On July 24, the Massachusetts legislature voted to override Governor Deval Patrick's veto of H.B. 3535, the state's transportation financing bill. This legislation includes significant changes to the sales and use taxation of computer and software services, the adoption of market-based sourcing for sales of items other than tangible personal property for purposes of corporation income tax apportionment, as well as changes to the tax on cigarettes and gasoline sales.1 Prior to the override of the transportation financing bill, on July 12, the Governor signed into law the state's fiscal year 2014 budget bill, which delays the implementation of the net deferred tax liability (FAS 109) deduction for a third time.2

Sales and Use Tax on Computer and Software Services

Of the legislative changes that occurred in Massachusetts this summer, the imposition of sales and use tax on certain computer and software services carries the most immediate significance given the July 31, 2013 effective date of this provision.3 Specifically, the legislation expanded the statutory definition of "services" that are taxable to include "computer system design services and the modification, integration, enhancement, installation or configuration of standardized software" and to exclude "data access, data processing, or information services," which will remain not taxable.4 Further, the term "computer system design services" includes "the planning, consulting, or designing of computer systems that integrate computer hardware, software or communications technologies that are provided by a vendor or a third party."5

In response to this newly-enacted legislation, the Massachusetts Department of Revenue quickly released guidance in the form of a technical information release the day following the legislative override.6 In this release, the Department provided that consulting and evaluation services with respect to existing computer systems to identify deficiencies and needs, and services to prepare a business to use modified software, such as training, are considered non-taxable personal or professional services. Additionally, the release provides the Department's position on sourcing, filing/payment requirements, and transition procedures.

Sourcing Rules

With regard to sourcing, vendors providing taxable services are required to collect and remit Massachusetts sales and use tax on transactions sourced to the state according to the following rules of ordering contained in the Department's guidance:

  • If the purchaser receives the service at a business location of the vendor, the retail sale is sourced to that business location of the vendor;
  • If the vendor knows the location where the service is received by the purchaser based on instructions for delivery as provided by the purchaser, tax is due based on that location, when use of this address does not constitute bad faith;
  • If the purchaser does not specify a location for the service to be delivered, the vendor must collect tax based on the purchaser's address that is known to the vendor as provided by the purchaser or based on information known to the vendor (e.g., as collected to complete the sale), such as address information from a payment instrument or credit card, when use of this address does not constitute bad faith; and
  • If neither the delivery location nor the purchaser's address can be determined, the vendor must collect tax based on the address of the vendor from which the sale was made.7

Reporting and Collection Requirements

A vendor is required to collect and remit sales and use taxes on computer and software services if such services are sourced to Massachusetts.8 However, a vendor may accept a multiple points of use exemption certificate from the purchaser in the event the computer and software to which the services relate are used by the purchaser in multiple states, shifting the liability to remit apportioned use taxes to the purchaser.9

Any taxes related to these services must be remitted electronically and are to be reported separately on additional lines added to Massachusetts Form ST-9 available as of July 31, 2013.10 The Department has directed that tax due on computer and software services occurring on July 31, 2013 be reported and paid by the September 20, 2013 due date along with August transactions.11

Transition Rule for Existing Contracts

Contracts for taxable computer and software services entered into before July 31, 2013 are not taxable except to the extent that the invoices for such services are billed after July 31, 2013 and the services to which the invoices relate were performed on or after July 31, 2013.12

Further Guidance from Department

It should also be noted that the Department has been soliciting questions from taxpayers regarding application of the new law, and to date has issued over fifty answers to the most frequently asked items.13 While not authoritative in nature, such responses may be useful in addressing the scope and impact of the tax. The Department also has released a working draft containing further guidance on this legislation and will be taking comments from practitioners prior to finalizing the document.14 The working draft contains the Department's intended approach in this area:

