Is cloud-delivered software exempt from Virginia use tax, are out-of-state-shipped purchases exempt, and can a third-generation audit's compliance and amnesty penalties be waived?

Plain-English summary

A government contractor was assessed use tax on software and other property it bought without paying tax. It contested the software (delivered electronically), other property (shipped or used out of state), the P-Card sampling method, and two penalties. The Tax Commissioner worked through each and reached a mixed result.

• Cloud/electronically delivered software is exempt -- with proof. Va. Code Sec. 58.1-609.5 1 exempts software delivered electronically. Both vendors here provided cloud-based software as a service, hosted online and accessed over the Internet, which counts as electronic delivery. The Department's documentation rule (P.D. 05-44) wants an invoice or contract certifying electronic delivery, but P.D. 15-153 accepts other evidence -- here vendor emails and purchase orders explaining the cloud process were enough. Those transactions were removed. (The taxpayer had cited the wrong statute -- Va. Code Sec. 58.1-648 C, the communications tax -- but the right rule reached the same place.)
• Out-of-state use is exempt; Virginia delivery is not. Va. Code Sec. 58.1-609.10 4 and 23 VAC 10-210-780 exempt property delivered outside Virginia for out-of-state use. Purchases shipped to and used in California under a federal contract were removed; items where Virginia tax was already charged were removed; but items shipped to the taxpayer in Virginia without tax stayed in the audit.
• P-Card sampling -- sent back for review. The taxpayer challenged how the error rate for corporate-card (P-Card) purchases was computed. The Department agreed to have the auditor review the taxpayer's alternative method and recalculate if it is more representative.
• Penalties stand. This was a third-generation audit; the taxpayer's use tax compliance ratio was 0%, below the 85% needed to avoid the mandatory compliance penalty (23 VAC 10-210-2032). The 20% amnesty penalty (Va. Code Sec. 58.1-1840.2; P.D. 17-156) applied because the audit period fell in the amnesty-eligible window and the ratio was too low. Both may be recalculated after the P-Card review.

What this means for you

Cloud SaaS is electronically delivered software -- keep the proof

Software hosted in the cloud and accessed online is exempt as electronically delivered. If your invoice doesn't say so, a vendor email or letter explaining the cloud delivery, plus the purchase order, can substantiate the exemption.

Out-of-state purchases need destination documentation

To keep a purchase out of a Virginia audit as out-of-state use, prove where title/possession passed and where it was used. Property that ships to you in Virginia is taxable even if later used elsewhere; property shipped to and used out of state is exempt.

Repeat-audit penalties are hard to shake

On a second- or third-generation audit, penalties are mandatory unless your compliance ratios clear the thresholds. A 0% use-tax ratio guarantees the compliance penalty, and an amnesty-eligible period with a low ratio brings the 20% amnesty penalty on top.

Common questions

My software was in the cloud -- why was it ever taxed? Without proof of electronic/cloud delivery, the Department assumes software came on a tangible medium and is taxable. Your vendor emails and purchase orders supplied the missing proof, so it was removed.

I shipped some items out of state -- are they all exempt? Only those delivered outside Virginia for out-of-state use. Items shipped to you in Virginia are taxable even if you later move them.

Can I get the penalties waived because the prior audit was smaller? No. On a third-generation audit the penalty is mandatory unless your compliance ratios meet the thresholds; a 0% use-tax ratio does not, and the amnesty penalty is set by statute.

Citations and references

• Va. Code Sec. 58.1-609.5 1 -- electronically delivered software (including cloud SaaS) is exempt; documentation per P.D. 05-44, 15-153.
• Va. Code Sec. 58.1-609.10 4 / 23 VAC 10-210-780 -- delivery outside Virginia for out-of-state use is exempt; interstate-commerce test.
• 23 VAC 10-210-2032 -- mandatory audit penalty; compliance-ratio thresholds for later-generation audits.
• Va. Code Sec. 58.1-1840.2 / P.D. 17-156 -- 20% amnesty penalty for amnesty-eligible periods left unpaid.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-65

Original ruling text

April 28, 2020

Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *:

This is in response to your letter submitted on behalf of * (the “Taxpayer”), in which you seek correction of the retail sales and use tax assessments issued for the periods March 2012 through March 2015. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer is a government contractor that provides technical services and facilitates materials requests for government and commercial clients. The auditor assessed use tax on untaxed purchases of software on which the Taxpayer did not accrue and remit the tax to the Department. The use tax was also assessed on untaxed purchases of other items of tangible personal property on which the Taxpayer did not accrue and remit use tax to the Department. Further, the auditor found that the documentation provided by the Taxpayer did not support the Taxpayer’s contention that the purchases at issue were properly made exempt of the tax.

The Taxpayer maintains that the assessment of tax on the purchases of software is incorrect because the software was delivered electronically. The Taxpayer contests the assessment of tax on the purchases of other items of tangible personal property, stating that the property was either shipped or used outside of Virginia. The Taxpayer also contests the sample methodology and requests that another methodology be used to calculate the error rate. Lastly, the Taxpayer requests waiver of the compliance and amnesty penalties assessed in the audit. Each of these issues is addressed below.

