Digital Products and Services Taxation Under the Microscope

States and taxpayers are working together on some consequential research that assesses the degree to which digital products create unique, bundling-related sales tax challenges compared to couplings of tangible goods and services.

This work is being led by the Multistate Tax Commission (MTC), which plans to publish a thorough, carefully vetted white paper on the issue in the next few quarters. If you’re not familiar with the MTC, it’s an intergovernmental state tax agency that works on behalf of states and taxpayers to facilitate the equitable and efficient administration of state tax laws that apply to multistate and multinational companies.

That white paper, which is currently in draft form, describes various taxation approaches to traditional product and service bundles; considers how these treatments apply to digital offerings; assess the pros and cons of these approaches; and presents findings and recommendations.

The findings and recommendations, located at the end of the document, are not entirely fleshed out in the current draft (they will be in the next version). That said, here’s one finding that I found interesting: “Bundling issues can make coding compliance systems much harder. From discussions with stakeholders, the technology is not the problem; it’s the complexity of products and states approaches with the multitudes of bundling approaches that exist.”

These approaches vary by state, and the paper highlights how different states address bundling. Examples include Streamline Sales Tax members states like Nevada as well as Colorado, Arizona, and Idaho.

Streamlined states follow a comprehensive set of rules for bundling (which is defined as “two or more distinct and identifiable products sold for one nonitemized price”) with some notable exclusions (true object exclusion, de minimis exclusion, variable sales price exclusion and food, drug and medical equipment exclusion). Non-Streamlined states typically have fewer, less comprehensive bundling rules, including broader sales price definitions (that cover bundling) in their tax codes, administrative guidance and case law related to true object tests. These approaches vary significantly, the draft asserts.

Another challenge the draft emphasizes concerns nomenclature: “Terms like distinct and identifiable, mixed transactions, separability, and others often have different meanings across jurisdictions, or two different terms have the same meaning.”

I appreciate that the MTC releases drafts of in-progress white papers. Doing so gives the indirect tax community a detailed look at how tax policy and tax compliance difficulties are assessed, researched and collaboratively addressed. As this draft notes, “At one MTC work group meeting a participant stated it this way: ‘if you can’t unbundle it, it isn’t a bundle.’” Consider lemonade: once it’s made, it cannot be “unbundled” into lemons and sugar.

One of the goals of this MTC research effort is to help make tax policy lemonade out of lemons (misalignment between the digitalization of commerce and traditional tax compliance rules). I’ll keep you posted on the brewing process as it advances.