Changes to Massachusetts tax policy became law became last week on July 24, 2013. One change included a new tax on “Software Services” involving “prewritten” software. This new tax became effective one week later – July 31, 2013.
I wrote an analysis of that law which generate some really great dialog (see the comments). In my analysis, I was alarmed because I though the intent of the new tax law did not match the wording. I sent my feedback to the Department of Revenue (DOR) asking for clarification. The DOR has responded.
The DOR response has a short overview page that includes a link to an FAQ on the new software services tax that contains the key clarifications. This FAQ is well done and provides a good deal of new, clarifying information in the form of 29 Questions with Answers. (I don’t necessarily like the answers it provides, as I wish the policies were different, but there’s no questioning that they do clear up certain areas of confusion substantially.)
Here is my take on a couple of the FAQ responses that, while very clear, are not the answers I was hoping to hear. The FAQ items cited are included verbatim in blue text.
FAQ Item 5 – Blindsided
FAQ 5. Why were businesses given such short notice of the new tax?
A. The effective date was set by legislation, not by the Department of Revenue. The Department’s TIR 13-10, “Sales and use Tax on Computer and Software Services” was issued one day after the legislation became law.
First, it is important to realize that the DOR was not responsible for writing the law, but they are trying to stay on top of it and issue timely guidance. One day after for the original TIR 13-10 and one week after that for this updated FAQ does not seem unreasonable since drafting answers these questions (many unanticipated by lawmakers) is not a casual endeavor. The authors of the FAQ appear to have taken into consideration lots of input, judging from the breadth of the questions it answers (including a couple of fairly esoteric ones).
This item is not speaking for lawmakers who should still explain how they thought they were acting responsibly by adding “sales tax” to software services where there never was such a thing before and have it become effective within a mere 7 days of becoming law. I did not say “why did they only give 7 days notice” because I don’t see this as giving the community “notice” – most effected consultants and services companies probably don’t even know about it yet – and it really did come out of the blue.
Lawmakers also still need to explain why they did not ask for feedback from the software services community in advance. Then the DOR FAQ could have been ready in advance. And maybe the law could have even been written more clearly. Did they ask for feedback in advance? If the publication of Working Draft Directive 13-XX: Criteria for Determining Whether a Transaction is a Taxable Sale of Pre-written Software or a Non-taxable Service is used as evidence that sufficient notice was given to the software services community, I strongly disagree. That draft was not a sufficient indicator of what was to come.
How the Software Services Community was Blindsided
- The publication of Working Draft Directive 13-XX: Criteria for Determining Whether a Transaction is a Taxable Sale of Pre-written Software or a Non-taxable Service is VERY DIFFERENT from the final law.
- The draft targeted software services tied to a larger software sale. Consider this key bullet from Directive 1 in the draft: “Pre-written software is bundled with a non-taxable service and sold for a single price, but only where the software constitutes the predominant value of the sale.” I can see this as taxing the services sold to make the software sale possible (think Enterprise Software which often require major integration) and to make it harder for vendors to shift licensing costs to services costs to avoid taxes.
- The draft exempted custom software and projects where the services were dominant part of the transaction. Consider these two key bullets from Directive 2 in the draft: “The seller is providing custom software.” and “Substantial personal or professional services are performed by seller’s employees and are bundled with the use of software and sold for a single price, and such services constitute the predominant value of the sale.”
- These seemed to be reasonable & logical criteria for taxation (Directive 1) and non-taxation (Directive 2). So why worry?
- The actual legislation took a major turn and is SO DIFFERENT in its scope and intent that it is not a logical successor to the draft. There is NO WAY our lawmakers can expect a reasonable reading of the draft suggests we might arrive at this final legislation.
- And, as mentioned, most impacted software services professionals don’t even know about the draft, the law, or the tax. HOW WERE WE SUPPOSED TO KNOW THIS WAS HAPPENING? How many lawmakers made an effort to socialize this with those of us in the profession? Anyone have any evidence that any outreach happened? Anyone reach out to your professional organization, company, or community group?
FAQ Items 9 and 10 – Taxing Open Source
FAQ 9. How does the new tax apply to use of Open Source software?
FAQ 10. Is Website Design a taxable service?
A9. Open Source software is available free on the Internet. Thus, no tax applies to the transfer of Open Source software where there is no consideration for the transfer. If a seller customizes Open Source software and sells it to one or more customers to be used on any electronic device, that customized software is subject to tax.
A10. The Department understands that website design may be accomplished in various ways. If the website designer is configuring or modifying Open Source (free) code or other prewritten software for the needs of a customer, the designer’s charges to that customer are subject to tax. If the website designer is creating custom software for its customer (that is, not based on other prewritten software), then the charges are not taxable.
I will tackle FAQ items 9 and 10 together here since my reaction spans both, and is one of astonishment. I had expected that the clarification on the tax law would be “oh my goodness, we never intended that, please let me amend that immediately!!” – but that’s plainly not the case.
This new tax law explicitly taxes software services and software consulting whenever “customizing” or “configuring” open source software is involved. This is pretty much every software application that uses open source – which is most software applications.
