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How Tax Laws Are Failing Digital Subscriptions

Tien Tzuo
CEO, Zuora

Take a thumb drive.

Let’s say you walk into an Office Max and buy some standardized, off-the-shelf business software on that thumb drive. Let’s say that Office Max is located in Sacramento, California. In California, the software on that thumb drive would be considered taxable, as it is a physical product. Its manufacturer would be obliged to collect and remit a specific sales tax.

But wait – what if you download that exact same software over the Internet? Well, then according to California regulations, that software is generally exempt from taxes. Why? Because it’s intangible. But let’s say you download that software (again in California, but note that the rules vary from state to state), and you intend to use that software for manufacturing or research and development purposes? Well, then I have some bad news and some good news: That software would probably be taxed, but at a reduced rate.

Once again, we find ourselves facing a familiar problem: old laws failing new technology. I’ve written extensively about how standard finance rules have fallen hopelessly behind the times when it comes to on-demand digital services, so it’s no surprise that our tax laws are still stuck in the days of bowler hats and Model Ts.

Most of our current tax laws are based on the product economy, where goods were made, sold, and shipped in discrete transactions and discrete locations. This was the world of Henry Ford and the Sears Roebuck catalog. This world is now gone; it’s simply not the way things work anymore. But Congress seems reluctant to interfere with local tax issues, leaving it up to states and the software industry to work out a solution among themselves.

It’s a mess. To paraphrase the great new Michelle Yeoh movie, when it comes to taxes, subscription services are responsible for everything, everywhere, all at once:

Everything: Tax laws categorize subscriptions in a confusing variety of ways.

Today, software is tax categorized up to ten different ways across 45 states. Whether sales tax applies or doesn’t apply to software transactions in a particular state depends on all kinds of factors: who’s buying the software, how it’s delivered, how it’s classified (standard versus custom, digital vs physical, stand-alone vs bundled), what it’s for, and where the seller and end user are located. As a result, it’s a nightmare to determine the taxability of specific software products and services from state to state. What’s more, all of these state laws are constantly in flux. Last year, the Mississippi Supreme Court overturned a ruling by the state’s Department of Revenue, which had earlier found that digital photographs were taxable (!). West Virginia now considers streaming services taxable after issuing earlier guidance that said it wasn’t. You can expect lots more changes in these local tax laws, because taxing sales of digital products is proving to be an excellent source of revenue; money from Chicago’s tax on streaming services, for example, nearly quadrupled between 2016 and 2021, to $117.2 million. Listen, I’m all for federalism, but there has to be a better way. And it gets even better:

Everywhere: Subscriptions can be used in multiple locations, but tax laws don’t understand that.

If there’s anything that the pandemic has taught us, it’s that today we live in a “post-place” world. The challenge for sourcing digital goods is they can be used in multiple locations and the seller often doesn’t know where the buyer uses the goods. But under the current regulations, it’s impossible for a business to calculate sales tax rates accurately without a full 9-digit ZIP code.The problem is that digital subscription vendors often don’t collect a buyer’s full address because nothing “tangible” is ever delivered. We don’t live in a world of Oracle installations and AOL mailer discs anymore.

I totally understand that if a tax does apply to a transaction, it needs to be applied at the proper rate. But that’s a hard lift if a seller doesn’t collect a buyer’s full address — and many software companies don’t, since they’re not delivering a tangible product to a street address. But without that exact street address, it’s impossible for a business to accurately calculate a sales tax rate — or for a tax authority to confirm that tax was properly collected. And guess what?

All At Once: Thanks to a recent Supreme Court ruling, you now may be required to collect sales tax wherever and whenever your subscription is consumed.

On June 21, 2018, the U.S. Supreme Court (SCOTUS) issued the South Dakota v. Wayfair Inc. et. al. (“Wayfair”) decision. Forgive the following legalese, but the effect of this decision is that a state may require a seller without a physical presence in their state to collect and remit its sales and use taxes on sales of products delivered into their state if: (i) the seller meets certain thresholds of activity (i.e., minimum number of transactions or certain dollar volume of sales) in their state; and (ii) the state’s laws prevent discrimination against or undue burdens upon interstate commerce.

That’s right. Anytime someone downloads your digital service, you may be liable to handle sales tax obligations based on their individual state or city. Now I firmly believe that Amazon should pay its taxes, but this law is a good way to smother a promising start-up in its crib. But let’s end on an optimistic note:

Fortunately, there are organizations fighting to minimize all this immense complexity, as well as revenue and tax automation systems that can provide material help.

The Streamlined Sales Tax Governing Board, which currently consists of 24 member states, is currently reevaluating its sourcing rules for digital goods and services with all these problems in mind. And while we wait for some common-sense legislation to address these issues, businesses can rely on automation platforms like Zuora Revenue and Avalara (full disclosure – Avalara is a partner) to tame all this complexity. I’m not holding my breath on a solution from the government anytime soon. But in the meantime, we can look for tax help from partners like Avalara who live and breathe this stuff all day long (the full Avalara Tax Changes 2022 report is available at Also, stay away from thumb drives.

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