The Virginia Tax Commissioner recently held that a Virginia taxpayer was not liable for retail sales or use tax on charges relating to software licenses, hosting services and travel reimbursement for on-site software training, where the tangible software was transferred outside the state from the out-of-state licensor directly to the out-of-state company hosting the software.1
Background
The taxpayer, a medical practice located in Virginia, entered into an electronic medical records software license agreement with a healthcare software developer (licensor) located outside Virginia. The licensor charged and collected Virginia sales tax on the costs for the software license, software maintenance, initial software training and initial setup management. It also collected Virginia sales tax on its reimbursable travel expenses that were incurred in connection with providing the taxpayer with on-site training. In addition, the taxpayer contracted with another out-of-state software company (hosting company) to host the electronic medical records software applications, under which the licensor transferred the tangible software directly to the hosting company, and the taxpayer subsequently accessed the hosted software by remote access via the Internet. The hosting company charged and collected Virginia sales tax on its monthly fee for hosting the licensed software.
The taxpayer requested a ruling of the Virginia Tax Commissioner concerning whether the licensor and the hosting company erroneously collected sales tax on their charges to the taxpayer.
Licensed Software and Related Expenses Not Taxable
In its ruling, the Tax Commissioner explained Virginia's rules with respect to software sales. According to statutory authority2 and the Department of Taxation's long-standing position,3 prewritten computer software licenses that do not involve the transfer of tangible personal property are exempt from sales or use tax because the customer is receiving a "right to use the software," which is treated as a non-taxable service.
Licensed Software
Assuming that the taxpayer purchased a license to prewritten, not custom, software, the licensed software and any corresponding annual support or software updates that are provided in tangible form are not subject to Virginia sales or use tax as long as two conditions are met: (i) title or possession of the tangible property passes to the taxpayer outside the state, and (ii) no use of the tangible property is made within the state. Since the out-of-state licensor provided the software directly to the out-of-state hosting company, the taxpayer was not liable for any sales or use tax on the software license and updates.
Hosting Charges
The Tax Commissioner found that under Virginia law, the hosting charges were exempt service charges not involving the transfer of tangible personal property.4
Reimbursable Travel Expenses
The Tax Commissioner discussed the taxability of the licensor's separate charges for employee travel and hotel expenses in connection with on-site software training.5 In a prior ruling, the Tax Commissioner held that employee travel and accommodation expenses were taxable only when they were charged in connection with the sale of taxable tangible property (i.e. the charge for installing taxable tangible property).6 Such expenses were exempt from the sales and use tax when the purpose of the trip was merely to provide exempt services to customers on site. Applied to the present matter, the Tax Commissioner determined that the purpose of the trip was the provision of on-site training where no tangible personal property was transferred within Virginia. Therefore, the licensor's reimbursable travel expenses were not taxable.
Commentary
Virginia is among the minority of states that continues to exempt electronically delivered prewritten software, in contrast to most states that tax prewritten software regardless of the delivery method. With this ruling, Virginia is remaining steadfast in its position that there must be a physical transfer of software within Virginia in order to trigger the retail sales or use tax. The fact that the user of the software is located in Virginia is irrelevant. As more companies choose to access hosted software on the "cloud," states with tax codes that have not been updated to reflect recent developments in technology, like Virginia, may be substantially impacted, at least from a sales tax revenue perspective. Perhaps the policy not to tax cloud computing services is part of a larger strategy to maintain Virginia's reputation as a state that provides technology companies with a favorable state tax environment. Based on the Commissioner's ruling, it appears that Virginia is not planning on following the lead of other states that are using administrative publications or rulings to determine that access to software applications via the Internet somehow constitutes a taxable transfer of software instead of an exempt service.
Footnotes
1 Ruling of Commissioner, P.D. 12-215, Virginia Department of Taxation, Dec. 21, 2012.
2 VA. CODE ANN. § 58.1-609.5.1 provides an exemption for "services not involving an exchange of tangible personal property which provides access to or use of the international network of the Internet and any other related electronic communication service, including software, data, content and other information services delivered electronically via the Internet."
3 Ruling of Commissioner, P.D. 01-61, Virginia Department of Taxation, May 5, 2001.
4 VA. CODE ANN. § 58.1-609.5.1; Ruling of Commissioner, P.D. 01-61, Virginia Department of Taxation, May 5, 2001.
5 These charges were separate from the charges incurred under the licensing agreement.
6 Ruling of Commissioner, P.D. 96-88, Virginia Department of Taxation, May 14, 1996.
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