States have tried to regulate the taxability of computing services through one of two paths: by either broadly addressing software and related services or by specifically focusing on traditional software products. From 1977 to 2007, Tennessee defined software as any “information and directions loaded into a computer which dictate different functions to be performed by the computer.” In 2008, the definition of software was refined to “a set of coded instructions designed to cause a computer or automatic data processing equipment to perform a task” and “any services that are a part of” creation, modification, or transfer of software were included as potentially taxable services. This definition has led to a quandary for staffing companies who provide the services of temporary workers in IT; however, Tennessee’s General Assembly has passed new legislation related specifically to the taxability of these services with the hope of providing clarity.
Under the old system, the Tennessee Department of Revenue asserted that any “modification or programming” performed by temporary employees was subject to sales and use tax which created problems on a variety of levels for staffing companies placing IT workers. Though staffing services are not on the statutory list of taxable services, the 2008 version of the law does allow for the taxation of services related to technology and software, including coding. However, the true object purpose of hiring these workers is to acquire labor, and most states do not subject labor costs to sales tax. Further, since these temporary IT employees will likely assist clients in taxable activities, assigning collection responsibility to the staffing firm unnecessarily complicates tax compliance for all involved parties. When temporary workers are hired through a staffing company, it is the hiring company (not the staffing company) who was left to decide if workers were performing taxable services with little to no input from the staffing agency who was required to charge and remit the tax. Auditors from the DOR, however, were likely to treat any jobs with coding expertise requirements provided by temporary employees as taxable, regardless of the actual work performed. Since the determination often – but not always – came down to if the temporary employee created or changed any code, staffing companies were required to present as much information as possible to prove coding had not been done by the temporary employee. This process led to many staffing companies being presented with an unplanned tax assessment with the options only to pay the DOR or to pay the cost to challenge it.
Tennessee did offer one option to avoid these issues– the “in-house” exemption, which allowed companies to treat software created within the company for its own use to be treated like any other service a business might perform for itself. An IT staffing company called Teksystems claimed this exemption in Teksystems, Inc. v. Farr in 2009. In the case, the IT professionals hired through Teksystems were hired to work on in- house software which was used only by the clients. The DOR argued the modification or fabrication would make Teksystems’s staffing services taxable; Teksystems argued temporary employees hired through Teksystems were mere agents of the clients and the exemption should apply. The Tennessee statutes governing “agents” “hinges on the right to control the agent’s actions” and undisputed facts in the case showed no difference between the clients’ employees and Teksystems employees other than which company issued the paycheck to the worker. The court in Teksystems determined the work performed by Teksystems employees qualified for the in- house exemption—a finding the Tennessee Court of Appeals upheld. However, after the Teksystems ruling, the DOR submitted a “technical corrections” bill with a provision that would limit the in- house exemptions to software created by employees of the company utilizing the software to the General Assembly. Once this bill was passed, IT staffing companies were no longer allowed to claim the exemption and the staffing agencies’ taxation issues returned as though the case found in favor of Teksystems never happened.
In 2022, the Tennessee General assembly revisited this issue and reversed the prior action. The new version of the statute allows for the exemption to be claimed on “the fabrication, installation, and repair of a computer software by a person, including the person’s agent or direct employee, for the person’s own use and consumption”. In line with the 2009 Teksystems ruling, any software created for a company’s own use is exempt from sales tax, whether created by a direct or indirect employee, and IT staffing companies may claim this exemption when staffers perform work on in- house software for client companies. In addition, the 2022 bill also allows for exemptions when the software is installed or repaired, instead of just fabrication of software. This exemption should cover most software- related work performed by temporary workers for in-house software. Although this bill granted a great deal of clarity, the Tennessee DOR created a bit of doubt again when it updated its Sales and Use Tax Manual in August 2022. The manual recognized the exemption in the case of “agents” but declined to explicitly apply the exemption to independent contractors. The manual notes the determination between “agent” and “independent contractor” will depend on “the common law concepts of agency developed in the Tennessee court system”. While this is simply stating the process for claiming the exemption, it does grant the DOR the power to narrowly apply the exemption.
Companies doing business in Tennessee and seeking the aid of temporary workers should carefully review job postings, with the understanding that other than this in-house exemption, the services of individuals related to software may be taxed. Even with the in-house exemption, the services of an independent contractor may be subject to tax, depending on how the DOR chooses to apply this exemption. Though a great deal of clarity has been provided by the General Assembly, there is still room for further consideration in the future.
(Sontag, Michael D., et al. “Closing the Loop on Taxing Temporary Services in Tennessee.” Tax News, Tax Articles and Information – Tax Notes, 5 Jan. 2023.)