Alana M. Barragán-Scott

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