We said it last year and we’ll say it again now: The software industry is supremely positioned to take advantage of ongoing digital transformation.

Generative artificial intelligence (AI) has captured headlines since the launch of ChatGPT on November 30, 2022. Nearly every industry, from education and government to healthcare and marketing, is exploring how AI can improve and streamline operations. According to Boston Consulting Group, close to 80% of business leaders surveyed say they’re already using AI in some capacity.

Software developers themselves “can complete coding tasks up to twice as fast with generative AI,” reports McKinsey & Company. AI particularly shines with “garden-variety tasks that software teams do regularly.” The technology “significantly improves the developer experience, which in turn can help companies retain and excite their best talent.”

SOURCE: McKinsey & Company

This is good news. Though recent developments in AI have raised alarms about mass unemployment, many tech companies are struggling to find IT talent. More than 85 million jobs globally — about the population of Germany — could go unfilled by 2030, according to a study by Korn Ferry. Unless more high-tech workers materialize by that date, the United States could miss out on $162 billion worth of revenue annually in tech alone.

Generative AI hasn’t significantly impacted IT spending as of July 2023, per Gartner, which expects worldwide IT spending to total $4.7 trillion in 2023. Businesses are spending more on software and IT services, but they’re spending less on data center systems and devices. Many are reallocating software budgets to core applications and platforms that support automation and efficiency gains, like enterprise resource planning (ERP) and customer relationship management (CRM, applications). Indeed, IT accounted for 14.85% of ERP users in 2020.

SOURCE: Gartner

Of course, AI technology isn’t all peaches and cream. The McKinsey study found that some tasks took junior developers 7% to 10% longer with AI tools than without them, and the research suggests the tools are “only as good as the skills of the engineers using them.” However, McKinsey believes a structured approach that includes generative AI training, workforce upskilling, and risk controls could lead to “extraordinary productivity and unparalleled software innovation.”

But there’s more to the software industry than AI. A host of companies are suiting up avatars and doing business in the metaverse, so inevitably, tax officials are starting to think about taxing transactions in virtual worlds. Governments are also getting a grip on digital currencies and non-fungible tokens (NFTs).

And, as always, policymakers are tweaking tax policies related to digital goods and services and software, and businesses are striving to be tax compliant.

SOURCE: Grand View Research

SOURCE: Gartner

SOURCE: Gartner

SOURCE: Avalara

This has got to be an exciting time for lawmakers and tax officials. Since the shape and tenor of sales tax laws were set long before the advent of digital goods and services, software, and virtual worlds, states have a lot to do to get sales tax laws up to date. After all, although the word “fungible” existed when Mississippi kicked off the U.S. sales tax trend back in 1930, “non-fungible tokens” have been a thing for less than 10 years (if indeed an NFT is a “thing”).

“The digital world has created new products and marketplaces that include advertising, data usage, and ecommerce and now account for 3% of a consumer’s spending, and this is increasing,” notes the National Conference of State Legislatures (NCSL) in an overview of its Indy 2023 Task Force on State and Local Taxation. “With growing markets, states are enacting policy as well as encountering related legal challenges to new taxes.”

That about sums it up.

Lots of states still don’t tax digital products or streaming services, although most tax the underlying tangible products. For example, while a hardcover or paperback book is subject to sales and use tax in California, an ebook is not. The same goes for West Virginia. And the same goes for vinyl records or CDs (which are typically taxable in those two states) vs. digital music (which is generally exempt).

Sales tax revenue may not be suffering too much in states that don’t tax many or most digital products and services, at least for now. Sales tax collections were surprisingly strong in a majority of states in August 2023, despite inflation, shaky consumer confidence, and the fact that state budgets are anticipating “a slower economy.”

But that’s likely to last only so long, as the percentage of a state’s economy that’s subject to sales tax is shrinking.

“The average sales tax breadth, or share of a state economy included in the sales tax base, was 29.71% in fiscal year 2021,” observes the Tax Foundation, as reported by the NCSL. “This represents the lowest point in a consistent downward trend over the past several decades.” If you’re skeptical, consider this: The mean sales tax breadth in 1970 was 49%.

SOURCES: Brookings, Tax Foundation

Rather than expand sales tax to more products and/or services, most states tend to raise sales tax rates when they need to increase collections. The median state sales tax rate in 1970 was 3.25%. Can you imagine? It jumped to 4% in 1980, 5% in 1990, and sits at 6% today.