The tax law does exempt building completely from scratch, but I don’t know of too many projects outside academia or hobbies that would apply to since it is usually a terrible waste of time. The law also exempts just handing over open source software “as is” (if your customer doesn’t want to download it themselves?) – but if you install it for the customer, that service will be taxed (see FAQ item 21 which clarifies that software installation services are taxable).
More generally, the tax on software services is triggered by customizing or configuring any prewritten software – including software that is freely available like open source.
Response – Activism
While my first essay attempted to show how the new tax law was written to be so sweeping, my hope was this would open eyes since I thought the vagueness of the law was unintended. Appears I was wrong.
I encourage everyone to read up on this and stay fact-based. I recommend starting with the most recent DOR short overview page and especially the linked FAQ.
The time has come to get organized and respond. My plans will include:
- Continue to increase awareness
- Continue to work with colleagues to plan a course of action
- Broaden the number of people I am aligning with (I’ll be making some phone calls)
- I will be contacting (again) my state rep and senator letting them know I believe this is just wrong
What else should I do? What do you plan to do?
I just sent the following to the DOR:
Thanks you for the link to the PDF.
I would like to restate that as a practical matter, it is extremely difficult if not impossible to find a situation where the tax would not be charged.
As I understand the the FAQ document provided.
Click to access faqss-computer-software-2013.pdf
what the legislation / DOR is considering called “Custom software” can contain only completely original code and the “operating system” (which would I assume be the software that comes with the computer and may contain various prewritten and/or open source software software installed by the PC hardware vendor).
Custom Software, in my 30 years of software development experience, without any exceptions I can think of, includes third party software beyond the operating system. Much as Ford does not make their own tires, and can give the customer a choice of tires to install on a finished car, “Custom Software” always takes advantage of third party software for components that perform “best in class” services for the final product. To not develop software this way would be to do disservice to the customer. The services that a custom developer provides will include their own particular areas of expertise, combined with many other pieces of software either within the operating system or from other sources.
Again, to use the car analogy, Ford does not make their cars completely from scratch using all their own parts. Even if I were to order a “custom car” that would be the case.
So, in reality “Custom Software” as defined in the above FAQ does not exist. Therefore, it is unnecessary to make the distention between “prewritten software” and “Custom Software” because for all intents and purposes there is no difference as defined. And the conclusion I make is that all software, developed either for retail sale or entirely for a single customer will be taxed according to my understanding. So, if the legislature proceeds with this tax they could eliminate the confusion by not trying to carve out an artificial class of software development hat might not be taxable but is actually, as defined, taxable. I have read legislators state in the press that their desire was to create a narrow tax. But it is my expert opinion that this law fails to do that – it is as broad as possible.
This brings up one of thousands of possible scenarios and questions.
It might be possible to begin a “Custom Software” project using only original code created by my developers and the “operating system”.
But then, a month into the project it is decided that the software needs to take advantage of a third party “prewritten” component.
Let’s say that I’ve billed 10000.00 on the project. Is it the case that only after the “pre-written” software is added to the project, I will then have to charge the sales tax going forward, even if the component is small, open source, for which I as the developer paid nothing for? So, the next month, and going forward, I would have to bill the customer
10625.00 for the addition of a small component of pre-written software which I obtained for free because it is open source with a BSD license?
Such scenarios are common, and seem impossible to avoid.
So, in conclusion – all software, prewritten modifications, custom software, etc. will be taxed, from what I can see. There is no practical distinction.
Dominion Software, Inc.
825 Beacon Street
Newton, MA 02459
Richard – Excellent letter and questions. I like the analogy with building cars.
Pingback: Open Letter on New Massachusetts Tax on Software Services | Coding Out Loud
I notice that the FAQ is changing, and question #5 no longer discusses the “short notice”. Not sure what else has changed. Maybe we should be tracking that document in a revision-control system, to keep track of any changing advice we are given? (They do indicate it is not a ‘public document’, and that they plan to revise it, so maybe no surprise.)
Bill- another thoughtful post and you are right on the original directive to what has just been enacted. The Council had this early on and was still very concerned on the impact to our members. I do have to say our Reps Brian Mannal and Randy Hunt have reached out early and are attempted to answer our questions. What we thought unfortunate was that no one believed that this would pass- so sounding the alarm from the industry professionals, was too little, too late. We are now trying make sure thatour members understand how this affects them- hopefully we educate them before the DOR does!
Interesting discussion. I am affected as well and have trouble figuring out whether my custom software, which of course uses prewritten components (PWC), is taxable or not. My thinking goes like this: I integrate PWC into custom software (example: .Net libraries), but I don’t sell the PWC (as suggested in Answer 9 above for open source components). I am also not “customizing” the PWC; those libraries are not changed. What’s more, the customer already possesses a copy of the PWC, e.g. because it came with the operating system. So the custom software I sell should be non-taxable, even though it contains PWC. Again, I do not customize the PWC, and I don’t charge anything for it because it is freely available.
Ultimately it seems the question of whether a software service is taxable or not comes down to technical details and their interpretation, which means this will end up in the courts very quickly, at great expense for all involved. Maybe at that point a judge will decide that the law can not be enforced as written.
Great analysis! It might be worth noting that the answers 9 and 10 have been amended as of 8/12 such that they don’t quite say what they did when you wrote this. They now seem to be basically saying “we don’t know and we’ll look in to it.”
Pingback: Reading List » J DuClos