Does anyone remember when the statutory definition of tangible personal property for sales tax did not include prewritten computer software? Prior to July 1, 2004, it did not. That changed in 2003 when Kentucky enacted 2003 H.B. 293 to adopt the streamlined Sales and Use Tax Agreement, effective July 1, 2004. H.B. 293 amended the definition of tangible personal property to tax such property regardless of the method of delivery and to specifically provide that tangible personal property includes prewritten computer software, and it also provided a statutory definition of prewritten computer software. Note that computer software other than prewritten computer software, such as customized software and separately stated charges for modifications or enhancements continue to be not subject to Kentucky sales tax. KRS 139.010(32).
What is the big issue with prewritten computer software now? It is prewritten computer software access services, which is one of the services made subject to sales tax by 2022 H.B. 8. Notably, unlike downloaded prewritten computer software which is taxed as tangible personal property, prewritten computer software access services are taxed as services. KRS 139.200(2)(ay).
PRIOR TO H.B. 8, WERE PREWRITTEN COMPUTER SOFTWARE ACCESS
SERVICES SUBJECT TO SALES TAX?
Unlike prewritten computer software transferred in tangible form (e.g., on a disk) or downloaded to a computer or server in Kentucky, Software as a Service (SaaS) was not subject to Kentucky sales and use tax; prior to H.B. 8, the Department of Revenue’s position was:
Software as a Service (SaaS) that is not delivered into this state is not subject to Kentucky sales and use tax. If the software is accessed exclusively via the “cloud” or on-line exclusively via the selling entity’s server, the software access is not subject to Kentucky sales and use tax. Software accessed via servers and in no way downloaded to the customer is not a retail sale of tangible personal property subject to Kentucky sales and use tax.
Ky. Dep’t of Revenue, Kentucky Sales Tax Facts (Dec. 2020). The Department confirmed its position regarding SaaS in Private Letter Ruling KY-PLR-21-01:
The Taxpayer provides its Service via a SaaS model. With this charge for access and use of the Taxpayer’s Software, there is no transfer or sale of tangible personal property. The prewritten computer software is a web-based SaaS model with no download of the Core Functionality.
The question here is whether the Taxpayer’s subsequent free offer of a downloadable Application, with limited functionality that enhanced the usefulness of the Taxpayer’s Software, changes the original exempt nature of the SaaS product for Kentucky sales and use tax purposes. The downloadable application for optional use by customers to record and upload Customer Information into the System is prewritten computer software.
The Taxpayer’s offering of an Application that is pre-written computer software as part of the Service, which remains accessible online under the SaaS model, does not create a transaction subject to Kentucky sales and use tax. Furthermore, this provision of a pre-written computer software component with the SaaS model does not constitute a bundled transaction since the free software application is a de Minimis component of the Taxpayer’s overall product provided to its customers.
When Kentucky did not tax SaaS prior to H.B. 8, it was aligned with the majority of states that do not tax SaaS. Only a minority of states, less than 20, tax SaaS; Kentucky joined the minority in 2023 by subjecting prewritten computer software access services to Kentucky sales tax.
WHAT ARE PREWRITTEN COMPUTER SOFTWARE ACCESS SERVICES?
Unfortunately, as of February 2023, there is no guidance on the Kentucky Department’s position regarding prewritten computer software access services.
According to the statutory definition, “prewritten computer software access services” means “the right of access to prewritten computer software where the object of the transaction is to use the prewritten computer software while possession of the prewritten computer software is maintained by the seller or a third party, wherever located, regardless of whether the charge for the access or use is on a per use, per user, per license, subscription, or some other basis….” KRS 139.010(33).
WHAT MAY BE THE BIG SALES TAX ISSUES IN REGARD TO PREWRITTEN COMPUTER SOFTWARE ACCESS SERVICES?
IS THE OBJECT OF THE TRANSACTION TO USE PREWRITTEN COMPUTER SOFTWARE?
