As the Virginia General Assembly’s session nears its conclusion, lawmakers continue to revise the two-year state budget that may create significant alterations to the state’s current taxing scheme, particularly in the areas of sales and use tax.
Background
Virginia institutes two forms of sales and use tax: the Retail Sales and Use Tax that is historically limited to sales of tangible personal property and a handful of enumerated services at a rate of 5.3%; and the Communications Sales and Use Tax that is levied on customers of communications services at a rate of 5% and typically includes prepaid calling services.
Digital Products
Currently, Va. Code Ann. § 58.1-648(C) statutorily excludes “digital products delivered electronically, including software, downloaded music, and reading materials” from the imposition of sales tax. Accordingly, as long as the transaction does not involve the provision of any disc, tape or other tangible medium, the state will not deem the transaction taxable – a stance that has been continuously reaffirmed in various rulings by the state’s tax commissioner.
The proposed budget removes this exclusion, thereby including all such products in the sales tax base for Retail Sales and Use Tax. Even more notably, the bill also includes a new, expansive definition in Va. Code Ann. § 58.1-602 for “digital personal property” that includes digital products, digital audio and audio visual products, reading materials and other data or applications that the purchaser owns or has the ability to continually access (downloading, streaming, or otherwise) without having to pay an additional subscription or usage after payment of the initial purchase price.
Current law also provides a narrow exemption for custom software, which is defined as a computer program specifically designed and developed only for one customer. Combining two or more prewritten programs does not constitute a custom program, regardless of the degree of modifications made. Va. Code Ann. §§ 58.1-609.5(6) & (7). Though Virginia has not provided guidance on this topic in recent years, it has previously deemed that in those circumstances where a software provider only markets its software product to one client and destroys all copies of the software upon termination of the provider-customer relationship, the adequate classification is a custom software.See Va. P.D. 04-176 (Oct. 6, 2004). The bill would repeal the service exemption for this customization, striking the related sections and imposing the Communications Sales and Use Tax to such modifications.
Including a Definition for ‘Taxable Service’
The bill also creates a new term in the tax code, “Taxable Service” under Va. Code Ann. § 58.1-602. This term means any of the following: software application services; computer-related services; website hosting and design; data storage; and streaming services.
This seemingly is meant to ensure that anything that may avert the definition of “digital personal property” from a taxpayer’s claims that its true nature is a service is also included in the expanded tax base for Communications Sales and Use Tax as digital subscription services.
B2B Exclusion
The definition does markedly state that such services will not include transactions where the purchaser or consumer is a business (“Business to business or B2B”). This could prove to be instrumental due to the state’s large government contractor industry that typically delves into such services. It should be noted that removal of this provision in conference may result in complications for B2B transactions.
What’s Next
Although the approved amendments generally reflect Gov. Glenn Youngkin’s initial budget proposal, the Senate and House of Delegates did remove provisions decreasing income tax rates and increasing the state sales tax rate, based on concerns of unsustainability. Lawmakers also included a proposal for a higher level of general-fund spending that would allow for greater pay increases for teachers and other public employees.
The budget has been referred to the Committee on Finance and Appropriations, where it awaits a discussed compromise before returning to Youngkin for his signature. The budget would take effect Jan. 1, 2025.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.
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