June 24, 2016
Re: Request for Ruling: Retail Sale and Use Tax/Corporate Income Tax
This will reply to your letter submitted on behalf of your client (the “Taxpayer”), in which you request a ruling on the application of the retail sales and use tax to the purchase and sale of computer software and the corporate income tax on gross receipts received from the Taxpayer's clients in the state of Virginia.
Retail Sales and Use Tax
The Taxpayer is a limited liability company located and headquartered in *****. The Taxpayer has a partnership with a software developer (the “Developer”) which allows the Taxpayer to license basic software from the Developer, customize the basic software, and resell the customized basic software to the Taxpayer's clients (the “Clients”). The Taxpayer purchases the license agreements through a reseller (the ”Reseller”) for the Developer. All transactions between the Taxpayer and the Developer, and the Taxpayer and their Clients are performed through cloud-computing services. There is no exchange of tangible personal property between the Developer and Taxpayer, or the Taxpayer and its Clients. The servers from where the software and data are hosted and backed-up (the “Data Centers”) are owned, operated and maintained by the Developer. One of the Data Centers to which the Taxpayer has remote access is located in Virginia. The Taxpayer has no access to, or control over, any server. The Taxpayer purchases subscriptions to the Developer's software, customizes the software to meet their Clients' needs, and resells the subscription services to its Clients. The customized software subscriptions include subscriptions to cloud-computing services.
The Taxpayer has employees in three states other than ****. These employees are involved in sales and consulting services. All other employees are located in *****, and the Taxpayer has no employees in Virginia or at the Developers Data Center located in Virginia.
The Taxpayer asks if they should be paying Virginia sales tax to the Reseller for the subscriptions to the software and/or the cloud-computing services. The Taxpayer also asks if the hosting of the software and the Clients' data on the Developer's server in Virginia constitutes a taxable use of tangible personal property in Virginia.
Corporate Income Tax
The Taxpayer also requests a ruling as to whether having a client in Virginia subjects the Taxpayer to corporate income tax.
Retail Sales and Use Tax
Generally, the sale of canned or prewritten software programs is subject to the Virginia retail sales and use tax, provided such software is transferred to the purchaser in the form of tangible personal property, i.e., tapes, disc, etc. Virginia Code § 58.1-609.5 7 provides a retail sales and use tax exemption for “custom programs as defined in § 58.1602.” Virginia Code § 58.1-602 defines custom computer software programs as follows:
“Custom program” means a computer program which is specifically designed and developed only for one customer. The combining of two or more prewritten programs does not constitute a custom program. A prewritten program that is modified to any degree remains a prewritten program and does not become custom.
In the present case, the Taxpayer is licensing prewritten software programs from the Developer, modifying the prewritten program to fit a particular Client's need, and reselling the program to the Client. Based on the definition of custom program provided in Va. Code § 58.1-602, the fact that the Taxpayer modifies a program to fit a Client's needs does not render the program a custom program, and the program remains a taxable prewritten program. However, it is the Department's longstanding policy that the sale of prewritten software program delivered electronically or downloaded from the cloud does not constitute the sale of tangible personal property and is, therefore, generally not subject to sales and use taxation. This policy is conditioned on the fact that no tape, disc, or other tangible personal property is subsequently provided to the customer before or after the electronic download of the software.
Based on the above statutes, and the longstanding established policy of the Department, the Taxpayer would not be required to pay the Virginia sales tax to the Reseller or to the Developer, nor would the Taxpayer charge sales tax to its Virginia Clients.
The Taxpayer is also inquiring about the Virginia sales tax implication of cloud-computing services provided by the Developer on Developer-owned servers located in Virginia. Generally, cloud-computing services are treated in the same manner as the electronic download and transfer of software products. There is typically no transfer or provision of tangible personal provided to customers of cloud-computing services. Therefore, the Taxpayer incurs no taxable use in downloading from the Developer's servers in Virginia.