DETERMINATION

Electronically Delivered Software

Citing Virginia Code 58.1-648 C, the Taxpayer asserts that it was erroneously assessed use tax on purchases of software from two vendors – * (“Vendor A”) and *** (“Vendor B”). The Taxpayer provides documentation with its appeal in support of its contention that the software was delivered electronically and requests that the transactions be removed from the audit.

Virginia Code § 58.1-609.5 1 provides, in pertinent part, that the retail sales and use tax shall not apply to “services not involving an exchange of tangible personal property which provide access to or use of the Internet and any other related electronic communication service, including software, data, content and other information services delivered electronically via the Internet.”

Virginia Code § 58.1-609. 5 1 governs the application of the retail sales and use tax on sales of software and provides that sales of electronically delivered software are not subject to the tax (1). Public Document (P.D.) 05-44 (4/4/05) sets out the Department’s minimum documentation requirements for confirming the exemption for electronic delivery of software products. P.D. 05-44 provides that “a sales invoice, contract or other sales agreement must expressly certify the electronic delivery of software and that no tangible medium for that software has been or is to be furnished to the customer.” Without sufficient proof of electronic delivery, the Department must assume that software and software updates are conveyed in tangible form and constitute taxable retail sales. In P.D. 15-153 (7/16/15), the Tax Commissioner allowed the exemption in a case where the transactional evidence was insufficient. Instead, the taxpayer provided vendor information and email evidence that was deemed acceptable in conjunction with the sales invoices submitted by the taxpayer.

Vendor A

The Taxpayer provides an email from Vendor A explaining its process for delivering the software at issue to the Taxpayer. The email further states that Vendor A provides cloud-based software as a service. It is my understanding that through this method of accessing software, the software is hosted in the cloud and accessed via the Internet. The Taxpayer also provides the purchase order related to the purchase of the software. In accordance with the aforementioned authorities and based on my understanding of Vendor A’s process for delivering the software at issue, the documentation provided by the Taxpayer is sufficient to support its position that the software was delivered to the Taxpayer electronically. Accordingly, the transaction at issue will be removed from the audit.

Vendor B

The Taxpayer provides a letter from Vendor B explaining its process for delivering the software at issue to the Taxpayer. Vendor B used the cloud-based software as a service delivery method for providing the Taxpayer access to the software at issue. Accordingly, the transaction at issue will be removed from the audit.

Other Contested Transactions

The Taxpayer states that purchases of land mobile radio support from * (“Vendor C”) are for use outside of Virginia. The transactions at issue were held taxable in the audit because the Taxpayer did not provide documentation showing the destination of the purchased items.

Virginia Code § 58.1-602 defines a sale as “any transfer of title or possession, or both, exchange, barter, lease or rental, conditional or otherwise, in any manner or by any means whatsoever, of tangible personal property and any rendition of a taxable service for a consideration….” Virginia Code § 58.1-603 imposes the sales tax on the gross sales price of tangible personal property when sold at retail or distributed in this Commonwealth. Virginia Code § 58.1-609.10 4 provides an exemption from the retail sales and use tax for:

Delivery of tangible personal property outside the Commonwealth for use or consumption outside of the Commonwealth. Delivery of goods destined for foreign export to a factor or export agent shall be deemed to be delivery of goods for use or consumption outside of the Commonwealth.

Title 23 of the Virginia Administrative Code (VAC) 10-210-780 interprets the above statute and provides that:

The tax does not apply to sales of tangible personal property in interstate or foreign commerce. A sale in interstate or foreign commerce occurs only when title or possession to the property being sold passes to the purchaser outside of Virginia and no use of the property is made within Virginia.

With its appeal, the Taxpayer provides the purchase order, contract and statement of work regarding the transactions at issue. The Taxpayer entered into a contract with an agency of the federal government that is located in California. The documents provided show that the purchases at issue were shipped to and used in California pursuant to the contract. Accordingly, these transactions will be removed from the audit.

The Taxpayer also provided invoices for other transactions held taxable in the audit. The Taxpayer states that either sales tax was applied in these instances, or that the property purchased was not shipped to or used in Virginia.

The invoices provided are for the purchase of tangible personal property, shipped to the Taxpayer in Virginia. The invoices do not include Virginia sales tax. Accordingly, these transactions will remain in the audit.

The invoices detail the purchase of property by the Taxpayer. The invoices show that the property was shipped to California. Accordingly, these transactions will be removed from the audit.

The invoice and Other Expense Summary provided by the Taxpayer are for the purchase of property and software. Virginia sales tax was applied to the transaction. Accordingly, this transaction will be removed from the audit.

P-Card Purchases Sample

The Taxpayer disagrees with the methodology used to determine the sample for P-Card purchases. The P-Cards are corporate credit cards used to make purchases by the Taxpayer. The Taxpayer maintains that the sample is incorrect because an unrelated Trial Balance for all expenses was used to calculate the error rate to determine the P-Card purchases liability. The Taxpayer contends that the error rate should have been calculated using the block sample taxable amount over the total population of the block sample and applied to the agreed upon P-Card population. Accordingly, the Taxpayer requests that the P-Card liability be recalculated using the methodology presented by the Taxpayer in its appeal.

