Service Providers: Don’t Assume You Are Always Tax-Free!

Service providers—especially in the professional services realm—can be quick to assume that their services are nontaxable and that they do not need to collect sales tax and remit sales tax on their sales of services.

However, it’s not that simple! Sales tax can indeed apply to certain services and the taxation of services across the states is an ever-changing landscape, particularly for services that have digital elements.

You must examine each and every service (or pass-through expense) you provide against state definitions so that you don’t incorrectly categorize your service as nontaxable and then get hit with a state assessment of uncollected sales tax. It can be tricky as state definitions as not always as clear cut as we’d like when it comes to delineating between service types, such as between professional services and data processing services.

Let’s explore examples of companies in four states that got caught in scuffles with the state over the taxation of their services and related charges. Each of these recent real-life example shares key lessons about the importance of applying the correct state definitions and how contract language, invoice presentation, and marketing materials can all impact your service’s taxability.

 

 

No Analysis, No Exemption: Bank’s Electronic “Accounting Services” Deemed Taxable in Ohio

The scenario: A bank in Ohio purchases computerized services from a third-party financial technology and financial services company to assist in the bank’s account-processing services, run transactions, and maintain the banks’ accounting and financial records. The bank filed for a sales tax refund on these purchases, claiming that it purchased nontaxable “accounting services” or nontaxable “customized software.” The Ohio Tax Commissioner denied the refund claim.

The bank’s claim was pushed to the Ohio Board of Tax Appeals and later the Ohio Supreme Court where the bank continued to argue that its pass-through data processing services do not qualify as taxable “automatic data processing” or “electronic information services” but instead constitute nontaxable “personal or professional services.”

The pushback: The Board of Tax Appeals upheld and the Supreme Court affirmed that the bank’s pass-through services from the third-party company do not constitute tax-exempt accounting services, stating:

“…updating and displaying of information upon input or request of the data respectively is not
accounting services; no studying, altering, analyzing, interpreting, or adjusting of the claimant’s
data or financial material occurs.”

The bank’s computerized accounting services for its customers (using the data from the third-party’s services) did not involve any analysis by bank employees or include any activities that required the accounting professional licensure. Therefore, the bank’s services were determined not to comprise nontaxable accounting-related services – nothing was done to the data to interpret, analyze, or adjust it.

The takeaways:

• If you are providing pass-through data processing services that you purchase as part of your own service offerings, are you doing any activities that study/alter/analyze/interpret/adjust the data? In order to provide nontaxable professional services, your professional expertise must be integral to the service offerings. Charges for data processing cannot simply be passed on.
• Think about the true object of your service transactions. In this example, was the bank’s intention in contracting with the third-party company to purchase customized software (nontaxable) or automatic data processing services/electronic information services (taxable) to help serve its customers?

 

Texas Law Firm’s Loan Document Packages Subject to Sales Tax

The scenario: A Texas law firm provides packages containing legal documents necessary to execute residential mortgage loans to clients by using document-generation services of two external vendors. The Texas Comptroller audited the law firm and issued a sales tax assessment for the purchases of loan packages from the vendors. Much like the Ohio bank, the law firm argued that it had purchased nontaxable data-processing services from the vendors and requested a sales tax refund. The law firm contended that the services it purchased constituted “nontaxable legal services” when provided to its clients.

The pushback: The Texas Court of Appeals eventually reviewed the law firm’s case and rejected the firm’s assertion that it solely provided nontaxable legal services and affirmed that the Texas Comptroller correctly classified the law firm’s purchases of packages of legal documents as data processing.

Texas imposes sales tax on data-processing services, defined as:

“…word processing, data entry, data retrieval, data search, information compilation, payroll and
business accounting data production, and other computerized data and information storage or
manipulation.”

When the Court applied Texas’s version of the true object test, “essence of the transactions,” to the law firm’s contracts with the outside vendors, the Court concluded that the essence of the transactions was the provision of data-processing services. The law firm paid the vendors to collect and manipulate data and return it according to the law firm’s instructions. The vendors did not perform legal analysis on the data.

In fact, Texas does not allow the sale of legal services that constitute “engaging in the unauthorized practice of law”. The law firm and vendors specifically structured their contracts to ensure that neither vendor provides a service that requires the use of legal skill or knowledge.

The takeaways:

• Just because a professional service firm, like a law or accounting firm, is involved in a transaction does not automatically mean that transaction will be nontaxable. You must look deeper into service descriptions.
• Watch your contract language and invoice language! It’s difficult to argue you’re purchasing or selling nontaxable services if the language in your contract does not support that assertion.

