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Podcast: State Taxation of Digital Health Products

Time to Listen: 15:45 Practices: Tax Controversy, Tax, Health Care, Digital Health, Appellate & Supreme Court

In this Ropes & Gray podcast, Isabelle Farrar, an associate in the tax controversy group, is joined by Elizabeth Smith, counsel in the tax controversy group, and Jennifer Romig, a partner in the health care group, to discuss the state taxation of digital products, an evolving area in several states. Specifically, they will discuss how new technologies are rapidly shifting the delivery of health products and services, and how these new technologies are creating uncertainties in the sales and use tax world.



isabelle-farrarIsabelle Farrar: Hello, and thanks for joining us today on this Ropes & Gray podcast. I’m Isabelle Farrar, an associate in the tax controversy group. Joining me are Elizabeth Smith, counsel in the tax controversy group, and Jennifer Romig, a partner in the health care group. We’ll be discussing state taxation of digital products, an evolving area in several states. Specifically, we’ll be looking at how new technologies are rapidly shifting the delivery of health products and services, and how these new technologies are creating uncertainties in the sales and use tax world.

Companies can be surprised when they are subject to a sales and use tax audit, with large amounts on the line, based on previously untaxed transactions. The laws surrounding this area are constantly changing, wide-ranging and very nuanced, which can seem daunting to companies facing an audit. At issue are state and local tax codes written before major digital service and technology providers—including household names like Netflix and Amazon—even existed. Gone are the days when you bought software in a box at your local office supply store; rather, many software providers now host their software and license subscriptions to users online, allowing users to access software remotely through web browsers or applications. Software as a Services, or SaaS, is one example of “cloud-computing,” where end users access software providers’ applications which operate on a cloud-based infrastructure owned by the provider. Often, cloud-based software applications deliver services, calling into question whether software or services are the ultimate product sold.

States have struggled with how to classify these digital services. On the one hand, states are hesitant to start taxing all services. On the other hand, sales of cloud-based software could arguably represent the transfer of tangible personal property, a taxable activity under many sales tax regimes. Recent changes in state tax law have complicated matters. For example, some states have passed legislation to address the sales taxation of digital technologies and products, while others have remained silent on the topic. This inconsistent legal landscape has led to confusion and compliance issues for many companies. Elizabeth, what can you tell us about the shifting landscape of sales tax?

elizabeth-smithElizabeth Smith: There has been a lot of change going on in recent months. To understand how these tax changes may affect health care and digital health businesses, you first have to understand the Supreme Court’s recent South Dakota v. Wayfair decision, which clarified states’ abilities to require remote sellers to collect and remit sales tax. Before the case, states could only impose sales tax collection obligations on a business if it had a “physical presence” within the state. This benefitted sellers from an administrative perspective: if a provider’s offices and servers were all located in one state, the seller was not required to collect and remit sales tax on taxable transactions with customers in other states. This is also why many consumers did not pay sales tax at the time of the transaction on orders from internet retailers like Wayfair and Newegg.

In the Wayfair case, however, the Supreme Court said that states can impose sales tax collection obligations whenever there are enough “economic and virtual contacts” between an out-of-state company and that state. While states have implemented varied laws and regulations in response to Wayfair, the sufficiency of the “economic and virtual contacts” is typically measured through sales revenue, transaction volume, or some combination of both. Some states may require collection of sales tax by an out-of-state seller if sales of a certain dollar volume are met, while other states require a certain number of transactions and dollar volume thresholds to be met. This is further complicated by the fact that not all sales are subject to sales taxation, and these rules vary by state. As a result, companies must evaluate their sales tax collection obligations on a state-by-state basis.

Wayfair has thus triggered a wave of changes that, in general, have imposed significant obligations on sellers to collect and remit sales tax that did not exist a year ago. And it has emboldened state taxing authorities to take more aggressive positions in sales and use tax audits.

