United States: Washington Department Of Revenue Adopts Final Rules Regarding Taxation Of Digital Products, Computer Hardware And Software

The Washington Department of Revenue recently adopted permanent administrative rules that address the taxability of digital products, computer hardware and software for purposes of sales and use tax and the business and occupation (B&O) tax.¹ The rules were revised to reflect legislation that went into effect in 2009 and 2010 as well as guidance that was issued by the Department. These rules go into effect on March 28, 2013.

Background

Effective July 26, 2009, Washington enacted tax legislation that conformed sales and use taxation of downloaded digital products to the Streamlined Sales and Use Tax Agreement, imposed sales and use taxes on certain streamed or remotely accessed digital goods² and digital automated services, and applied the traditional retailing and wholesaling B&O tax rates to electronically transferred digital products.³ The legislation also created a number of exemptions for certain digital products (i.e. purchased for resale or multiple points of use (MPU)).

Prior to the effective date of the legislation, the Department issued an Excise Tax Advisory (ETA), an interpretative statement indicating that it would implement the legislation in a "phased process."⁴ Because there were challenges in implementing the legislation,⁵ the Department used a phased implementation process that was intended to provide progressive guidance to avoid confusion and an unreasonable burden on taxpayers. As part of this process, the Department indicated that it would provide guidance in phases to taxpayers by issuing a series of ETAs⁶ to explain the implementation process and provide as much guidance to taxpayers as soon as possible. During this period, taxpayers were expected to a make a good faith effort to comply with the guidance as it was issued by the Department. If the Department determined that the taxpayer made a good faith effort to comply, the Department would work with the taxpayer to bring it into compliance with the new law without "adverse consequences." The advisory requested taxpayer feedback and also instructed a taxpayer to request a letter ruling if (i) the taxpayer was unclear if its activities fell under the new law or the ETAs, or (ii) the taxpayer believed it needed additional time to make the systemic changes required to collect sales tax.

In 2010, Washington enacted legislation to clarify ambiguities and correct unintended consequences related to the 2009 legislation.⁷ Due to the passage of this clarifying legislation, publication of additional information and responses to letter ruling requests, the Department ended the initial phase of implementation on June 30, 2011.⁸ Beginning July 1, 2011, the Department is using "normal enforcement practices." As part of this shift toward normal enforcement, the Department has promulgated permanent rules pertaining to the sales and use and B&O taxation of digital goods and services.

While the Department repealed its "Information and Computer Services" rule,⁹ it replaced it with the "Taxation of Computer Systems and Hardware" rule,¹⁰ and also adopted both the "Taxation of Computer Software"¹¹ and the "Digital Products" rules.¹²

Taxation of Computer Systems and Hardware

The new "Taxation of Computer Systems and Hardware" rule discusses the distinction between computer systems and hardware and also discusses the implications of computer systems and hardware for wholesalers, retailers, and manufacturers. To verify the wholesale nature of the sale of computer systems or computer hardware, the rule now specifies that the seller must obtain "reseller permits," as opposed to "resale certificates," from buyers.¹³ The rule also adds a new statutory citation for sourcing information.¹⁴

Computer Software

The new Taxation of Computer Software rule¹⁵ provides guidance with respect to the classification of software as prewritten versus custom software, and explains the tax treatment of wholesale sales, the royalties received for licensing software, the duplication of software, and the installation and maintenance of software. It also highlights tax considerations for manufacturers and software developers.

In addition, the rule contains new language to clarify that certain examples: (i) are meant to serve only as a general guide; (ii) are "self-contained" or stand on their own unless otherwise indicated by reference to another example; and (iii) assume that the taxpayer has nexus with the state.¹⁶ The rule also added language to clarify that wholesale or retail prewritten computer software remains subject to sales tax and the wholesaler or retailer B&O tax regardless of the method of delivery¹⁷ and that prior to July 26, 2009, the sale of remote access prewritten software was subject to B&O tax under the service and other activities classification.¹⁸