The purpose of the audit sample is to determine a factor for errors within a representative select period. Once the error factor is determined, the factor is extrapolated over the entire audit period. The purpose of the projection is to account for likely similar transactions on which Virginia tax has not been paid. Every effort is made to select objectively the sample periods that are representative of the period being audited.

Based upon the information provided in the Taxpayer’s appeal, the Department’s auditor will review the methodology presented for determining the P-Card purchases sample and calculating the error rate. If this methodology is determined to be accurate and more representative of the P-Card expense transactions, the error rate will be recalculated and the assessment will be adjusted accordingly.

Compliance Penalty

The Taxpayer requests a waiver of the compliance penalty. The Taxpayer contends that it has acted in good faith, filing monthly returns on time and without negligence or intent to defraud, based on the information available from its prior Department audit. Further, the Taxpayer states it had no reason to believe that the current audit would result in a significantly higher assessment than that of the prior Department audit. The Taxpayer argues that if it had been assessed at a comparable rate to the last audit assessment, the compliance ratio would be more in line with the ratio needed to avoid being penalized.

Title 23 VAC 10-210-2032 B 1 provides that “The application of penalty to audit deficiencies is mandatory and its application is generally based on the percentage of compliance determined by computing the dealer’s compliance ratio.” Title 23 VAC 10-210-2032 B 5 provides that for all audits beyond second generation audits, “Penalty will be applied unless the taxpayer’s compliance ratios meet or exceed 85% for sales tax and 85% for use tax….”

The audit at issue is a third generation audit. The Department previously audited the Taxpayer’s records for the periods March 2004 through April 2006 and January 2007 through September 2012. The compliance penalty was assessed in the current audit because the Taxpayer’s use tax compliance ratio is 0%, which does not meet the required use tax compliance ratio for a third generation audit. Accordingly, the compliance penalty cannot be waived. However, after the P-Card purchases sample methodology has been reviewed and verified, the compliance penalty will be recalculated if warranted. If the compliance ratio for a third generation audit is met, the compliance penalty will not be applied to the assessment.

Amnesty Penalty

The Taxpayer also requests that the amnesty penalty assessed in the audit be waived. The Taxpayer states that the audit started before the announcement of the Department’s amnesty program. The Taxpayer further states that within the 18 month period from the commencement of the audit to the beginning of the amnesty period, the Department offered no indication that an assessment would be issued or what the amount of the assessment would be. The Taxpayer states that based upon the prior audit and inaction by the Department, it had no reason to believe that it would need to participate in the amnesty program.

Virginia Code § 58.1-1840.2 F 1 provides that:

If any taxpayer eligible for amnesty under this section and under the rules and guidelines established by the Tax Commissioner retains any outstanding balance after the close of the Program because of the nonpayment, underpayment, nonreporting, or underreporting of any tax liability eligible for relief under the Program, then such balance shall be subject to a 20 percent penalty on the unpaid tax. This penalty is in addition to all other penalties that may apply to the taxpayer.

The 2017 General Assembly enacted legislation establishing a Tax Amnesty program, spanning a 60-75 day period that was administered by the Department. The Guidelines for the Virginia Tax Amnesty Program are addressed in P.D. 17-156 (9/5/17). Taxpayers with delinquent returns for amnesty-eligible periods qualified for amnesty benefits. Any tax liability that was eligible for amnesty benefits but remained unpaid is subject to a 20% amnesty penalty in addition to all other penalties. The amnesty-eligible periods for ongoing field audits is the month of April 2017 and prior. The 20% amnesty penalty also applies to second or subsequent Virginia tax audits that include amnesty-eligible periods and the compliance ratio for sales tax is less than 85% and the use tax compliance is less than 60%.

In accordance with the statute and the Amnesty Program Guidelines, the amnesty penalty was properly assessed in the audit. The audit period for the audit at issue falls within the amnesty-eligible period. Further, the Taxpayer’s use tax compliance ratio did not meet the required percentage to avoid the penalty assessment. Accordingly, the amnesty penalty cannot be waived.

CONCLUSION

Based upon this determination, the audit will be returned to the appropriate field audit staff to make the adjustments and to review the sample methodology presented by the Taxpayer as stated above. The audit staff will contact the Taxpayer regarding any documentation or information needed to review the P-Card sample. Once the review and adjustments are complete, revised bills, with interest accrued to date, will be mailed to the Taxpayer. No further interest will accrue provided the outstanding assessments are paid within 30 days from the date of the bill. The Taxpayer should remit payment to: Virginia Department of Taxation, 600 E. Main Street, 15th Floor, Richmond, Virginia 23219, Attn: *. If you have any questions concerning payment of the assessments, you may contact at **.

The Code of Virginia sections, regulation and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department’s web site. If you have any questions about this response, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

(1) The Taxpayer cited Virginia Code § 58.1-648 C in its appeal. This statute governs the communications sales and use tax and is not applicable in this instance.

AR/1745P

Related Documents

05-44

15-153

17-156