 

 

Washington Telecom Company Computer Storage Services Subject to B&O Tax

The scenario: A telecommunications company provides colocation services to Washington customers that generally consist of renting space in data center facilities to provide power, cooling, and physical security for the server, storage, and networking equipment of customers. The company retains control over each rental space, how it is used, and when it can be accessed.

The Washington Department of Revenue audited the company and issued an assessment for back taxes. The company disputed the DOR’s assessment of business and occupation (B&O) tax on gross income it received from its colocation services and petitioned for a refund, arguing that the income is revenue from real property leases that is exempt from B&O tax.

The pushback: The Washington DOR’s Administrative Review and Hearings Division reviewed the company’s case and determined that the company had not granted its licensees the “absolute right of control” over their assigned spaces that would constitute the rental or lease of real estate, which are nontaxable services. In Washington, a lease or rental of real estate gives:

“…exclusive right in the lessee of continuous possession against the world, including the
owner, and grants to the lessee the absolute right of control and occupancy during the term
of the lease or rental agreement”

While a license to use real estate:

“…grants merely a right to use the real property of another but does not confer exclusive control
or dominion over the same. Usually, where the grant conveys only a license to use, the owner
controls such things as lighting, heating, cleaning, repairing, and opening and closing the
premises.”

The company had restrictions on licensees’ activity in the data center facilities, their control of lighting and heating on the premises, and restrictions on access to the premises. This limited use did not align with state definitions of the lease or rental of real estate. The company’s gross income from the rentals was found to be derived from licensing of real estate, a taxable service.

The takeaways:

• Closely compare your services with state definitions. When the Washington DOR Administrative Review and Hearings Division laid out state definitions of lease/rental vs. license, it was clear the company was offering a license to use real property. How the state distinguishes certain terms can greatly impact the taxability of your service offerings!

 

 

Advertising Analysis Service Provider Required to Collect New York Sales Tax

The scenario: A data and consulting company provides services to New York clients that measure advertising effectiveness. Part of these services is giving advice and recommendations on how to improve client advertising. The New York Division of Taxation audited the company for sales and use tax and made an assessment for back taxes – the company then appealed.

An Administrative Law Judge reviewed the case and found that the company’s primary purpose was to collection information on the effectiveness of client advertising through activities like surveys, data analysis, and the provision of reports. The Administrative Law Judge concluded the company’s services were taxable as “information service” as the company would have nothing to report to clients without first collecting information.

The company filed an exception to this determination, contending they provide nontaxable consulting services.

The pushback: The New York Tax Appeals Tribunal received the case and reviewed the company’s argument that the primary function of their services was to provide advice and recommendations and that information furnished is in the form of client reports, not the underlying data. New York tax law imposes sales tax on the following types of services:

“The furnishing of information by printed, mimeographed or multigraphed matter or by
duplicating written or printed matter in any other manner, including the services of collecting,
compiling or analyzing information of any kind or nature and furnishing reports thereof to other
persons…”

But excludes:

“…the furnishing of information which is personal or individual in nature and which is not or may
not be substantially incorporated in reports furnished to other persons.”

One of the services the company provides was considered “personal and individual in nature” and qualified for the exemption. However, for other services, the company provided information to third parties and thus did not meet the test that information cannot be incorporated into reports provided to others to qualify for the exclusion.

The company’s marketing materials and contract language also did not help their hopes of qualifying for a tax exemption. The Tribunal noted that marketing materials highlighted data collection as a key service feature and that company’s standard contract generally commits the company to providing “advertising effectiveness studies” and describes their services as “research solutions”.

The takeaways:

• Separate your services that may fall into different categories on your invoice. One service that is not tax-exempt can make a whole service transaction taxable if a mix of taxable and nontaxable services are bundled together.
• Work with your marketing department on the language and terminology used to describe your services. The words you choose can greatly impact whether a state will view your services as taxable or exempt. Be sure to describe your services consistently across selling platforms.

 

Feel Confident Where You Stand with Tax on Your Services and Associated Charges

Our economy is evolving, and the service sector is growing. An expanding services sector has resulted in an expanding state interest in imposing sales tax on services particularly when these services look and sound like computer services. Regularly review and go deep into state definitions for services to understand what qualifies as exempt. As these four company examples demonstrate, service providers are far from immune in being audited for sales and use tax. You don’t want to get caught misapplying a definition that leads to an assessment of tax.

To ensure your sales tax compliance going forward, don’t forget to be collaborative. Work with outside departments like marketing and legal to make sure you are all on the same page about the type of language you use to describe your services. You want to set your company up for success and feel confident with where you stand with the state if you plan to continue offering tax-exempt services.

Easier said than done of course.