Furthermore, the rule specifies the exemption certificate that buyers can use to claim the "multiple points of use" (MPU) exemption when purchasing prewritten software or remote access prewritten software: the Department's "Digital Products and Remote Access Software Exemption Certificate." Finally, the Department added an example to illustrate the MPU exemption.¹⁹

Digital Products

The new Digital Products rule²⁰ provides a structured approach for determining the taxability of digital products and codes. It contains new language clarifying that the rule is intended to function as a "decision tree" and also clarifying the tax conclusions reached in some of the examples.²¹

The decision tree provides as follows:

• Are the products or services transferred electronically? If yes, go to the next line. If no, the product or service is not a digital product that is subject to tax. However, digital codes do not need to be transferred electronically in order to be considered a digital code.²²
• Does the product or service meet the general definition of digital product (digital good or digital automated service) and digital code? If yes, go to the next line. If no, the product or service is not a digital product or digital code that is subject to tax.²³
• Are there applicable exclusions from the general definition of the digital product or digital code? If no, go to the next line. If yes, the product or service will generally not be considered a digital good or digital automated service for sales and use tax purposes, but B&O tax may apply.²⁴
• Are the sales of the digital product or digital code sourced to Washington? If yes, go to the next line. If no, the sale is sourced outside Washington and is not subject to Washington sales tax or B&O tax.²⁵
• Are there applicable sales or use tax exemptions for the purchase or use of the digital product or digital code? If yes, the transaction will not be subject to sales or use tax. If no, the transaction is likely taxable in Washington.²⁶

Moreover, the new rule explains that end user transactions involving photography are subject to retail sales tax, and that certain other non-end user photography transactions remain subject to royalties B&O tax.²⁷ It also simplifies the analysis pertaining to the "primarily human effort" exclusion from the definition of "digital automated services" by reducing the number of factors to consider (time and direct costs only), and providing an alternative method of analysis in certain situations.²⁸ In addition, the Department added that sales of digital products or digital codes sourced outside Washington are not subject to Washington sales or B&O tax.²⁹ Finally, the Department also clarifies that the "business purpose" exemption for purchases of digital goods (but not digital automated services, prewritten software, or remote access prewritten software), which exempts digital goods when purchased solely for "business purposes" or when relevant to the buyer's business needs, is only available to purchasers who present the seller with an exemption certificate.³⁰

Commentary

Washington has taken the lead in addressing the taxability of digital products and services through specific legislation, the Department's interpretations and now, final rules issued by the Department. The implementation of the legislation has been a slow, but steady process, and now taxpayers have greater clarity regarding the state's position. During the implementation process, taxpayers were only required to make a "good faith" effort to comply with the legislation. With the issuance of the new rules, taxpayers should ensure that they are following all Department guidelines in order to avoid penalties. As noted above, the digital products and services legislation was effective July 26, 2009, but the new rules are not effective until March 28, 2013. The new rules do not provide that they are retroactively effective to July 26, 2009. If the rules cover an issue that is not addressed in the legislation or the Department's guidance issued after the legislation took effect, there is a possibility that taxpayers could have refund opportunities. Taxpayers could argue that the rules relate back to 2009 because they are interpreting the legislation. Conversely, taxpayers conceivably could be exposed to new tax liabilities.

Footnotes

1 WASH. ADMIN. CODE § 458-20-15501 (Taxation of Computer Systems and Hardware) was amended and WASH. ADMIN. CODE §§ 458-20-15502 (Taxation of Computer Software) and 458- 20-15503 (Digital Products) were added. The previous rule on information and computer services, WASH. ADMIN. CODE § 458-20-155, was repealed.

2 For example, the state imposed tax on digital audio works, digital audio-visual works, digital books, digital automated services, and digital codes used to obtain digital goods or digital automated services.

