Traps for the Unwary: Taxation of Digital Products

Recently, I presented at a webinar hosted by Strafford Publishing on the subject of sales and use tax on digital products and services. It almost goes without saying that the interstate sale of digital products—whether books or software—is complicated, if for no other reason than it requires analyzing the sales and use tax consequences of such transactions based upon forty-five states’ (and the District of Columbia’s) sales tax laws, which were adopted long before the advent of the digital age. For example, the starting point for sales tax analysis in most states is whether the transaction involves the sale of “tangible personal property.” Is a digital product such as a digital book that is downloaded by the customer tangible personal property?

The states do not provide for uniform treatment of the taxability of digital products from state to state, nor are all digital products taxed similarly within a given state. Colorado, for example, taxes digital books and music, but does not tax digital software. Twenty-five states tax digital books, music and videos, while thirty states tax prewritten software.

What makes analysis in this field even trickier are the different methods of delivery of digital products and the various pricing plans under which such products are sold. For example, under one delivery method, the seller provides the buyer an electronic access code to permit the buyer to download the digital product at the buyer’s convenience. For a sale such as this, in addition to analyzing whether the underlying product is taxable, the seller must also determine whether the sale of the access code is taxable at the time of such sale. The SSUTA, of which there are 24 member states, treats the sale of a “digital code” that entitles the purchaser to download a taxable digital product as a taxable transaction. See Section 332(G). But not every state, of course, is a member of the SSUTA and non-member states do not always follow this principle. For instance, the non-member states of Texas, New York, and Illinois treat the sale of such access codes as tantamount to selling a gift card. These states treat the sale of a gift card or access code as the sale of an intangible. It is only when the gift card is redeemed that a taxable sale of tangible personal property has occurred. See, for example, Ill. General Information Letter ST 10-0052-GIL (June 4, 2010).

The law is even cloudier if the seller sells for one price a “bundle” of rights to access not only a taxable product but also a non-taxable product. For example, in Tennessee Department of Revenue, Revenue Ruling No. 12-11 (July 24, 2012), the Department of Revenue considered whether a bundled service that provided access to both reference books and computer simulation programs at a single price was taxable. The Department noted that access to digital books is taxable, while access to the software is not taxable. Nevertheless, because the provider charged one price for these products, the Department held that the entire “bundled” product was taxable. This ruling falls in line with New York’s so-called “Cheeseboard Rule,” in which tax was due on the entire purchase price where a seller was selling for one price tax exempt cheeses together with a taxable cheese board. See 20 NYCRR 527.1(b).

The conclusions that can be drawn are that a retailer of digital products should determine the taxability of the products it sells based on the nature of the products sold and the method of access or delivery of the products. In addition, a seller should consider whether to sell its products for a “bundled price,” or to price its products separately, when selling distinctly taxable or nontaxable items such as software and other digital products. If one price is charged, the seller is likely liable for tax on the entire price.

Posted by Martin Eisenstein