Figuring out how sales and use tax applies to software purchases can be very tricky. There are so many factors that can determine whether the purchase is taxable or exempt. How is the item characterized? How was it delivered – in physical form, electronically or remotely accessed? And you need to realize that every state taxes software transactions in their own unique way – no two states are exactly the same.
It’s a lot to stay on top of, and in doing so, you may be missing out on a big cost-savings opportunity. When discussing sales tax for software, it’s important to remember that there are exemptions out there that may be available based on how the software is used. These are often overlooked when researching the taxability of software and will apply when the software is otherwise taxable. These exemptions could also exempt services that might be generally taxable. We’ll talk about three different types of software exemptions that may be available in some states.
Many states offer an exemption for machinery and equipment used to manufacture items of tangible personal property for sale. But what may be overlooked is that software used in the manufacturing process can qualify for the manufacturing exemption in some states.
Typically, for software to be included in the exemption, it must control machinery used in the manufacturing process and not just provide reporting. In Connecticut, exempt software must be used exclusively to control or monitor an activity during the production process or testing/measuring materials being produced.
Also note that the definition of “manufacturing” varies from state to state. So you may be surprised what activities fall under a state’s manufacturing exemption. And if you are a software company, don’t forget that creating software can be considered manufacturing. This means computers used to develop canned software could qualify. New York and Illinois are two states that take this position.
Some states provide an exemption for research and development activities. Equipment and supplies used in research & development may be included in a state’s manufacturing exemption, or the research & development exemption may be separate.
In some states, software may qualify for the research & development exemption. For example, in Iowa, operating software sold with exempt equipment can qualify for the research & development or manufacturing exemption. As always, make sure to review the individual state’s tax laws carefully to see if software is included in the exemption.
Other states provide high tech exemptions to encourage businesses to establish operations within the state. These exemptions typically apply to equipment (and often building materials) used to establish high tech service centers such as server farms or high-tech developers. Some states even include call centers in the exemptions.
Texas has enacted a temporary sales and use tax exemption for qualified data centers. The exemption applies to certain tangible personal property used in data centers that meet certain capital investment and new employment requirements. The exemption covers hardware, software and infrastructure items necessary and essential to the operation of a qualified data center.
In addition to the above “use-based” exemptions, don’t forget that many states offer full or partial exemptions for services associated with software. It’s important to review the state’s tax laws for any of these exemptions to confirm if an exemption applies to software or related services.