Navigating Use Tax Challenges for Digital Service Providers in the US

Digital services transformed the global economy, where the United States and its tech giants played a pivotal role in reshaping the global supply of goods and services. From subscription-based streaming platforms to providing other online services such as downloading ebooks or music, cloud-based games, and many more, the rise of digital services created new challenges for Tax Authorities, including those relating to the collection of sales and use taxes.

Use tax, introduced to complement sales tax and level playing fields for in-state and out-of-state purchases, applies when consumers purchase goods or services without paying sales tax. However, the applications of rules defined in the non-digital era have proven to be complex, leaving digital service providers to cope with compliance issues. At the same time, state governments strive to secure revenue.

The Current Use Tax Legal Landscape

There are no federal rules governing the sales and use tax. Therefore, each US state, except the so-called NOMAD states that did not implement a sales and use tax, has legislation defining sales and use taxability rules. The result is more than 13,000 sales and use tax jurisdictions in the US.

US states implemented use taxes to ensure that transactions not subject to sales tax still contribute to state revenues. The use tax rate usually corresponds to the sales tax rate, which explains its purpose of establishing equality between in-state taxpayers and out-of-state competitors. Moreover, use taxes are supposed to ensure that the same tax amount is collected and paid to state budgets, no matter where the transaction occurs.

To put it in simpler terms, if a provider in one US state pays tax on a product or service in another US state and brings it into its state of residency or establishment, the sales tax paid is credited against any use tax due. However, if the sales tax is not paid, the use tax must be paid in the US state where the provider is.

The 2018 Supreme Court decision in South Dakota v. Wayfair, Inc. was the turning point for digital service taxability rules. The decision allowed US states to impose tax collection obligations on remote sellers, including digital service providers, based on an economic nexus rather than a physical nexus. Additionally, it sets terms for states to adopt tax laws that meet the needs of the digital economy, ultimately leading to new requirements for digital service providers that vary from state to state.

Key Challenges for Digital Service Providers

The diversity of laws and policies across the US has led to several challenges for digital service providers. The first one is the fragmented nature of state tax laws, which makes it challenging to track applicable taxability rules for provided services, determine applicable tax rates, and implement efficient mechanisms to collect and remit use tax accurately.

The second issue is the classification of digital service disparity. There is no unified classification on the US level of digital services, leaving enough room for each state to implement its rules and regulations. Although some common ground exists between US states, digital service providers must ultimately have state-to-state knowledge to ensure compliance with in-state requirements.

Rules relating to the economic nexus are another complication for digital services providers. The first issue is that every US state has its registration threshold, which puts additional pressure on digital service providers to monitor where their consumers come from and when they need to register for sales and use tax. Additionally, nexus issues can arise once the provider that did not have a nexus establishes it by exceeding the threshold.

The issue in that situation is that until the threshold was exceeded, the user was responsible for remitting the use tax. Once the threshold is exceeded, the provider must collect and remit the sales tax. This could lead to double taxation, where users and providers remit taxes.

If we add that tax exemptions vary from one state to another, we come to the point where digital service providers must be cautious about where their services are taxed and exempt. For example, SaaS is not taxed in all US states. And even in some states where it is subject to tax, only personal use is taxed. 

This leads to situations where a digital service provider from one US state can supply SaaS to a client and consumer in another US state. In this case, the B2B transaction is not taxed, while the B2C transaction is. This may confuse who is responsible for paying taxes and in which state.

Finally, the ongoing challenge for digital service providers is the constant change in taxability rules across the US. US states are updating and changing their state and local laws, making services taxable and exempt, and publishing opinions and court decisions that have binding effects. Thus, the responsibility for collecting and remitting sales and use taxes is shifting.

Moreover, digital service providers that use third-party services may have trouble determining who is liable for remitting use tax and where. For example, a digital service provider can use a third-party hosting vendor from out of state. The provider must self-assess and pay use tax if the vendor does not collect sales tax.

Conclusion

To ensure compliance, digital service providers need clear guidance on which purchases and sales are taxable and which are not and which party is liable for the sales or use tax. Furthermore, companies with a digital-based business model should consider using tax software to help them track and monitor all the rules and regulations regarding applicable tax rates and thresholds and changes in legislation that may affect their day-to-day business operations.

Although consumers are primarily responsible for remitting use tax, digital service providers must ensure compliance with sales and use tax requirements, as the penalties and fines are more severe for them. Proving they did not violate laws may require time and financial resources, ultimately representing a distraction and burden for businesses.

Source: Thomson Reuters, Texas Comptroller of Public Accounts, KPMG, VATabout