Isabelle Farrar: That seems like a major shift. Jenn, have you seen these changes affect clients in the health care and digital health spaces?

jennifer-romigJennifer Romig: There have definitely been recent sales and use tax obligations imposed that our health care and digital health clients haven’t seen before, leading to some unexpected state sales tax audits. More and more, these audits deal with digital products or the delivery of services through software in some way. Cloud-based computing is increasingly utilized in the health care industry, but a big problem is that clients are almost being forced to guess if their sales are subject to sales tax or their purchases are subject to use tax in some states where the law is developing or unclear, like you mentioned before, especially as the line between traditional health care and technology services are blurred into the current digital health landscape.

Notably, the use of cloud-based software has become particularly relevant to the health care industry. Health care involves the exchange of massive amounts of information and data, from electronic medical records, or EMRs, to insurance provider information, with information coming from a variety of sources. Cloud-based applications permit health care businesses to share, store, and process information from multiple sources, in a consistent manner and in one central location.

Furthermore, SaaS applications are often less expensive than traditional hard-copy software systems because users avoid the costs associated with purchasing and maintaining these complex software systems. This is especially important in an industry as cost-conscious and consumer-facing as health care. Along these lines, users can easily scale their usage of cloud-based software based on size and volume, and can avoid the complication of integrating legacy systems. Given the trend towards consolidation and partnerships within the health care industry, these features make cloud computing applications particularly appealing in the health care space.

On the flip side, digital health and health care companies are increasingly utilizing cloud-based software to deliver services to patients. Many of our clients are thus both providers and consumers of cloud-based applications.

Not surprisingly, a 2014 study found that 83% of health care organizations used some form of cloud-based services, with 67% reporting use of SaaS-based applications. We can assume that number will rise as the availability and security of cloud-based software continues to improve. As the demand for cloud-based applications increases in the health care market, sellers will need to consider seriously how they may be impacted by the tax changes in the wake of Wayfair.

Isabelle Farrar: Elizabeth, what is it that makes the sales taxation of digital products particularly complex?

Elizabeth Smith: At bottom, it is difficult for sales tax codes to keep up with the rapid evolution of technology, and taxing authorities are often trying to fit sales of digital products and services into an ill-fitting existing framework. I think this area is particularly hard because states are taking dramatically different approaches to taxing sales of digital products, including cloud-based software like SaaS. Some states do not impose any tax at all. Take California for example—the state does not treat cloud-based software sales as a tangible transfer of personal property, so there is no tax imposed. On the other hand, some states like Iowa are explicit that sales of software as a service are subject to sales tax.

The inquiry is further complicated when the SaaS provider is using software to provide services. On the one hand, most states do not subject most services to sales tax, but they do tax software sales. SaaS providers often find themselves in disputes with state revenue officials over whether they are in fact selling non-taxable services or taxable software. Many states follow the approach taken in Massachusetts, where sales tax determinations are made by considering the “object of the transaction.” In applying this principle, a Massachusetts tax tribunal recently held that sales of SaaS products were subject to tax because remote access to prewritten software, and not obtaining the video and audio conferencing services delivered through the software, was the primary object of the transaction. This approach is aggressive and currently on appeal to the state’s highest court. Other states like New York are similarly following aggressive approaches.

Changes in law also introduce uncertainty. In a recent Alabama case, a taxpayer relied on a long-standing regulation stating that custom software programs were not taxable. However, the Alabama Supreme Court disagreed and held that all software was “tangible personal property,” making it subject to sales tax. Now, only the services provided by a software company—not the software itself—are exempt from tax in Alabama. In Connecticut, a recent bill increased the tax rate on software by more than five percent, but included a carve-out for business-to-business use of electronically accessed software. Vermont has swung back and forth, with SaaS originally becoming taxable before becoming statutorily exempt from sales tax. Now, the Vermont legislature is considering removing the exemption—even though a bill to do just that was defeated during the last year. Change like that can be a complicating factor for businesses.

Jennifer Romig: Another complicating factor is that not all health care companies view themselves as selling software, but software still plays an important role in their business model. For example, many modern providers utilize applications to inform treatment or provide care navigation services to patients. These providers aren’t software developers, but they’re providing patients access to a software service in an attempt to improve the ultimate delivery of care.