There’s another way: The NCSL and the Tax Foundation are in favor of broadening the sales tax base and, if possible, lowering sales tax rates — but taxing more products and services tends to be politically unpopular. “We’re going to tax a lot more of your sales!” is not a favored line on the stump. And indeed, there were more new sales tax exemptions in 2023 than new sales taxes.

David Lingerfelt, Senior Director of Indirect Tax at Avalara, says he doesn’t see significant statutory developments on the 2024 horizon for software or digital goods, “but states may continue refining their positions on software and digital goods taxability through bulletins, notices, and court cases.”

A number of states did update sales tax policies related to certain digital goods and services, and/or software in 2023. Some new policies or clarifications came in the form of new laws, some in the form of rulings or guidance. These include, but certainly aren’t limited to, the following:

The taxability of software in Mississippi depends on the location of the server. Senate Bill 2449 amended Mississippi sales and use tax law to address the taxation of computer software and computer software services in the state. As of July 1, 2023, remotely accessed software hosted on servers located outside of Mississippi is exempt from Mississippi sales and use tax. If the server is located in Mississippi, these transactions are subject to Mississippi sales tax. 

Licenses to access cloud-based software are subject to Arizona TPT. Arizona courts have upheld the Arizona Department of Revenue’s position on the taxability of software as a service (SaaS). Thus, licenses to access cloud-based software are considered rentals of tangible personal property and subject to Arizona transaction privilege tax (TPT). 

Prewritten computer software is tangible personal property in Michigan. According to a Revenue Administrative Bulletin (RAB) issued by the Michigan Department of Treasury on July 31, 2023, prewritten computer software is considered tangible personal property and is subject to sales and use tax, whereas “software originally designed for the exclusive use and special needs of the purchaser” is exempt. The RAB is lengthy but distressingly short on “X is taxable, Y is exempt” statements.

SOURCE: Michigan Department of Treasury

Virginia’s sales and use tax exemption for equipment purchased or leased for use in a data center applies to qualifying equipment first delivered to a storage facility. In June 2023, the Virginia Tax Commissioner ruled that equipment purchased or leased for use in a Virginia data center is exempt from Virginia sales and use tax “regardless of whether such equipment is delivered to a storage facility prior to delivery to the data center.”

Remote personal electronic storage capacity services are not subject to the New Orleans French Quarter Economic Development District sales and use tax. The Louisiana Board of Tax Appeals ruled that sales of remote personal electronic storage capacity services are exempt from the New Orleans French Quarter Economic Development District sales and use tax (at least in this particular case); the federal Internet Tax Freedom Act (ITFA) prohibits state and local jurisdictions from taxing internet access, which includes personal electronic storage capacity provided independently or not packaged with internet access.

New York sales tax applies to a company’s vendor management service. The New York Division of Tax Appeals determined a taxpayer’s vendor management service was a taxable sale of prewritten software. New York Tax Law § 1105(a) imposes sales tax on the receipts from every “retail sale” of tangible personal property, which includes “prewritten computer software.” 

Kentucky sales tax applies to prewritten computer access services. “Prewritten computer software access services” are included in the list of warranty contracts subject to Kentucky sales and use tax as of January 1, 2023. Prior to that date, extended warranty service contracts that covered prewritten computer software access services (cloud-based software) were not subject to sales and use tax.

The enactment of HB 360 clarifies that Kentucky sales and use tax applies to charges to keep or retain prewritten computer access services in Kentucky (retroactive to January 1, 2023). It also specifies that a “use” does not include the keeping, retaining, or exercising any right/power over prewritten computer software access services purchased for use outside of Kentucky and transferred electronically outside Kentucky for use solely outside Kentucky.

Georgia taxes retail sales of specified digital products. As of January 1, 2024, specified digital products, other digital goods, or digital codes sold to an end user in Georgia are subject to Georgia sales and use tax provided the right of use is permanent.

One of the most challenging aspects of taxing digital goods and services is that states don’t necessarily define them the same way — or even at all — for sales and use tax purposes. The Streamlined Sales Tax Governing Board (SSTGB or simply SST) is working to rectify that, at least for its 24 member states. (SST was created to simplify sales tax administration for governments and reduce the burden of compliance for businesses.)

Under Rule 332 of the SST Rules and Procedures, approved October 2005 and most recently amended October 2021, specified digital products include digital audiovisual works, digital audio works, and digital books. Member states are free to tax or exempt all or some of these products as they see fit, as long as they use the same definition for specified digital products, digital audiovisual works, digital audio works, and digital books.

