The Massachusetts Department of Revenue (MA DOR) has issued a working draft of amendments to regulation 830 CMR 64H.1.3, "Computer Software and Related Transactions" (draft regulation), on applying sales and use tax to the sales or use of computer software within the state.

The proposed regulations would replace the current regulation "Computer Industry Services and Products" and "are intended to clarify the statutory rules as they apply to sales and use tax imposed upon the purchase of software in light of changes in commercial practices and the analyses in recent cases."¹

Key takeaways from the draft regulation include:

• Replacing the "object of the transaction" test MA DOR has historically followed and providing an exception to the general application of sales and use tax to transfers of software, including the use of software, when it is an inconsequential element of a professional, insurance or personal service
• Generally treating automated online services as software as a service (SaaS) (this change stems from 2021 litigation)
• Repealing letter rulings and prior public written statements that are inconsistent with the new rules in the proposed draft
• Adopting new preapproval requirements for purchasers seeking to apportion sales and use tax

Definitional changes to when online services are SaaS also have corporate income tax and local property tax implications. For example, these changes may impact whether a taxpayer qualifies as a manufacturing corporation.

The applicability date of the draft regulation is not specified.

Interested parties are requested to submit comments by December 15, 2024, but MA DOR typically accepts comments after the due date.

This Tax Alert summarizes the draft regulation.

Taxable sales of standardized computer software

Massachusetts sales and use tax generally applies to the sale, purchase, license, or other right to use or consume transfers of standardized computer software, regardless of how it is delivered, accessed, used or consumed (e.g., electronic delivery, lease or physical transfer, access software installed on a remote server, load-and-leave, and updates/upgrades). The draft regulation would provide an exception to this general rule for transfers of the right to use software if the software is "an inconsequential element of a professional, insurance, or personal service transaction" (discussed later).

Whether a transaction is subject to sales or use tax would depend on whether software is transferred or otherwise made available for customer use, and not on how it is characterized by the parties.² The draft regulation describes indicia that a transaction is a taxable sale of standardized software, which include:

• Standardized computer software is transferred under a contract or other written agreement to the purchaser via a license (including licenses that are exclusive, non-exclusive, restricted or limited), sale, subscription, lease or other means for consideration.
• The purchaser may access, use or control a vendor's standardized computer software and enter and manipulate that information, as well as produce reports.
• The software provided to the purchaser functions automatically with little to no intervention by vendor other than what is provided through a help desk (or similar technical support).
• The vendor refers to itself as an Application Service Provider or to is software as SaaS or a similar reference that typically indicates a taxable transaction.
• The software provides an organizational tool or function that is used by the purchaser.

If some or all of those indicia are missing, the draft regulation could still treat the transaction as a taxable software transaction.

The draft regulation would describe in more detail SaaS transactions, standardized computer software upgrades and license updates, and in-app purchases, and would distinguish custom software, data access and telecommunications services from standardized computer software.

An otherwise taxable transfer of software, however, could be exempt from sales and use tax if it were to qualify for a statutory exemption, such as the manufacturing exemption or a sale for resale.

Software transferred with a service

Software transferred as part of or in connection with a service for a single charge is taxable. An exception to this general rule would apply when the software transferred is "an inconsequential element of a professional, insurance, or personal service transaction" and the charge for the software is not separately stated. A transfer of software would not be "an inconsequential element of the transaction" if the value of the software were to exceed 10% of the total transaction charge; it would be "presumptively not an inconsequential element of a transaction" if the software were an essential component of the transaction. Circumstances under which software would be considered an inconsequential element of a transaction include when there is not a separate charge for the transfer of software to the customer and the customer uses the software to access a distinct service not performed by the software (e.g., booking a ride-share, accessing digital information, streaming digital content).

If telecommunications services are sold with standardized computer software and transferred with a nontaxable service for a single charge, the value of both the taxable software and taxable telecommunications services would be considered together in determining whether these components are an inconsequential element of a professional, insurance or personal service transactions.

Under Massachusetts law, the taxable sales price of software sold or purchased for use in the state includes the value of any service provided as part of the sale,³ including charges for services that are a required component of the software transaction, such as charges for required server and desktop maintenance. The taxable sales price would not include charges for optional services that are reasonable and separately stated.

For bundled transactions, charges for services generally are not taxable when:

• They are separately billed or itemized from a charge for taxable standardized software or other taxable items.
• The purchase of the service is optional.
• The separate charge is reasonable and stated in good faith.

A separately stated service charge, nevertheless, would be included in the taxable sales price if it related to the functionality of purchased software or the right to use the software. Mandatory charges the purchaser must pay to acquire or use the software would be included in the taxable sales price, regardless of whether the charge is separately stated.

