It’s no secret that technology companies based in the State of Washington are among world leaders in advancing technology related to “digital products.” Think cloud computing, music streaming and smartphone apps, just to name a few areas where Washington companies excel.

But this transition from products traditionally purchased in brick and mortar stores and services provided in person by a live human, to electronic products/services delivered via the internet has also been blamed by a number of states for a sharp decline in sales tax revenues. And with looming budget deficits, states are attempting to recoup those lost revenues by expanding the tax base to include these electronically transferred goods and services.

The State of Washington accomplished this in 2009 by enacting legislation that addressed the sales tax treatment of “digital products” (a statutory term that encompasses digital goods, digital codes, and digital automated services). Although the law has now been in effect for almost four years, many businesses are still working on understanding the underlying concepts. Complicating this learning process is the fact that the regulation interpreting the digital products law was not finalized until February 2013, more than three and a half years after the enactment of the law.

Structurally, the legislation purposefully utilizes broad definitions of key terms (in the hope that the guidance will remain relevant as technology evolves), and provides a number of specific exemptions to prevent taxation of goods not intended to be taxed. Thus, retail sales or use tax applies to all digital products unless a specific exemption applies. The law allows either the seller or the purchaser to be held liable for the tax due; if it is not collected at the time the transaction takes place. As a result, both sellers of digital products and businesses that are consumers of technology must understand the rules in this area in order to avoid potential exposure.

Certain digital equivalents of tangible goods have always been subject to sales tax, according to the Washington Department of Revenue. Examples would include e-books, movies, and digital music files. But prior to July 2009, such digital goods were only subject to retail sales tax if the buyer took possession of the item on physical media such as a CD/DVD or by downloading it; now all digital goods delivered to a purchaser in Washington are subject to sales tax regardless of whether the item is downloaded, streamed, or merely accessed online. By definition, “digital goods” consist of digital content only: images, sounds, data, facts, information, or any combination thereof.

In contrast, a digital automated service is defined as “any service transferred electronically that uses one or more software applications.” This broad definition has led to widespread concern among taxpayers and practitioners that the state’s tax authorities will be inclined to consider all online applications to be digital automated services. According to the recently adopted regulation, a digital automated service combines the operation of software applications and elements of digital goods in an integrated fashion to produce an electronically delivered service. Understanding the boundary between digital goods and digital automated services is important because certain exemptions from the sales and use tax apply only to digital goods.

The specific exemptions that apply only to digital goods that are (1) purchases intended solely for a business purpose and (2) purchases used directly in the manufacturing process or research and development.

This first exemption applies only if the use of the digital good is relevant to the buyer’s business needs. However, “business needs” are not defined in the statute or regulation so there is still likely to be disagreements on how broadly this exemption can be used.

The second exemption applies in cases where the digital good fits the requirements of Washington’s manufacturing machinery and equipment (”M&E”) exemption. This should be an easier concept to apply since the qualifying criteria for the M&E exemption are well established.

Because digital products are defined as a retail sale, general tax exemptions and exclusions (such as those covering sales for resale and sales to the federal government) will also apply. Some additional exemptions are unique only to digital products, such as purchases to be made available for free to the general public and the partial exemption for items that will be used concurrently within and outside of Washington.

In order to avoid exposure for uncollected sales tax as a seller (or unpaid use tax as a purchaser) as well as unintended overpayments, businesses should understand when the sale, acquisition, or the use of a digital product is subject to tax; this will also require a familiarity with the many exemptions and exclusions in order to properly apply them.

In addition, businesses will need to keep abreast of future clarifications and interpretations of the law, as these rules are expected to evolve in step with technological advances in the products/services we acquire electronically and the ways we purchase them.

Just as in any field where rapid advancement and changes take place, there will likely be some surprises and some opportunities as the law struggles to keep up with changes in technology. This could benefit those who take the time to understand the law and its application, just as it could lead to significant controversy and unintended exposure for those who do not.

Contact a member of our SALT team if you have further questions.

© Clark Nuber PS, 2013.  All Rights Reserved

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.