Elizabeth Smith: That’s a great point, and could impact the resulting tax liability. We’ve actually seen clients face audits in that exact situation. Let’s imagine that a company is located in North Carolina and provides some kind of hypothetical information management services for hospitals. A Massachusetts hospital system engages the North Carolina company’s services to modernize its records by scanning old patient files, creating digital images of prior patient files, and creating a portal for information to be input digitally by health care providers in the future.

If Massachusetts wanted to impose sales tax on this transaction, it would argue that the object of the transaction was providing access to a centralized digital records software, making it taxable. Let’s assume that the North Carolina company did not collect and remit the sales tax and comes under audit in Massachusetts. It would argue that the purpose of the transaction was to engage in non-taxable records management services. I think that the taxpayer could have a winning argument here.

Isabelle Farrar: Does the determination of whether a sale is of software or services operate like a sliding scale?

Elizabeth Smith: I think that’s a good way to put it, at least in states like Massachusetts. The more that the transaction is dependent on software, the more likely it is to be taxed. So, if the North Carolina company were to sign a contract with a separate Massachusetts hospital system for only the digital information portal I mentioned earlier, the state may have a stronger—albeit not irrefutable—argument that the transaction is subject to sales tax.

But again, not all states take the same approach. Iowa just started taxing SaaS transactions in 2019, and it follows a completely different approach. There, a new statute explicitly states that SaaS transactions will be subject to sales taxation, along with any subscriptions to databases or information services. However, Iowa simultaneously expanded its “business-to-business” exemption to include SaaS “furnished to a commercial enterprise for use exclusively by the commercial enterprise.” To qualify for that exemption, a business must provide an exemption certificate.

This goes to show that companies face greater tax complexity (and uncertainty) as they expand into new markets. As the uncertainty grows, so does the risk of an audit.

Isabelle Farrar: It seems like the analysis depends heavily on the facts of each situation.

Elizabeth Smith: That’s correct.

Isabelle Farrar: Jenn, given that understanding, it might be helpful to provide more detail about some of the differences between major digital health products. Could you offer some insight here?

Jennifer Romig: Within the health care space, we see a wide variety of services being offered by digital health companies. One distinction we see is which phase in the cycle of care the digital health product is designed to address. For example, many applications are designed to help individuals locate and seek initial care, by directing them to available third-party medical providers, while many providers are now offering the use of digital products to patients already under their care to help improve the ultimate delivery of care. We have started to see digital products where the actual delivery of care is through the digital application, for example, applications facilitating direct messaging with licensed providers, such as therapists, while other digital products simply provide a platform through which providers share and amass data, intended to inform and improve future care. As we can see, there are a variety of providers within the health care and digital health spaces, and thus a variety of transactions involving SaaS and other digital tools.

An added layer of complexity is the bifurcation of many health care clients into professional and non-professional entities; sometimes called the “friendly” or “captive” PC model. To Elizabeth’s earlier point about many types of services, including professional services, not being taxable, but SaaS potentially being taxable, determining which entities hold the software license is important. Specifically, if the non-clinical entity (often referred to as a “management services organization”) develops or holds the software license, then the digital application is more likely to be viewed as divorced from the professional services furnished by the clinical entity that is non-taxable. In pursuing the captive PC structure, which is ideal for many reasons, companies in the digital health space will need to think through the downstream tax issues earlier on due to these regulatory developments.

Isabelle Farrar: So, Elizabeth, how would these different models change the tax results?

Elizabeth Smith: Not to sound like a broken record, but it is complicated and varies from state-to-state. It might depend on the digital health company’s ultimate customer. Many states, including Iowa and Connecticut, have explicit exemptions for sales between businesses, so long as the SaaS is used for business purposes only. But this would not encompass sales of SaaS applications to patients, for instance. And the taxation of a digital health application that, for example, allows health care providers to communicate with patients would depend on a variety of facts, including who was selling the application, how the application was marketed to patients, and what the consumers were primarily purchasing—the services available through the software or the software itself.

Isabelle Farrar: It will be interesting to see where this all goes. Unfortunately, that’s all the time we have for today. Elizabeth, Jenn, I want to thank you for sharing these insights. Please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or of course, www.ropesgray.com for additional news and commentary about other important tax developments as they arise. If we can help you to navigate this complex and rapidly developing area of the law, please do not hesitate to contact us. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.

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