Software and Turkish baths taxed the same?

UPDATE: Serious public policy discussions continue within the Legislature about this issue. Lew McMurran, government affairs for the Washington Technology Industry Association, is lead on coordinating a lobbying effort. He can be reached at lmcmurran@washingtontechnology.org. At this point, we need thoughtful, constructive, substantive examples of how extending the sales tax to custom software services would impact companies, researchers, governments and others. Please learn about the small business credit included so that you know the ‘net’ impact as well. Rep. Ross Hunter and I continue to work together to assess the public policy implications and options associated with this legislation.

(original post)

Hundreds of entrepreneurs, venture capitalists, technology executives and others have reached out to me as a colleague in arms expressing concern about the ‘custom software tax’ that has been proposed as a part of the revenue package being considered by the Legislature and Governor.

After an analysis of the real implications, I remain strongly opposed to this tax and have been working hard to educate fellow legislators that this is, fundamentally, simply an extension of the sales to tax to ONE category of professional services. It is not about a product, it’s about a service. The problem is that no other such services are taxed in that fashion (lawyers, accountants, health care, real estate, manufacturing, etc.). I am not inherently opposed to a thoughtful, genuine dialogue about extending sales tax to services (don’t mistake that for excitement by any stretch) but I do not support backing into one category and pretending it’s about a product.

This is extending the sales tax to a major category of a service and we don’t have a handle on the implications or market impacts. It’s not baked by any stretch.

The largest policy problem for me, however, remains the fact that it is not technology neutral and would result in a direct disincentive (in the form of 10% higher costs for not doing so) for a company such as Microsoft, AT&T Wireless, T-Mobile, Amazon, Real Networks, Boeing or even local, county or state governments to use ‘insource development resources’ as opposed to ‘outsource development resources.’ What does this mean? It means that a 5 person team of entrepreneurs building a cool custom software suite, or a group of system integrators, would face a 10% tax on their services while keeping the exact same project in-house would not be taxed. It would be a massive blow to the entrepreneurial community in our state.

Fortunately, Rep. Ross Hunter, the powerful chairman of the House Finance Committee, has a firm grasp of this issue and has been more than willing to work with me as we try and figure out the viability of this or similar approaches. We’re engaged in a substantive dialogue with stakeholders, too, and hopefully good public policy will win out.

In the end, we must have the courageous honesty to acknowledge that our tax system needs a new look and a new outlook. Raising taxes is very, very hard. And it should be.

I asked the state Department of Revenue for an overview of the policy issues associated with the custom software tax. In an effort to help you understand some of the issues, here’s the memo they provided in full:

Custom Software Bill Issues

Issues

Rep. Carlyle requested an analysis on three issues surrounding the custom software bill:
1. Product v. services centric policy
2. In-sourcing v. out-sourcing incentives resulting from tax
3. The impact of this bill on the small business tax credit

Product v. Service Policy RCW 82.04.215, WAC 458-20-155, and 458-20-15501 currently recognize a distinction between a “product” subject to sales/use tax and Retailing B&O tax and a “professional service” subject to Service & Other B&O tax. Under the current rule, custom software programming is considered a professional service and prewritten software is considered a product. Custom software programming may become a product if it is sold to more than one customer. The current proposal would continue to recognize that custom programming services are professional services, but it would subject them to sales/use tax and retailing B&O tax rather than services & other B&O tax.

Because custom software has traditionally been treated as a service, implementation and administration of this bill would be very similar to the implementation and administration of existing retail services that are legislatively defined as services subject to retail sales tax and Retailing B&O tax, such as:
• Custom construction services;
• Physical fitness services;
• Tanning salon services;
• Tattoo parlor services;
• Steam bath services;
• Turkish bath services;
• Escort services;
• Dating services;
• Amusement and recreation services (including but not limited to golf, pool, billiards, skating, bowling, ski lifts and tows, day trips for sightseeing purposes, and others) when provided to consumers;
• Abstract, title insurance, and escrow services;
• Credit bureau services;
• Automobile parking and storage garage services;
• Landscape maintenance and horticultural services but excluding (i) horticultural services provided to farmers and (ii) pruning, trimming, repairing, removing, and clearing of trees and brush near electric transmission or distribution lines or equipment, if performed by or at the direction of an electric utility;
• Service charges associated with tickets to professional sporting events; and
• Digital automated services.

In-Sourcing v. Out-Sourcing Incentives As with most retail services, passage of this bill would subject the outsourcing of custom software to the retail sales or use tax. If the same activity were performed “in-house” by employees of the company, then it would generally not be subject to the retail sales or use tax.

Therefore, just as with construction services that are performed in-house or outsourced, there may be a tax incentive to perform that custom software programming services in-house in order to not be subject to retail sales or use tax. However, this assumes that the in-house cost (salary, benefits, infrastructure, insurance etc) is lower than the outsourcing cost. It also assumes the outsourcing company and service company are both in Washington. In-state service firms hired by out of state companies will not charge sales and use tax on services delivered outside Washington.

Small Business Tax Credit

Businesses whose B&O tax liability is $420 or less are eligible for a credit equal to their B&O liability, i.e. they do not pay B&O tax. The amount of “tax free” income a business can have depends on the tax classification(s) the business reports under.

Because this proposal lowers the B&O rate paid by small businesses selling custom software, it will have the effect of extending the benefit of the credit. For example, a business that does all its work in Washington that now reports under Service would report under Retailing:

B&O classification & rate Annual Gross Income
Customer location B&O Tax Liability with SBTC
Service = 1.5% $28,000 Anywhere $0
Service = 1.5% $89,000 Anywhere $1,335*
Service = 1.5% $890,000 Anywhere $13,350*
Retailing = .471% $89,000 All in WA $0
Retailing = .471% $890,000 All in WA $4191.90*
Retailing = .471% $890,000 10% in WA, 90% outside WA $0

*It is important to note that these examples are not eligible for the small business tax credit because their annual gross income is too high. Businesses whose B&O tax liability is between $420 and $840 are eligible for a partial small business tax credit.

(end of memo)

Your thoughts?

Your partner in service,

Reuven.