3 Ch. 535 (H.B. 2075), Laws 2009, adding WASH. REV. CODE §§ 82.04.192 (digital products definitions for B&O tax); 82.04.257 (B&O tax on digital products and services); 82.04.258 (digital products—apportionable income); 82.08.0208—82.08.02088 (sales tax exemptions for digital products); 82.12.0208—82.12.02088 (use tax exemptions for digital products); 82.14.457 (digital goods apportionment for local sales and use taxes); 82.32.532 (digital products nexus); 82.32.533 (digital products amnesty); amending numerous statutes including WASH. REV. CODE §§ 82.04.050 (B&O tax retail sales); 82.04.060 (B&O tax wholesale sales); 82.04.070 (B&O tax gross proceeds of sale); 82.04.2907 (B&O tax on royalties); 82.04.297 (B&O tax on Internet access); 82.08.010 (sales tax definitions); 82.08.195 (sales tax on bundled transactions); 82.12.010 (use tax definitions); 82.12.020 (imposition of use tax); 82.12.0255 (use tax exemption for digital products); 82.32.730 (sourcing under the Streamlined Sales and Use Tax Agreement).

4 Excise Tax Advisory No. 9001.2009, Washington Department of Revenue, July 24, 2009.

5 As explained in the advisory, the new law posed the following challenges in implementation: (i) some of the concepts in the law were new and determining their application in individual circumstances proved challenging for taxpayers and the Department; and (ii) determining the proper tax treatment of many of the varied business practices used in electronic commerce required detailed and complex analysis before some of the general guidance needed by taxpayers could be made available. Id.

6 The Department indicated that the ETAs eventually would be replaced by administrative rules. An ETA was issued to provide guidance on the taxation of digital songs, movies, books and online games transferred electronically. Excise Tax Advisory No. 9002.2009, Washington Department of Revenue, July 24, 2009. Also, an ETA was issued to provide a general analysis of the tax liability for digital products. Excise Tax Advisory No. 9003.2010, Washington Department of Revenue, Nov. 30, 2010. Finally, the Department has posted a draft version of an ETA that discusses the sourcing of digital products and digital code sales. The digital product ETAs may be accessed on the Department's Web site at http://dor.wa.gov/Content/FindALawOrRule/ETA/etatoc9000.aspx.

7 Ch. 111 (H.B. 2620), Laws 2010. For example, the 2010 legislation specifies that the right to access and use prewritten software to perform data processing constitutes a taxable "sale at retail." WASH. REV. CODE § 82.04.050(6)(b).

8 Excise Tax Advisory No. 9001.2011, Washington Department of Revenue, June 30, 2011. Note that this replaced the original 9001 advisory that was issued in 2009.

9 WASH. ADMIN. CODE § 458-20-155.

10 WASH. ADMIN. CODE § 458-20-15501.

11 WASH. ADMIN. CODE § 458-20-15502.

12 WASH. ADMIN. CODE § 458-20-15503.

13 WASH. ADMIN. CODE § 458-20-15501(1)(c), (3)(b). Effective January 1, 2010, businesses must present vendors with a Department-issued reseller permit when purchasing items exempt for resale. Prior to January 1, 2010, a resale certificate could be presented.

14 WASH. ADMIN. CODE § 458-20-15501(5). Taxpayers are directed to WASH. REV. CODE § 82.32.730 for more information on sourcing retail sales of computer services.

15 WASH. ADMIN. CODE § 458-20-15502.

16 WASH. ADMIN. CODE § 458-20-15502(2)(e).

17 WASH. ADMIN. CODE § 458-20-15502(3)(a), (b).

18 WASH. ADMIN. CODE § 458-20-15502(10)(b).

19 WASH. ADMIN. CODE § 458-20-15502(11), Example 35.

20 WASH. ADMIN. CODE § 458-20-15503.

21 Id.

22 WASH. ADMIN. CODE § 458-20-15503(101), (102).

23 WASH. ADMIN. CODE § 458-20-15503(201)—(204).

24 WASH. ADMIN. CODE § 458-20-15503(301)—(303).

25 WASH. ADMIN. CODE § 458-20-15503(401)—(403).

26 WASH. ADMIN. CODE § 458-20-15503(501)—(511).

27 WASH. ADMIN. CODE § 458-20-15503(302)(d)(i).

28 WASH. ADMIN. CODE § 458-20-15503(303)(a).

29 WASH. ADMIN. CODE § 458-20-15503(401).

30 WASH. ADMIN. CODE § 458-20-15503(505).

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