Section 332.G specifies that the tax treatment of a “digital code” be the same as the tax treatment of the specified digital product to which the code relates; you basically look through the code to the underlying specified product. SST defines digital code as “a code that provides a purchaser with a right to obtain one or more digital product(s) within one or more of the ‘specified digital product’ subcategories having the same tax treatment.” A digital code may be transferred electronically or via a tangible medium, such as a card, invoice, or gift certificate.

As noted, this is how SST defined digital code and specified digital products in October 2021. That was just a few months after the first NFT artwork sold for over $69 million. Everydays: The First 5000 Days by Beeple wasn’t the first NFT — many consider that to be Kevin McCoy’s Quantum, which was minted in 2014 — but it definitely caught the attention of tax policymakers.

SOURCE: NFT Now

Because NFTs were so new in 2021, they weren’t addressed in any state’s sales and use tax laws when that $69 million sale occurred. Not directly, at any rate. As a result, at least one state probably missed out on a whole heap of sales or use tax revenue.

“Commerce will always evolve faster than tax policy,” notes David Lingerfelt. “It is typically a trigger event, such as significant revenue seepage over multiple budget cycles or a high-dollar sale highlighted in the news, that gets the attention of policymakers.”

So, SST is developing a new definition for “digital code.” It’s very meta: “‘Digital code’ means an alphanumeric or graphic code, which provides a purchaser with an object to obtain a ‘digital code object.’” It also includes “a code provided to purchasers in the form of an electronic instrument that is capable of being scanned from the purchaser’s electronic device.” One pictures a QR code.

As proposed, “digital code object” includes:

• A specified digital product
• A product transferred electronically
• Prewritten software delivered electronically
• Access to a digital computing environment or physical venue
• Evidence of ownership of property
• Object to obtain the performance of a service or any other object afforded the possessor of the digital code, regardless whether such property or service is capable of electronic transfer or delivery

The proposed update to the digital code section further specifies that “tax rules applicable to sales of digital codes apply “regardless of the nomenclature used to describe the code including its characterization as a non-fungible token and regardless of the technology used to generate the code, including blockchain technology.”

In other words, SST is trying to cover all the bases. All the bases it knows about today, at least.

SST’s State and Local Advisory Council also recommends moving the time of tax collection up from the time the product is delivered (when no money changes hands and there’s little to no opportunity for the seller to collect tax) to the time the digital code is delivered. And it would like to expand the digital codes look-through rule beyond specified digital products to sales of digital codes for software delivered electronically and to codes delivered using NFTs that result in the transfer of other types of products.

Because it is possible to purchase an NFT that provides membership to an exclusive real-world club where you can eat real food and drink real drinks, and the like.

SST is to be applauded for tackling this issue. “Most tax authorities and policymakers don’t really get the metaverse,” says David Lingerfelt. “They don’t understand the issues triggered by the metaverse. Whoever would have imagined that you would buy a digital pair of shoes to put on a digital representation of yourself?” Or better yet, that you’d want your real body to have a matching pair?

Tax authorities may not get it, but businesses sure do.

Holders of the Adidas Into the Metaverse NFT, created in December 2021, were guaranteed access to exclusive physical products through 2022. You can collect virtual Jibbitz charms and win yourself physical charms in the Crocs virtual Jibbitz store. And the first label to launch on SYKY, a community-driven fashion platform, included a 1:1 digital and physical handbag — a 3D-printed, resin-and-electroplated collectible with a digital twin.

There’s real money at stake. The market for in-game skins (clothing and such for avatars) is worth an estimated $40 billion, and virtual products can drive demand for counterpart products in the real world.

SOURCE: VentureBeat

And this isn’t just happening with intangible and tangible things: The audience for virtual concerts is growing. Three out of four people attended an online event during the pandemic, according to a survey of 1,000 consumers, and 88% of those who did said they would do so again once in-person gatherings returned. And why not? You don’t have to deal with crowds, or parking, and the price of admission is often much less.

So what does all this mean for sales tax and admissions tax? Should sales tax apply when you buy a sweatshirt for your avatar and for your real body? If so, at what point? Does the admissions tax you paid for a nosebleed seat at a Taylor Swift concert apply to your virtual chamber music subscription?

Well, tax authorities are still sorting that out.

“Some state legislation governing admissions tax is broad, so you could argue it applies to a virtual event,” says Lingerfelt. “But you can drive a bus through broad. People will argue that the original admissions tax law was not intended to apply to a virtual event.”

