Home Health Products Podcast: State Taxation Of Digital Health Products – Tax – United States – Mondaq News Alerts

Podcast: State Taxation Of Digital Health Products – Tax – United States – Mondaq News Alerts

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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.

Transcript:

Isabelle 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 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 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.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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