By Mark A. Balistrieri, CPA

The taxation of digital products and services has been a lively topic in recent years for both business consumers and providers of these services. Many of the states with a sales tax do impose the tax on some form of digital products or software. But within the past decade we have seen states enact statutes that not only redefine software as tangible personal property, but also include items such as mobile apps, streaming services, games, and digital books in their definition of taxable tangible personal property or taxable services. Additionally, some states have expanded the tax base to include data processing services. On the surface, the move to define such purchases so they are included in the tax base would seem a natural evolution to align with consumer spending habits gravitating toward digital products as they become more woven into our everyday lives.

Businesses, too, have transformed a number of their internal processes and are now reliant on digital solutions. Digital solutions have become prevalent in many company functions, including human resources, accounting, and customer relationship management, and more are being implemented daily. Many of these solutions involve creating digital platforms that allow the service provider to access company data and return the desired deliverable. In the past, when similar services were delivered through a more traditional, manual methodology, they were considered professional services that were not subject to sales tax in most jurisdictions. However, many state departments of revenue and taxation are reconsidering that position and determining that -- since software, data, or digital access are included with the service -- the recently enacted digital sales and use tax rules allow for these services to become taxable too. To date, the majority of states have not issued definitive guidance as to which services would be considered taxable and which ones would still be exempt services. This has left both service providers and business consumers wondering whether or not they should subject their individual services to tax. In a number of instances this muddled policy has resulted in sizable audit assessments and/or denied refund claims.

As one would expect, the statutory- and appeal-level answers to the issue vary by state; in some instances, they have even varied within the same jurisdiction. For example, the Ohio State Supreme Court has issued a ruling that the true object test must be applied to determine taxability.¹ While the ruling was partially favorable to the taxpayer, it still leaves ambiguity as to when the true object is a professional service or the sale of automated data processing services that are defined as taxable in Ohio. In Pennsylvania, there was a 1998 repeal of a statute that taxed computer programming services in which customization and enhancements to software were considered exempt, provided they were separately stated and charged for from the purchase of the software itself. However, legislation in 2016 defined software as tangible personal property, and the Department of Revenue has begun considering such services as the alteration of tangible personal property that has been defined in other sections of the tax code as subject to sales tax. In these examples, neither state has provided the taxpayers with more definitive guidance so they may become compliant. While one can consider the overall validity of either department’s position of taxability for the services, it is made more difficult without such guidance.

This issue has led to an expansion of the tax base that may, or may not, have been intended by the various state legislatures when enacting the digital products statutes. For certain, the change in position has led to the business community paying a larger portion of tax in almost all jurisdictions.

What should service providers and consumers of the services do moving forward? When entering into agreements where there is a digital component to the service, the respective parties should contact a tax professional to understand the various state and local taxing rules that may apply to the service. They can then make an informed decision on how best to approach the sales and use tax complexities that continue to evolve.

¹ Cincinnati Fed. S.&L. Co. v McClain, 168 Ohio St.3d 123, 2022-Ohio-725.

Mark A. Balistrieri, CPA, is director, state and local tax, with Schneider Downs & Co. Inc. in Pittsburgh. He can be reached at mbalistrieri@schneiderdowns.com.

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