  • With respect to newly taxable software services, the sales and use tax applies only to services occurring in association with taxable prewritten software.15
  • Web site design services are considered a taxable modification if the Web site designer or customer obtains (through purchase, license or by other means) taxable prewritten software providing a platform to create the Web site.
  • With respect to the sales and use tax on computer system design services, a computer system that integrates hardware, software or communication technologies refers to a system that includes and integrates hardware, software, and/or communications components, which system is used to support a business operation. According to the Department, this tax is not applicable to the design of computer hardware or software embedded in a machine or similar product.16

The Department also plans to amend a current regulation that addresses an exemption for sales of custom software and a discussion of custom modifications to prewritten software in light of the new legislation.17

Market-Based Sourcing

With respect to the corporation income tax, a significant change to the sourcing of sales of items other than tangible personal property from a preponderance cost of performance to a market-based sourcing approach will become effective for tax years beginning on or after January 1, 2014.18 The legislation requires sourcing of sales of items other than sales of tangible personal property to Massachusetts if the corporation's market for the sale is in Massachusetts.19 In the case of the sale of services, such items are sourced to Massachusetts if the services are delivered to a location in the state.20 Sales from other items are sourced in the following manner:

  • The sale, rental, lease or license of real property is sourced to the location of such property.
  • The rental, lease or license of tangible personal property is sourced to the location of the property.
  • The lease or license of intangible property, as well as a sale or exchange of such property where the receipts from such sale or exchange derive from payments contingent on the productivity, use or disposition of the property are sourced to the location where the property is used.
  • With respect to other sales of intangible property, contract rights, government licenses or similar intangible property authorizing the holder to conduct a business activity in a specific geographic area are sourced to the location of use or other association.
  • Other sales of intangible property not addressed in these provisions are excluded from the sales factor calculation.21

If the sourcing provisions for sales of items other than tangible personal property are inconclusive, such sourcing must be reasonably approximated.22 If a reasonable approximation cannot be made, or if the taxpayer is not taxable in the state of assignment, such sale is excluded from the sales factor calculation.23

Cigarette Tax

The excise tax which applies to any manufacturer, wholesaler, vending machine operator, unclassified acquirer, retailer, and stamper that must file a return under Mass. Gen. Laws. Chapter 62C, Section 16 is imposed at a rate equal to 150.5 mills sold. This amounts to an increase of 50 mills over the previous amount. The increase went into effect on July 31, 2013, seven days following the effective date of the legislation.24

Gasoline Tax

The legislation increased the tax on fuel by 3 cents per gallon to 24 cents per gallon effective July 31, 2013.25

Delay of FAS 109 Deduction

While the transportation financing bill contains significant sweeping changes, it is important to note the delay in the FAS 109 deduction that was enacted as part of Massachusetts' budget bill. Originally included in the legislation which imposed mandatory combined reporting for tax years beginning on or after January 1, 2009, the legislature enacted a special deduction for certain publicly held companies.26 Massachusetts corporate excise taxpayers that experienced an increase in a combined group's net deferred tax liability as a result of the enactment of combined reporting are entitled to a FAS 109 deduction in order to alleviate the potential financial statement impact resulting from the move from separate to combined reporting.27 Originally, the deduction was to be prorated over a seven-year period beginning with the combined group's taxable year beginning in 2012.28 Due to budget considerations, the date on which the deduction was to become available has been delayed three times, most recently by the recent budget bill which delays the first deduction to the combined group's taxable year that begins in 2015.29

Commentary

Given the desire to increase the breadth of the traditional sales tax base through the taxation of services, Massachusetts' imposition of sales tax on certain computer software and services is not surprising, though the implementation of the tax with seven days' notice could create some challenges. Out-of-state businesses that provide potentially taxable services to Massachusetts businesses or residents may not become aware of the change in tax treatment for some period of time, potentially resulting in sales tax exposure for some. As the sales tax is applicable to existing customer contracts, it may be administratively difficult for those that have knowledge of the change to make adjustments, and at the very least will require service providers to review their contracts with Massachusetts customers. While the frequently asked questions provided by the Department are helpful, they do not carry the weight of precedent and cannot be relied upon if a business is audited by the Department. Likewise, the development of a technical information release is welcomed, but it remains open to question as to when the Department will begin the process of developing binding regulations. Only then will businesses in these industries completely understand how broad or narrow this new tax will be applied.