Corporate Income Tax
Virginia Code § 58.1-400 imposes income tax “on the Virginia taxable income for each taxable year of every corporation organized under the laws of the Commonwealth and every foreign corporation having income from Virginia sources.” Generally, a corporation will have income from Virginia sources if there is sufficient business activity within Virginia to make any one or more of the applicable apportionment factors positive. The existence of positive Virginia apportionment factors clearly establishes income from Virginia sources.
Public Law (P.L.) 86-272, codified at 15 U.S.C. §§ 381-384, however, prohibits a state from imposing a net income tax where the only contacts with a state are a narrowly defined set of activities constituting solicitation of orders for sales of tangible personal property. The Department has a long established policy of narrowly interpreting the provisions of P.L. 86-272. The Department limits the scope of P.L. 86-272 to only those activities that constitute solicitation, are ancillary to solicitation or are de minimis in nature. See Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992). Although P.L. 86-272 only applies to the sale of tangible personal property, Virginia applies the same “solicitation” test to sales of intangible personal property. Based on the facts provided, the Taxpayer has at least one client located in Virginia, but it does not appear that the Taxpayer solicits orders in Virginia. Therefore, the issue becomes whether the Taxpayer performs any unprotected activities in Virginia that create more than a de minimis connection to Virginia.
Title 23 of the Virginia Administrative Code (VAC) 10-120-90 G exempts activities that are de minimis in nature. Under this regulation, consideration is given to the nature, continuity, frequency and regularity of the unprotected activities in Virginia, compared to the nature, continuity, frequency and regularity of such activities outside Virginia. Pursuant to Wrigley, all nonancillary activities are examined to determine if, when considered together, they create more than a de minimis connection to Virginia.
If the Taxpayer is merely purchasing cloud-computing services from the Developer that it then resells to its own customers, such services would not be attributable to the Taxpayer for purposes of nexus if the Developer is considered an independent contractor. The Department, however, would not consider the rental of servers in Virginia to be a protected activity under P.L. 86-272. In addition, the continuous use of such servers would likely create more than a de minimis connection to Virginia.
Further, under P.L. 86-272, different standards apply to the activities of a representative versus the activities of an independent contractor. An entity is not protected from taxation by a state pursuant to P.L. 86-272 if its representatives maintain an office in such state or engage in activities that go beyond the mere solicitation of orders. However, an independent contractor can engage in a broader range of activities within a state without subjecting its out-of-state corporate customer to that state's income tax.
An independent contractor is defined in P.L. 86-272 as a “commission agent, broker, or other independent contractor who is engaged in selling, or soliciting orders for the sale of, tangible personal property for more than one principal and who holds himself out as such in the regular course of his business activities . . . .” This definition sets forth a two-part test, both of which must be met, in order for an agent to be considered an independent contractor. The agent must represent two or more principals and the agent must be, in fact, independent from the principals.
When a corporation contracts with a third party service provider in Virginia, the Department views such activities as if a corporation is purchasing services only if a third party service provider is an independent contractor. See Public Document (P.D.) 01-136 (9/18/2001). Under such circumstances, the corporation is not considered to be conducting the activities in Virginia and the unrelated third party would not create nexus for a corporation that is otherwise protected under P.L. 86-272.
The Department will, however, take a different approach if a third party provider is not independent of the Taxpayer. The Department attributes unprotected activities performed by an entity that is not independent to a business entity for purposes of determining whether or not the entity has nexus with Virginia. As such, a third party service provider that is not independent of the Taxpayer is considered to be providing services on behalf of the Taxpayer to the Taxpayer's customers. See P.D. 99-278 (10/14/1999).
In this case, the Taxpayer has not indicated whether a relationship exists between it and the Developer such that it may not be independent of the Taxpayer. The Taxpayer will need to evaluate its relationship with the Developer to determine if the Developer meets the definition of an independent contractor under P.L. 86-272. If it is and the Taxpayer is merely purchasing cloud-computing services from the Developer,then the cloud-computing services would not be attributable to the Taxpayer for purposes of nexus. In that case, based on the facts provided, the Taxpayer would not have nexus with Virginia because it would not be considered to be engaged in any unprotected activities in Virginia.
