Sales tax on digital products remains a confusing issue for businesses because of the differences in rules and application that you may experience from state to state. Online retailers and businesses that sell digital goods to customers in Pennsylvania may appreciate the simplistic approach that broadly applies sales tax to the purchase of these items. However, other issues could further complicate your Pennsylvania sales and use tax collections and pose risks for a future audit. We explain these challenges in more detail below and explain how our sales tax professionals may be of service during an audit or when appealing an assessment.

Pennsylvania Sales and Use Tax Applies Broadly to Digital Products

Since 2016, the state of Pennsylvania has broadly applied its sales and use tax to the purchase of digital products delivered to a customer electronically. The state passed Act 84 of 2016 to remove the doubt over the taxability of digital products as tangible personal property simply because they were not delivered over a tangible item, such as a CD, flash drive, or another storage device. Generally, taxable digital products includes a wide range of items, such as the following:

Video and audio files
E-books
Applications and online games
Photos

As examples, an electronic transfer of these taxable digital products could refer to downloading or accessing the item over the internet in addition to receiving it via email.

Is Computer Software a Taxable Digital Product in Pennsylvania?

Canned computer software is also taxable under 61 Pa. Code § 60.19. This taxability equally applies to any charges for updates, enhancements, or upgrades to the software. However, Pennsylvania exempts sales of custom software, which is any software designed, created, and developed for the specifications of an original purchaser. Modifications to canned software could also qualify as an exempt sale of custom software if they are made for the specific needs of a particular customer.

What Pennsylvania Sales Tax Rate Applies to Electronically Transferred Digital Products?

Pennsylvania has a statewide sales tax rate of six percent that applies to transactions that take place in the state. Several local sales tax rates could also apply for products delivered to customers in certain areas. For example, Philadelphia has an additional two-percent local rate and Allegheny County has a one percent local rate that businesses must collect for sales in these locations on top of the six percent rate. The challenge for businesses, especially out-of-state online retailers, that electronically deliver digital products and computer software is identifying the proper location for the sale, which is usually the customer’s billing address.

Possible Pennsylvania Sales Tax Exemptions That Could Apply to Digital Product Transactions

Many of the same exemptions that are available to other goods and services sold in Pennsylvania may also apply to digital products and computer software. A Pennsylvania sales and use tax exemption for a digital product may depend on the nature of the item, who is buying it, and what its future use is. For example, consider the following exemptions that could apply to your business or its customers:

Sales to qualifying charities, volunteer firefighter companies, religious organizations, and nonprofit educational institutions
Newspaper and magazine subscriptions
Sales for resale
Digital products and software bought for direct use in manufacturing, processing, and research activities.

Why Digital Product and SaaS Businesses Are at Greater Risk for a Pennsylvania Sales Tax Audit

Compared to other states, Pennsylvania’s taxability of digital products and computer software is interpreted extremely broad. During a Pennsylvania sales tax audit, the state will often consider anything downloaded electronically to be a digital product, whether it truly is or not. Most sales of these items will be subject to Pennsylvania sales and use tax unless a specific exemption applies. Still, businesses can quickly find themselves under risk of audit because of other sales tax issues that often apply to businesses engaged in the digital economy.

A major concern is the proper allocation of sales tax in a mixed or bundled transaction involving SaaS or digital products. These are sales of items not clearly distinguishable from one another but that may contain both taxable and nontaxable elements. Mixed transactions are not uncommon in software sales because they often involve other business services or products, especially in business to business relationships. It can be easy for businesses to under or over-collect sales tax in these arrangements because of the complexity of the specific transaction that often requires a case-by-case analysis to determine tax obligations.

Another key audit issue for software and digital sales are transactions that involve multiple locations. For example, a business that purchases software for use in offices located in several states. Businesses must understand who will be accessing the software and where to determine the appropriate method for collecting sales tax or paying use tax. Having a reasonable allocation method that conforms to the state’s standards, and documentation to support it, is critical for avoiding further assessment upon audit–an issue explored in more detail in a recent case before the Pennsylvania Board of Finance and Revenue.

Meet with a Sales Tax Professional for Audit Defense and Appeal Help Today

The sale of software and digital products are an increasingly difficult industry for sales and use tax compliance. Multi-state online retailers and software companies facing an audit or assessment from the Pennsylvania Department of Revenue may benefit from the guidance of an experienced sales tax professional to better understand their exposure and actions that could reduce their overall sales tax liability. We provide audit defense and assessment appeal services to protect against unfair tax agency decisions and to manage the sales tax compliance process on your behalf, giving you the time and resources to look after the more important parts of your business.