Some of the questions that need to be addressed in order to properly tax transactions in a virtual world include:

• What was sold? A digital product? A digital service? Neither? Both? What about if the sale of an NFT results in the purchase of a physical product or real-world experience?
• Who sold it? Many virtual worlds essentially function as marketplaces, and in another “meta” move, there can be secondary marketplaces within them. Should marketplace facilitator laws apply? 
• Who has jurisdiction over the transactions? Is it the location of the server? The operator of the platform? The buyer? What if you don’t know who or where the seller or buyer is?
• What’s the sales price? If cryptocurrency was used to make a purchase, should tax be based on the date-of-sale value or the time-of-sale value?
• What are the rules? Are they set? In flux?

SOURCE: PWC

SST and the Multistate Tax Commission are working on this, as are tax officials in some individual states. But this is uncharted territory, so it’s slow going. State officials are wary of making a new rule, policy, or law that could end up leading to a lot of litigation.

To date, only about five U.S. jurisdictions have issued guidance on taxing NFTs:

• Minnesota
• Pennsylvania
• Puerto Rico
• Washington
• Wisconsin

SOURCE: Avalara

David Lingerfelt is hoping more states will address NFTs in 2024. Whether any actually will remains to be seen, but the issue is getting attention in some other countries. For example, Italy has proposed exempting an NFT from value-added tax (VAT) if all the NFT rights are assigned by its original artist. And the European Commission’s Value Added Tax Committee mentioned dynamic NFTs in a working paper published February 2023; the paper summarizes how Belgium, Norway, and Spain have answered questions related to the taxation of NFTs.

Maryland’s digital advertising tax was vetoed, challenged in state and federal courts, dismissed by the federal court, ruled unconstitutional by the circuit court, and allowed to stand by the Maryland Supreme Court. Through it all, the state (if not all tax officials in the state) has steadfastly defended its right to collect the digital advertising gross revenues tax. The tax had reportedly generated more than $106 million in revenue as of May 2023. (Do you think that covered the legal fees?)

The Maryland Supreme Court overturned the lower court’s ruling on the grounds that it lacked jurisdiction. It didn’t address the constitutionality of the tax, so we’re basically back to where we started. We probably haven’t seen the last of the legal battles, and we probably won’t in 2024, says David Lingerfelt. “It will trudge along.”

Meanwhile, states interested in establishing similar digital ad taxes may be emboldened to move forward. As they look to tax digital advertising, observes Toby Bargar, Senior Tax Strategist at Avalara, they’ll have to take into account some of the key aspects of the Maryland case.

To wit, the District of Columbia Tax Revision Commission met in September 2023 to discuss various tax proposals, including to strengthen and clarify taxation of digital ads and services. The Commission will deliberate the proposals, consider public comments, and submit a final set of recommendations to the D.C. Council at the end of 2024.

D.C. isn’t alone, although the Council On State Taxation generally considers state digital services taxes to be “a bad idea under any theory”:

• States that have considered some sort of digital advertising gross receipts tax include Connecticut, Massachusetts, Montana, New York, and Texas
• States interested in digital ad taxes on social media transactions include Arkansas, Connecticut, and Indiana
• States interested in taxing data mining, personal information, and/or sales of personal data include Massachusetts, New York, Oregon, Washington, and West Virginia

New Jersey is also studying these taxes, though it hasn’t yet gone so far as to introduce them. And New Mexico is working to clarify that its tax on advertising services applies to digital ads despite the fact that the law predates digital ads.

In October 2023, the New Mexico Taxation and Revenue Department issued proposed rule amendments that detail which receipts from the sale of digital advertising services are subject to gross receipts taxation and which are deductible. It also clarified the sourcing rules for such receipts. The tax department did more or less the same thing in 2022, but pulled the proposed regulations after hearing taxpayers’ concerns.

This 2023 proposal addresses many of those issues, including sourcing methodology. It proposes changing the source of digital advertising receipts from the location of the server to the location of the digital platform company where the advertisement is viewed or accessed.

It can be difficult to accurately source digital sales or digital advertising, which may not be considered a digital good for tax purposes. For starters, many states don’t provide adequate guidance. Even if there is proper guidance, the seller may not know where a digital good was received or used, or how many people inside a state saw a digital ad. The location of the purchaser may not be known, or there may be multiple locations or multiple points of use (when digital goods, computer software, or services are concurrently available for use in more than one jurisdiction, or a digital ad appears on devices up and down the East Coast).

For instance, businesses purchasing digital products that may be used concurrently within and outside Washington are entitled to the multiple points of use sales tax exemption. The buyers must provide the exemption certificate and pay use tax based on the following equation: Divide the number of users (e.g., employees or agents) in Washington by the number of users everywhere.