As for the enactment of market-based sourcing of sales of items other than tangible personal property for purposes of the corporation income tax, Massachusetts' historic reliance on cost of performance sourcing resulted in Massachusetts-based service businesses with inflated sales factors. The Department and taxpayers frequently disagreed with the application of the cost of performance rules, with one of the main disputes revolving around whether to use the transactional approach, examining where each specific transaction within an operational unit should be sourced, or the operational approach, examining the business as a whole to determine where an operational unit's revenues should be sourced.30 The advent of market-based sourcing, which follows the lead of numerous states in the last ten years, may prevent future litigation on the appropriate method to apply the cost of performance rules, but may spur litigation dealing with how to determine where a service provider delivers its product to a customer, and what constitutes a reasonable approximation when the location of delivery is unknown.31 Again, regulations will need to be promulgated by the Department in an effort to create more certainty in how these provisions should work. Regardless of what these regulations say, the change from cost of performance to market-based sourcing is likely to flip the tax burden borne by Massachusetts-based companies to out-of-state companies that may not have significant physical presence in the state.

Footnotes

1 Ch. 46 (H.B. 3535), Laws 2013.

2 Ch. 38 (H.B. 3538), Laws 2013.

3 Ch. 46 (H.B. 3535), Laws 2013, §§ 48, 49, 89.

4 MASS. GEN. LAWS ch. 64H, § 1.

5 Id.

6 Technical Information Release 13-10, Massachusetts Department of Revenue, July 25, 2013.

7 Id.

8 MASS. GEN. LAWS ch. 64I.

9 MASS. REGS. CODE tit. 830, § 64H.1.3(15).

10 MASS. GEN. LAWS ch. 62C, § 5.

11 Technical Information Release 13-10, Massachusetts Department of Revenue, July 25, 2013.

12 Id.

13 Frequently Asked Questions: The New Computer and Software Services Tax Effective 7/31/13, Massachusetts Department of Revenue.

14 Working Draft Technical Information Release 13-XX: Further Guidance Regarding the Scope of Sales and Use Tax on Computer and Software Services, Massachusetts Department of Revenue, July 25, 2013.

15 Id. Note that the integration of taxable prewritten software generally would be taxable, but where the value of the taxable services in integrating taxable prewritten software is inconsequential (valued at less than 10 percent of the total charge), and the modification or enhancement of the prewritten software is not the object of the services, the software designer is not required to collect and remit tax unless the charges for the taxable services are separately stated.

16 Id.

17 See Frequently Asked Questions: The New Computer and Software Services Tax Effective 7/31/13, Massachusetts Department of Revenue, Response to Question 4. The regulation to be amended is MASS. REGS. CODE tit. 830, § 64H.1.3(6).

18 Ch. 46 (H.B. 3535), Laws 2013, §§ 37, 84.

19 MASS. GEN. LAWS ch. 63, § 38(f).

20 Id.

21 Id.

22 Id.

23 Id.

24 Ch. 46 (H.B. 3535), Laws 2013, §§ 45, 89.

25 Ch. 46 (H.B. 3535), Laws 2013, §§ 43, 89.

26 Ch. 173 (H.B. 4904), Laws 2008, § 95.

27 Id.

28 Ch. 173 (H.B. 4904), Laws 2008, § 95(2).

29 Ch. 38 (H.B. 3538), Laws 2013, § 142. Massachusetts had delayed the FAS 109 deduction in the prior two legislative sessions. Ch. 68 (H.B. 3535), Laws 2011, § 136; Ch. 139 (H.B. 4200), Laws 2012, § 140.

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