Software and the Taxman
By Jeffrey A. Levenstam, Partner, Ernst & Young LLP—International Tax Services
used with permission from the Microsoft Small Business website
What do you consider when you’re buying new business software? How well the product addresses the needs of your organization? Naturally. The cost per seat? Sure. The ease of administration and maintenance? Of course. The tax implications of the purchase?
If you’re not thinking about taxes, you should be. The green-eyeshade gang in your finance department will thank you for it, and heaven knows we could all use a friend or two in finance. So, sharpen your pencil and grab your abacus, and let’s take a look at some of the tax implications of software licensing.
Two Strategies, Different Tax Treatments. The first thing to consider, tax-wise, is the different way in which subscriptions and purchases are treated. If you acquire your software through a subscription, such as Microsoft Enterprise Agreement subscription for Office or Windows, the subscription costs are considered an operating expense. If you pay the entire subscription fee upfront, the payment is capitalized as a prepaid asset and amortized over the subscription term for financial accounting purposes. For income tax purposes, if the subscription payment is by the month, the fees will be expensed as they are paid. How about software from the cloud—that is, software such as Microsoft Exchange hosted by Microsoft? This arrangement is considered a subscription and thus is treated as an operating expense and subject to the same income tax treatment as was stated above.
But what if you purchase your software licenses outright—say a Select License for a SQL solution? In this case, the expenditure is treated as a capital expense and is spread over the life of the license, which is generally 36 months from the time the software is placed into service. If you acquire your software as part of the hardware, it is generally treated as part of the cost of the hardware and treated accordingly, as a capital expense, unless the costs are broken out on the invoice, then the licenses are capitalized under the generally 36 month rule.
So, the decision here is really between leasing (subscription) and buying. The former will result in an operating expense for financial statements and budgeting purposes, and the latter will be handled as a capital expense. The former would be tax deductible as incurred and the latter would be capitalized and amortized over 36 months for US federal income tax purposes. Work with your finance department to determine which arrangement is best for your company, both in terms of the absolute cost of the software and the favorability of the income tax and financial accounting treatment as well as from a budgeting perspective.
Software Assurance—Fish or Fowl. Software Assurance (SA) includes product upgrades along with training and support. But it does entail special tax treatment. When you purchase a license with SA, you must separate out the SA cost from the cost of the underlying license. Why? Because SA is considered a maintenance cost, and therefore an operating expense rather than a capital expense. For income tax purposes the SA fee is either deducted when paid or if a contract will last longer than a year and is prepaid, the prepayment would be capitalized and amortized over the life of the contract. Moreover, when the time comes to renew, the entire renewal cost is considered an operating expense for financial accounting and budgeting purposes. This is because you already own the underlying software licenses, and are only renewing Software Assurance coverage. The income tax treatment would be the same as stated above for the intial SA fee payment.
The Taxman Cometh—to the Datacenter. You need to keep in mind that the location of a datacenter can trigger tax implications. If you place your datacenter in a different state, or in a foreign country, the facility and quite probably the transactions which run through the facility will be subject to the tax laws of that jurisdiction. These tax laws can vary widely, so you and your finance department will need to exercise due diligence in evaluating potential datacenter locations. The same goes for e-commerce sites placement.
As you evaluate the tax implications of datacenter and e-commerce locales, keep in mind that many states and countries will offer tax incentives to get your business. Be sure to ask about such inducements, as they can significantly reduce the tax burden.
What you do not know can hurt you. What if your company has domestic and foreign operations, or even users? Such multinational organizations generally seek global contracts. While this makes good sense in that it promotes procurement efficiencies, it brings its own set of challenges for both you and your vendors. For one thing, the vendors might have different versions of the software selling in different global markets. More importantly, the sellers are faced with withholding taxes on software royalties in many countries—taxes that will be passed onto you. In such cases, you may need to set up internal administration of withholding for software acquired through global contracts. The key is to remember that withholding tax is due for cross-border payments depending on the country of use and country of the recipient.
Internal administration tax? Internal administration of information technology as well as global software contracts can be tricky, and can cause a multinational company to run afoul of their tax reporting requirements and possibly even to miss some withholding tax obligations. How so? There are two major challenges in this area. Typically, a parent company will manage its technology infrastructure and its software licenses worldwide, for at least some applications and will then allow subsidiaries in various countries to use their services or applications without charging for those services or applications. To avoid such problems, central IT costs should be charged to the various legal entities based on applicable income tax transfer pricing principles. Typically, this means adding in a mark-up to the cost of the IT services. While a specific study needs to be done to reflect the specific facts of your situation, in general the mark-up would be in the range of 5% to 10% of these costs. In addition, your finance department should track who benefits from the IT services so that the charge-outs can be properly executed and documented for the tax authorities.
Similarly, if the parent company signs a global software license, it should charge the applicable portion of the royalties to the group companies that use the application. Often, this is based on seats of use. It is important when these group companies are in different countries that the appropriate withholding taxes be collected with the charges made to comply with local rules for software royalty withholding taxes. You should consult with your tax team to determine the appropriate administration for such withholding taxes on global contracts.
The Magnificent Seven. Here is a handy list of the seven factors to watch as you work with finance to develop your tax strategy in regards to software licenses and IT expenses:
1.Weigh the relative merits of subscriptions versus perpetual licenses
2.Remember that Software Assurance and licensing costs are allocated differently
3.Keep in mind that software as a service is taxed as a software subscription
4.Be aware that US state taxes are applied at the delivery or invoice address
5.Consider the tax impact of datacenters and e-commerce sites
6.Don’t neglect cross-border withholding taxes if you have multinational operations
7.Impose a 5 to 10 percent markup on centrally provided global IT services
Above all, work with your finance department to come up with the tax strategies that best serve your company. By keeping in mind the tax implications of your software decisions, you can escape George Harrison’s lament in Taxman: “Let me tell you how it will be/There’s one for you, nineteen for me…’Cause I’m the taxman.”
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This article expresses the views of the author and not necessarily those of Ernst & Young LLP.
Any U.S. tax advice contained herein was not intended or written to be used and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. This information is for educational purposes only and is not intended, and should not be relied upon, as accounting advice.
Jeffrey A. Levenstam is an international tax services partner based in San Francisco/San Jose. He joined Ernst & Young’s’s International Tax Services Group in 2005 and assists clients with all aspects of international tax, including transfer pricing, capital structuring and foreign operational issues. He has extensive experience with the software industry and the emerging online business models that are becoming increasingly popular for cloud computing and other online applications.