Because the Taxpayer is using servers located in Virginia, questions have been raised concerning whether such use creates a positive property factor. Virginia Code § 58.1-409 provides that the property factor consists of the ratio of the average value of a taxpayer's real and tangible personal property owned or rented and used in Virginia over the like property located everywhere. See Title 23 VAC 10-120-160 through 10-120-180.
It does not appear that the Taxpayer owns any property in Virginia. The Taxpayer, however, subscribes to the Developer's software and cloud-computing services that are provided over the Developer's network of Data Centers, one of which is located in Virginia. The Taxpayer should carefully examine whatever agreements it has with the Developer and the Reseller regarding subscriptions to the software and cloud-computing services. If any servers in Virginia are being rented as a part of any such subscription, the Taxpayer would likely have a positive Virginia property factor. The Taxpayer should be aware that a lack of physical access to servers does not preclude their inclusion in the property factor. See P.D. 12-36 (3/28/2012).
Pursuant to Va. Code § 58.1-412, the payroll factor is a fraction, the numerator being the total amount of compensation paid or accrued within Virginia during the taxable year by a taxpayer and the denominator being the total compensation paid or accrued everywhere during the taxable year. See Title 23 VAC 10-120-190. All of the Taxpayer's employees work in ***** or other states besides Virginia. Therefore, it is unlikely the Taxpayer has a positive payroll factor.
The Taxpayer should be aware that there are instances in which a taxpayer may not have a positive payroll factor but is still required to withhold Virginia income tax from employee wages. See, e.g., P.D. 12-151 (9/21/2012). Virginia Code § 58.1-461 requires employers to withhold taxes from employee wages for each payroll period. Virginia Code § 58.1-460 defines “employer” as “[t]he person, whether a resident or nonresident of the Commonwealth, for whom an individual performs or performed any service as an employee ....” (Emphasis added). Further, this section defines “employee” as “[a]n individual, whether a resident or a nonresident of the Commonwealth, who performs or performed any service in the Commonwealth for wages ....” (Emphasis added).
In P.D. 94-192 (6/20/1994), the Department held that the presence of employees within Virginia constitutes the requisite nexus to impose withholding tax collection responsibilities in accordance with Article 16, Chapter 3 of Title 58.1 (§ 58.1-460 et seq.) of the Code of Virginia. In this case, it does not appear that any of the Taxpayer's employees perform services in Virginia. The Taxpayer should be aware, however, that it would be required to withhold Virginia income taxes from an employee who is not a resident of Virginia if that employee earns income from Virginia sources by traveling into Virginia to perform services on behalf of the Taxpayer. The nature of the services performed may also impact whether the Taxpayer has nexus with Virginia for income tax purposes.
The Taxpayer asks whether it is subject to Virginia income tax because it sells subscriptions to software and cloud-computing services to a client in Virginia. Virginia Code § 58.1-416 provides that sales, other than sales of tangible personal property, are deemed in Virginia if:
1. The income-producing activity is performed in Virginia; or
2. The income-producing activity is performed both in and outside Virginia and a greater proportion of the income producing activity is performed in Virginia than in any other state, based on costs of performance.
Pursuant to Title 23 VAC 10-120-230, sales of services from multistate activities are only included in the numerator of the Virginia sales factor if the greater proportion of the income-producing activity is performed in Virginia than in any other state, based on costs of performance. The regulation defines “cost of performance” as the cost of all activities directly performed by the taxpayer for the ultimate purpose of producing the sale to be apportioned. “Income producing activity” is the act or acts directly engaged in by the taxpayer for the ultimate purpose of producing the sale to be apportioned. Indirect expenses such as interest or activities produced by independent contractors are not included.