The true object test or essence of the transaction test has been employed in Kentucky to determine the object of the transaction. An example of this analysis may be found in WDKY-TV, Inc. v. Revenue Cabinet, 838 S.W.2d 431 (Ky. App. 1992) in which the sales tax issue involved WDKY’s purchases of taxable videotapes and nontaxable intangible broadcast rights.
In the context of prewritten computer software access services, this would logically involve at least two inquiries.
First, is the object of the transaction prewritten computer software or non-prewritten computer software? The former being subject to sales tax and the latter being not subject to tax. By analogy, software designed and developed by the author or other creator to the specifications of a specific purchaser when it is sold to that purchaser are not prewritten computer software, nor are separately stated modifications and enhancements. KRS 139.010(32). So, logically, that would also hold true for prewritten computer software access services.
Second, is the object of the transaction to use prewritten computer software or something else, like a non-taxable service or intangible? In Kentucky Tax Alert, Vol. 22, No. 5, (Sept. 2003), the Department recognized that the Kentucky Board of Tax Appeals employed the true object test in a case originating in 1999 to determine that a taxpayer was purchasing information, which was not subject to sales tax.
Accordingly, the object of the truncation will be an important issue for SaaS purchases. Is the object of the transaction the purchase of software (like a spreadsheet program, for example) or a non-taxable service or intangible?
HOW ARE PREWRITTEN COMPUTER SOFTWARE ACCESS SERVICES SOURCED?
When the sales tax was expanded in 2018-2019, the services subjected to tax were generally such that the service was received in the same location as where the service was performed, e.g., landscape services. But, prewritten computer software access services may be received in many locations. Surely, the General Assembly did not intend for the Kentucky sales tax to extend to the receipt of such services outside of Kentucky.
The Department has not addressed sourcing for prewritten computer software access services, but it has referred taxpayers to KRS 139.105 as applying to other services. According to the Department, “Sales tax on services is based on where the customer receives the service. For example, a lobbying provider located in Washington, D.C. lobbying on behalf of a Kentucky client would charge the Kentucky sales and use tax because the client is receiving or making first use of the service in Kentucky. See guidance on the sourcing of retail sales in KRS 139.105 and information on receiving services in Kentucky Administrative Regulation 103 KAR 30:190.” Ky. Dep’t of Revenue, Tax Answers (Dec. 2022) (Lobbying Services). Extrapolating this to prewritten computer software access services, logically, a position could logically be developed that Kentucky sales tax applies only to prewritten computer software access services received in Kentucky.
Taxpayers based in Kentucky purchasing prewritten computer software access services that will be received in locations outside of Kentucky should consider informing the seller of the locations to which service will be received; otherwise, the seller could inadvertently bill Kentucky sales tax on services delivered outside of Kentucky as under KRS 139.105, the sales tax is generally sourced to the address of the purchaser when the locations to which service will be received are unknown. In such a situation, this statutory presumption would seem to be constitutionally suspect due to extraterritorial effect.
WHAT ABOUT EXEMPTIONS?
As the scope of services subject to sales and use tax expands, the importance of exemptions increases. Fortunately, prewritten computer software access services may be purchased tax-exempt as for resale. The Department recognized this in Kentucky Sales Tax Facts (June 2022), stating, “KRS 139.260is amended [by H.B. 8] to allow all the newly taxable services (KRS 139.200(2)(g) through (ay) [including marketing services under KRS 139.200(2)(r)]) to be purchased for resale.”
Software delivery has evolved from being delivered to computers via tangible mediums like disks and CDs to downloads, and now to SaaS.
Unquestionably, many exemptions apply to prewritten computer software that is delivered via tangible mediums or downloaded, but what about prewritten computer software access services?
The imposition of Kentucky sales tax on prewritten computer software access services will create some issues, but some thoughtful planning can hopefully address many of them.
This is a modified version of Mark A. Loyd’s regular column, Tax in the Bluegrass, “What to Do Now that Kentucky taxes SaaS” which appeared in Issue 1, 2023 of the Kentucky CPA Journal.
March 6, 2023