If a vendor were to sell standardized software it purchased from a third party and the sale were "an inconsequential element of a professional, insurance, or personal service transaction," the transaction would not be taxable. Rather, the vendor would be the consumer of the software and liable for payment of tax on the purchase.

The draft regulation would provide guidance on software transactions billed as a single charge and those billed as two or more charges. The draft regulation includes several examples (1) discussing whether standardized software is an inconsequential element of a service transaction when there is a single charge for software and services, and (2) evaluating whether separately stated charges billed to a customer as part of a transaction transferring software are taxable.

Apportionment of computer software sales

Businesses could apportion tax on sales of software for use in Massachusetts and other states if the business were registered⁴ with and received a Software Apportionment Certificate (certificate) from the Commissioner and meets the requirements in 830 CMR 64H.1.3(5). Under 830 CMR 64H.1.3(5), a business with a certificate can either apportion the tax at the time of the transaction based on anticipated use of the software, or after the transaction based on actual use of the software. The calculation of the apportionment percentage under the actual-use option would include use of the software by the purchaser and any agents or affiliates that use the software. In calculating the software use on an anticipated basis, the apportionment rules in 830 CMR 64H.1.3(5)(d)(2) would apply prospectively.

The draft regulations provide specific apportionment methods depending on who is using the software. For software purchased for use by all the purchaser's employees, tax would be apportioned based on number of employees in Massachusetts relative to the total number of employees using the software in other states during the license period; for software purchased or for use by only a portion of employees, tax would be apportioned based on the number of employees who used the software in Massachusetts relative to the total number of employees who use the software in other states.

For software licensed to run the purchaser's computer hardware or other systems, tax would be apportioned based on the locations where the hardware runs the software; for software licensed for primary use by customers tax would be apportioned tax based on a reasonable estimate of the customers' locations.

A purchaser would be required to reasonably and consistently apply the apportionment percentage to the software's sales price or license fee. The apportionment percentage would apply to the total charge if the software were sold (1) on a per-user basis and the charges were the same for all users, or (2) for a lump sum charge. If the software were to be sold on a per-user basis and varying fees applied, the purchaser would have to apply the appropriate apportionment percentages as determined by 830 CMR 64H.1.3(5)(d). If the purchase price were not based on the actual number of users, apportionment would be based on the expected use of the license period.

The Commissioner could require the use of an alternative apportionment method if the statutory method did not reasonably represent the use of the software in the state. Further, purchasers using an alternative method that reasonably estimates their use of purchased software could not subsequently use an alternative method that apportions a lower amount of use to Massachusetts.

In addition to the certificate, purchasers would be required to provide a written statement to vendors that (1) certifies a reasonable apportionment percentage to apply to the transaction, (2) describes the anticipated in-state use of the software, and (3) includes other information the Commissioner deems necessary or helpful. The purchaser would have to provide both the certificate and the apportionment statement to the vendor at the time of purchase.

Vendors would be responsible for collecting and remitting sales and use tax using an apportionment percentage. If the vendor were to accept a purchaser's apportionment statement and certificate, tax would be collected as provided in the statement and the vendor would be relieved of any further collection obligation and liability for any tax deficiency. If the vendor did not receive those documents at the time of sale, tax would be required to be collected on the full sales price of the transaction. The purchaser could subsequently provide the vendor with documentation to support the apportionment of the tax collected and remitted.

The draft regulation includes several examples on apportioning tax.

Previously issued public statements

According to the draft regulation, "830 CMR 64H.1.3 supersedes all prior public written statements, including letter rulings, to the extent it is inconsistent with any such prior statements or portions thereof."

Implications

Under these new rules, it is likely that more transactions, to the extent they involve prewritten software, are going to be considered taxable transactions. Purchasers or vendors seeking to prove that transferred software is an inconsequential element of a professional, insurance or personal service transaction that is exempt from tax should carefully review the qualification criteria.

Because the design, development and sale/license of prewritten software is a qualifying manufacturing activity, the changes in the proposed regulations could affect qualification as a Massachusetts-based manufacturing corporation. Corporations that engage in qualifying manufacturing activities in the state may qualify for additional Massachusetts tax benefits, including an investment tax credit and an exemption from local property tax on personal property. Manufacturing corporations must apportion using only the sales factor; for tax years beginning on or after January 1, 2025; however, all taxpayers must apportion using only the sales factor.

Finally, the draft regulation's requirement that purchasers get preapproval from the DOR to apportion sales and use tax on software transactions departs from prior procedures.