In General Motors Corporation v. Commonwealth of Virginia, 268 Va. 289, 602 S. E.2d 123 (2004), the Virginia Supreme Court held that Title 23 VAC 10-120-250 is inconsistent with Va. Code § 58.1-418 when it limits the costs of performance used to apportion income of a financial corporation to direct costs, excluding costs of independent contractors. Because the language defining “cost of performance” and “income producing activity” in Title 23 VAC 10-120-230 is identical to the language in Title 23 VAC 10-120-250, the cost of performance for purposes of sales of intangibles may not be limited to direct costs and may not exclude indirect expenses such as interest or activities produced by independent contractors.
In response to the General Motors decision, the Department issued Tax Bulletin (VTB) 05-3 (4/18/2005). This bulletin explains that financial corporations may elect to file returns prepared in accordance with Title 23 VAC 10-120-250, pending the Department's adoption of policies in response to the General Motors decision. Because the Department administers Va. Code § 58.1-416 in a manner similar to Va. Code § 58.1-418, taxpayers, including pass-through entities, with sales other than tangible personal property may also elect to file returns prepared in accordance with Title 23 VAC 10-120-230 pending the adoption of policies in response to the General Motors decision.
The determination as to whether a transaction or sale is a Virginia transaction or sale is an all or nothing test. A taxpayer would first have to determine the direct cost associated with each transaction for a given taxable year. Then the direct costs would be attributed to the states in which they occurred. See Title 23 VAC 10-120-230 C 1. If the transaction resulted from direct costs occurring both in Virginia and outside Virginia, such transaction would be considered to be in Virginia if a greater portion of the direct costs occurred in Virginia than in any other state. See Title 23 VAC 10-120-230 C 2. Conversely, a transaction would not be a Virginia sale if a greater portion of the direct costs occurred in any state other than Virginia.
If the Developer is not considered an independent contractor or the subscription agreements the Taxpayer has with the Developer specifically provides for the rental, leasing, licensing or other use of servers or other tangible personal property in Virginia, then the costs associated with using such property in Virginia would be considered a direct cost of performance. See Title 23 VAC 10-120-230. If the Developer is an independent contractor that merely provides services to the Taxpayer that the Taxpayer resells to its clients, the costs associated with such services would be an indirect cost of performance. In that case, however, the Taxpayer may not have nexus with Virginia in the absence of additional contacts, because such services performed by an independent contractor would not be attributable to the Taxpayer for purposes of P.L. 86-272.
In P.D. 08-137 (7/30/2008), the Department ruled that costs incurred to generate fees from on-line advertising loaded and stored on Virginia servers would be costs associated with income producing activities in Virginia. The question became whether the greater portion of the income producing activities for the fees occurred in Virginia or another state.
In this case, the Taxpayer generates fees from subscriptions to custom software and cloud-computing services that are provided, at least in part, over servers located in Virginia. The Taxpayer incurs some costs in Virginia to generate such fees because the Taxpayer also subscribes to basic software and cloud-computing services that are provided by the Developer over the same network. For any given subscription, the Taxpayer would need to determine whether the greater portion of the income producing activity occurred in Virginia or another state. Because most of the Taxpayer's business activities, including software development, marketing and general business administration, occur outside Virginia and because the Developer's network also includes servers that are not located in Virginia, it appears unlikely that the greater portion of the income producing activities for any given subscription fee occurs in Virginia. It might be possible; however, that the greater portion of the income producing activities for some fees could occur in Virginia to the extent any particular subscription is connected only to servers located in Virginia. This possibility may be even more likely to the extent that any other costs associated with such subscription are split between more than one other state besides Virginia. See P.D. 08-137.
The findings in this letter are based solely on the facts as presented by the Taxpayer. Any changes in the facts as presented may result in a different conclusion. The Va. Code sections cited in this letter are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's website. If you should have any questions regarding this response, please contact ***** in of the Office of Tax Policy, Appeals and Rulings, at *****.
Craig M. Burns