Software tax: eroding the 5 pillars of economic development

If current proposed legislation, HB 1192, is enacted in its current form, Colorado companies will begin paying much higher taxes as early as March 1 of this year. The new tax would be imposed on purchases of software made by all businesses, hitting the high-tech sector hardest. The sales tax could send shock waves through an industry which currently contributes in excess of $1 billion to the state’s tax coffers – and end up eroding the state’s tax base in an effort to raise $15 to $20 million in new tax revenue.

Hungry for dollars to feed into the state’s yawning fiscal deficit, the current administration has begun an assault on what it and the media are calling, “tax exemptions” and “tax breaks” enjoyed by business. Legislators predictably are hauling out the business-needs-step-up because everyone else is rhetoric.

The Governor’s office informed the Colorado Software and Internet Association (CSIA) that they intended to proceed with the software tax proposal last week and have aggressively pushed the measure through the House. They have decided to accelerate when the tax would be effective, moving the date from July 1 to March 1.

Business, as it has been suggested, needs to share in the burden of dealing with the $1 billion estimated state revenue shortfall. But how is that best achieved? The points made in this article are not meant to criticize one party or one particular administration but to analyze the potential impact of a particular tax policy.

Diving for $15 million

Here’s how the Denver Post has portrayed this situation: In all, Gov. Ritter is seeking to eliminate what it labels 13 “tax breaks” for business and raise $100 million a year. The sales tax of software has always been a confusing topic that was exacerbated when the Department of Revenue attempted to aggressively apply tax. When the application of state tax to the purchase of software was clarified in 2006 for all taxpayers to clearly understand, the Department of Revenue issued $60 million in refunds of overpaid tax in the years that followed.

Here’s what really happened: From approximately 1970 to 2002, software that was deemed “canned,” or destined in bulk to multiple customers, and was delivered in a tangible medium (CD-Rom, disk or tape) it was taxed in Colorado. If software was not delivered via a tangible medium or if it was customized or written by developer for a single client and not meant for a mass market, it was not taxable.

In 2002, the Department of Revenue – which can’t make tax law but only give guidance and interpretation of existing statute – sought to give “guidance” that all software was were taxable. But the Owens administration and the Department of Revenue, upon reconsideration rescinded this misguided interpretation under the presumption that the existing law did not extend to intangible materials such as software. However, no replacement guidance was offered by the Department of Revenue and taxpayers were left in a quandary. “Tax or not-to-tax” software sales was the prevailing question.

Software producers played it safe, however, and imposed the sales tax on software sales to make sure they were not held liable. But as the regulation became clear through the years, they realized they had over-collected and paid for Colorado sales tax and filed for $60 million worth of returns – the exact number the state now says it missed out on.

In 2006, myself and a handful other experts, acting on behalf of the Colorado Association of Commerce and Industry, proposed draft language to clarify the taxation of software. This draft language became Special Regulation (SR-7) and it was adopted by the state. Essentially, we provided the “bright-line” tests that business’ need to efficiently make taxing determinations: Tangible software, primarily sold in disk, would be taxed. Software purchased over the Internet would not. Colorado remained one of the 35 states without an “Internet” software tax; that is until now.

What is software, anyway?

Those that plan to present the bill are trying to explain their position with this “simple” logic: If you purchase software on a CD-Rom it is taxable; however, if you download software it is exempt. The application of sales tax based on the method of deliver is not logical. The purchase of software should be taxable regardless of the method of delivery.

While this position does have some logic it ignores a basic premise: Software itself has never been subject to tax because it is intangible. The only thing subject to tax is the tangible medium (the CD-Rom) because it is tangible personal property. The addition of intangible property to the CD-Rom increases the inherent value of the tangible personal property because the two items are combined together. As a result, what is taxed is a piece of tangible personal property that has increased in value. Software in and of itself has never been taxable.

Today most software isn’t software as we once knew it: It’s an always-changing series of code that is transmitted over the Internet. Additionally, software is an integral component of most services that a person or business buys. For example, when you pay an annual fee at your local bank to cover your banking services, you are also buying access to software to allow you to conduct your on-line banking needs. This could become a taxable sale under the proposed bill. This is a difficult distinction to make, especially for taxpayers that have operated on a basic premise that services aren’t taxed in Colorado and most states.

To add confusion for taxpayers, a majority of software purchases are made under an “Alternate Service Provider” model (ASP) or under a “Software as a Service” model (SAAS). These two models do not require the delivery of software into Colorado. Instead a remote service provider (maybe located in Utah) may host software purchased by their customer in Colorado or the software may never be sold to the customer; instead, as previously referenced, the customer receives the benefit of the software in the form of a service owned by the “service provider” and maintained in the service provider’s facility. Under the current proposed language, such services would be subject to sales tax, regardless of where the software is located and instead taxed on where a person benefits from its use. It could get really complicated when an employee temporarily enters Colorado for business; the state could apply the tax to any software brought with the employee on their lap-top or PDA phone. How would a business every track these movements of software and hope to comply with the law?

The concern that many have is that the state, in attempt to generate an additional $15 million of revenue, erodes the current tax base to a much greater extend and also damages growth in the IT industry for years to come. A number of a business CIO (Chief Information Officers) and others in the community have voiced their concern that the State is “cutting off its nose to spite its face” and the message appears to be gaining momentum. With the effort from these citizens, the state and legislature seem to be listening. Perhaps the next important consideration will be to ensure that the state carefully evaluates the impact of the legislation in a couple years to truly understand the overall impact to the creation of jobs in the state.

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