SOURCE: Washington State Department of Revenue

Digital sales are generally sourced to one of the following:

• Destination of the product (usually for digital goods classified as tangible personal property)
• Destination of the person who benefits (usually for digital goods classified as a service)
• Billing address

Alternatively, the taxing authority may look at the multi-state benefit — though this approach comes with challenges. How exactly do you source the sale of digital goods or services between multiple states? Do you base tax on the actual usage or expected usage (and how can you tell)? Do you base it on the value of the usage? Something else?

Unfortunately, businesses often don’t obtain the buyer’s full address for remote sales of digital goods or services. If the transaction involves an NFT or cryptocurrency, there may be no physical address at all. This is an issue SST member states and the SST Business Advisory Council have been chewing on for years.

In September 2023, the National Association of Certified Service Providers (NACSP) suggested revising the Streamlined Sales and Use Tax Agreement to address this issue. Though they believe the current sourcing provisions have generally worked well and should be “retained to the maximum extent feasible,” they “recognize there are differences in interpretation that could be clarified.”

Under the existing SST sourcing provisions, a seller is required to use delivery information “known to the seller,” “available from the business records of the seller that are maintained in the ordinary course of the seller’s business,” or “obtained during the consummation of the sale, including the address of a purchaser’s payment instrument.” If those rules can’t be applied, sales are sourced to the point of origin.

Certified Service Providers (CSPs) understand states have legitimate concerns with origin sourcing, including that origin sourcing could incentivize companies to move operations offshore or to non-sales-tax states. Accordingly, they propose adding two new sections, Section 310(A)(6) and Section 310(A)(7).

Section 310(A)(6) would read: “Except as set forth in Section 310(A)(7), nothing in this Section places an affirmative duty on a seller to obtain a delivery address under Section 310(A)(2), a purchaser address under Section 310(A)(3), or address information not necessary to complete the sale under Section 310(A)(4).”

Section 310(A)(7) would read: Notwithstanding Section 309 and Section 310(A)(6), a seller shall be considered to have collected the correct amount of state and local tax on a sale if the seller:

1. Sourced the sale using Section 310(A)(5),
2. Has not obtained either a street address, a 5-digit ZIP code, or a 9-digit ZIP code from the customer, and
3. Requested but did not obtain a street address, a 5-digit ZIP code, or a 9-digit ZIP code from the customer. 

A seller will be deemed to have requested such information if it provides a prominently displayed location, on its ordering page or other equivalent documentation, specifically designed and designated for such information. “The seller may not state that the information is ‘optional.’ On the other hand, the seller is not required to state that the information is ‘mandatory.’ The seller is not required to reject the transaction if the information is not provided by the customer.”

These are ideas. Whether SST will adopt them as a best practice is unknown at this time.

The Organisation for Economic Co-operation and Development (OECD) is opposed to digital services taxes, and that’s taken some of the steam out of digital services taxes in other countries. In July 2023, the 138 countries and jurisdictions that have agreed to reform international taxation rules also agreed to refrain from imposing newly enacted digital services taxes or relevant similar measures on any company before December 31, 2024.

SOURCE: OECD

Nevertheless, Canada intends to levy a new digital services tax on January 1, 2024.

In October 2023, the OECD released the text of a new multilateral convention that will update the international tax framework and remove digital services taxes if ratified. Ratification in the U.S. could be difficult. For one, it requires a two-thirds majority in the Senate. For two, it would subject large multinational corporations — including American companies — to an effective tax rate of 15% of their profits in every jurisdiction where they operate.

Whatever happens with OECD’s plan may or may not influence states that are considering some type of tax on digital services, such as advertising.

Taking a lesson from the pandemic, states turned their attention to the taxability of online training and education. “There were no major statutory developments,” says David Lingerfelt, “but some states issued guidance to clarify how online training and education is taxed under current law.”

The general rule of thumb is that education for academic credit, whether a class is online or in person, isn’t subject to tax. If it’s not for academic credit, the deciding factor is often whether the instruction is live, interactive, or prerecorded. The more interaction a student has with a teacher, the less likely charges for instruction are to be taxed.

SOURCE: Avalara

The type of institution selling the online education also matters. While education taught by nonprofit or government institutions is exempt in many states, education taught by for-profit institutions doesn’t benefit from these exemptions.

That’s far from everything, but we have to draw the line somewhere.

Avalara can help you account for tax changes and improve tax compliance for your business. Learn more about Avalara’s cloud-native tax compliance solution for software and SaaS businesses, including tax rate calculation, returns preparation, and document management.

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