Software change bigger than Amazon issue

Amazon’s seemingly nonsensical firing of its Colorado affiliates grabbed most of the attention following a litany of state tax law changes last month.

In late February, the Legislature passed and Gov. Bill Ritter signed a series of bills to raise tax revenue, including lifting exemptions on items ranging from candy and soft drinks to agricultural compounds and pesticides, and asking out-of-state online retailers to report sales taxes owed by customers in Colorado. Amazon reacted by disassociating from Colorado-based websites that drove traffic to its site. That tax is expected to generate up to $4.7 million in the 2010-11 fiscal year.

Another change, though, will have a bigger impact on the state’s budget and on Colorado businesses. For decades, state residents and businesses have had to pay sales tax on software only if it was packaged – downloads were not taxed. Thanks to House Bill 1192, any standardized software – on disk or downloaded – will now be subject to sales tax. Custom software will continue to be sales tax-free. The new law is expected to generate $23.7 million in the 2010-11 fiscal year.

The Colorado Software and Internet Association fought tooth-and-nail to head off the software tax. President Su Hawk called it the “most dangerous bill ever in CSIA history” in a January blog post. Despite her disappointment in the passage of HB 1192, Hawk counts a few victories. As originally written, the tax would have included cloud computing; software as a service, or SaaS; and other emerging IT services that are exempt in the final law.

The CSIA is worried that this tax will have far-reaching and long-term negative impacts on the state’s software industry. Colorado-based IT teams might be passed over for professionals in one of the 38 states that do not tax downloadable software, or there could be harsh repercussions for state software companies targeted for acquisition, Hawk said.

“The biggest concern I have is the unintended consequences,” Hawk added.

She also worries that once businesses fully understand the impacts of the bill, they will feel slighted by the Legislature.

The discussion is far from over. While the state issued emergency regulations to get the tax changes into effect almost immediately, a final rulemaking hearing will be held on a date that had not been set at press time.

“We’ll certainly get a lot of feedback,´ said Mike Couch, spokesman for the Department of Revenue. “This has been an unsettled area of taxation for a long time.”

Software tax different

Colorado’s software tax regulations were first formulated in 1977 – the same year personal computers hit the world market. The regulations called for a two-part test to decide whether or not a piece of software was taxable, and any reasonably intelligent businessperson could plan his or her software purchase in a way to circumvent the taxes, according to Bruce Nelson, a senior tax manager for EKS&H in Fort Collins.

As a result, the Colorado Department of Revenue started looking into changing the code in the mid-1990s. Under the leadership of Mary Michael Cooke, named executive director in 2002, the department began requiring sales tax on all standard software that had a material existence – it could be physically held. Nelson said that provision wasn’t popular with everyone at the time, especially within the Department of Revenue.

Nelson feels that there is a legal battle brewing. On the Department of Revenue website, the software sales tax changes are listed along with the newly eliminated exemptions.

“The software regulation is different,” Nelson said.

There is a difference between a tax exemption and a tax exclusion. An exemption takes something that is part of the tax base out of it, while an exclusion is something that is not a part of the tax base to begin with. Nelson said that downloadable software was not a part of the tax base, therefore it was an exclusion. The recent changes were to the definition of what is tangible property, pulling downloadable software into the tax base.

“That’s a key difference, and it could be significant for a TABOR violation,” he said.

Hawk wouldn’t confirm that the CSIA is preparing for a legal battle, but she also pointed out the potential for TABOR issues.

“We think that there are elements that are a brand-new tax,” Hawk said.

Nelson also pointed out that different rules of taxation could soon lead to companies doing business in multiple states paying more than their fair share. There is a push now to get all states to adopt a multiple-points-of-use method to allow the state where software user licenses are used to collect the taxes, but not all states have signed on. Without it, a company could be held accountable for paying the full sales tax on its software purchases in its base state as well as taxes for its licenses used in other states.

“The software people are correct in being apprehensive about this,” he said. “This is an area that is going to be revisited because technology is changing so fast.”

Kristen Tatti covers technology for the Northern Colorado Business Report. She can be reached at 970-221-5400, ext. 219 or ktatti@ncbr.com.

on Facebook on LinkedIn