Today, there are more than 15,000 SaaS companies worldwide, and a vast majority of them haven’t yet managed to file their taxes accurately. Neglecting the importance of tax filing and knowledge of tax jurisdiction often costs companies too much.
With an abundance of SaaS startups, many countries have started imposing sales tax on SaaS services. As a business owner, compliance with sales tax is paramount to the business’s success. Sales and income tax is a grave concern for many companies and can hurt their profitability.
People no longer install software from CDs or floppy disks with technological breakthroughs. In stark contrast, all the software is accessed via the cloud today.
We live in an era where SaaS has become an industry norm and has garnered widespread industry traction. Today, more businesses rely on SaaS-based products to remain competitive in the market than ever before.
The widespread adoption of SaaS and its ability to generate recurring revenue for businesses has led many governments to enact tax laws for SaaS.
This blog post will walk you through the different tax laws, practices, and regulations a SaaS Company should know. Apart from that, we’ll also discuss how you can legally reduce the tax burden of your SaaS Company without violating any law?
General Tax Rules for SaaS Companies
As an owner of a SaaS Company, you first need to specify your standing with the nexus. SaaS Companies should know in which nexus do they fall? Because having a correct knowledge of that, helps them fill accurate taxes.
Nexus specifies whether a company is liable to pay taxes to the tax jurisdictions for their services. Based on the state, this definition might fluctuate as every state processes taxes in an utterly different manner.
“Physical Nexus” indicates that a company has a physical presence in a state where they operate. In some countries, “Economic Nexus” represents companies whose net revenue exceeds a certain dollar threshold or have a particular volume of transactions in a country where they operate.
Furthermore, both ‘income tax nexus’ and ‘sales tax nexus’ are crucial for SaaS companies.
How Does Tax Impact SaaS Companies?
The United States has varying tax rates for different software categories, i.e. downloadable, tangible, customisable, configurable, and accessible via the cloud. SaaS Companies do not run their physical server but rely on the cloud to provide instant and uninterrupted access to their user.
This peculiar feature of SaaS sets them apart from the traditional software categories.
It is worth mentioning that you are operating your SaaS Company in a state where there are no sales or income tax laws. You do not need to worry about them at all. However, no such country exists today.
Here are some significant factors that need to be taken into account for accurately filing taxes for SaaS:
· What is the location of my SaaS company, and what are their laws regarding sales or income tax?
· Do the sales revenue I generate from my customers falls under the category of ‘economic nexus?’
· Do my SaaS business activities in other states give rise to ‘physical nexus?’
· Whether my SaaS income taxable or not?
· How often I am supposed to file my tax returns?
· Is my SaaS income only taxable if generated from the business or an individual customer?
· What evidences should I have to provide while I am being audited?
· What could be penalties if I fail to comply with tax laws?
General Taxability of the SaaS Business
As we have discussed earlier, the taxability of the SaaS business varies significantly among the states. Moreover, SaaS needs to introduce many interpretations for this offering, making an existing tax system a little bit complex for entrepreneurs.
For instance, tax laws exist for “prewritten software” and tangible goods. If that is the case, all kinds of software come under the tax net. Similarly, these states treat SaaS in the same manner.
Thus, if the customer downloads the software on their computer or accesses it via the cloud, tax laws remain the same.
State laws usually do not promote the adoption of the latest technologies. For these reasons, many states consider the sale of software delivered automatically and tangible goods identical and impose uniform rates on them.
However, these states do not tax SaaS because no physical infrastructure exists.
Another interpretation that many states have derived so far is that SaaS service falls under the rental of tangible personal property. This interpretation is that customers of SaaS service do not own the software but have only purchased the subscription plan for a certain timeframe. In that case, SaaS remains subject to income and sales tax.
What is the Difference between B2B and B2B SaaS Business?
There are many differences between B2B and B2C businesses and how they are taxed because they have utterly different customer bases.
B2B SaaS Companies limit themselves to registered businesses, whereas B2C SaaS companies sell their services to individuals.
Both types of SaaS Companies should pay attention to the tax jurisdictions in their respective states, so they can file and remit taxes accurately.
Key Considerations When Selling SaaS Services Globally
With the lack of harmonization of the sales tax regime worldwide and even across the same country, a SaaS company must consider too many things while selling services globally. Failure in complying with international tax regulations leads to hefty losses.
With an abundance of tax jurisdictions worldwide, states and even the same cities, here are some critical considerations for scaling SaaS business and selling globally.
Taxable goods
What falls under the category of taxable goods in a specific location and what not?
B2B Vs B2C
B2C transactions are taxable in most cases, depending on your destined territory. B2B transactions aren’t always taxed, but an increasing number of jurisdictions are imposing a tax on them. Besides, many jurisdictions do not differ between B2B and B2B transactions.
Threshold and Tax Rate
You have the minimum quantity of sales you and the minimum amount you have to pay as tax.
Audits
What evidence must you have about the taxable and non-taxable sales?
Filling and Remitting Taxes
How often you are legally obliged to file taxes and the method of tax filing and currency you will pay your tax liability.
Penalties for Not Following the Tax Obligations
If a SaaS Company does not comply with the state tax laws, they are likely to face additional charges, and in some states, failure to comply is considered a criminal offence.
Tax Trends across the World
As the subscription-based SaaS business thrives, tax authorities consistently introduce new tax regulations. The most prominent of them all is:
1. VAT System in the Middle East
The Middle East first enacted it in 2018. It is applicable in all Gulf Cooperation Council Countries. Over the last couple of years, countries like Japan and Korea have passed laws to force overseas sellers to bring them into the sales tax net.
2. Wayfair Ruling
This regulation laid the foundation of the “economic nexus” that indicates that sales in a state are only taxable when they exceed a certain threshold.
Tax Territories across the World
To manage taxes efficiently, you need to comply with the country’s tax regulations from where you are operating. Here is a glimpse of tax regulations across different territories.
United States
Due to the absence of a blanket tax system, the US has around 11,000 tax jurisdictions across its province, states, and cities. With varying tax rates and different tax treatments for different types of software and digital goods, dealing with the tax could be confusing for SaaS entrepreneurs.
The most prominent example of this tax regime is in New York, wherein electronically downloadable software and SaaS are taxable, but digital books and other digital products are exempted.
Therein the real irony lies. How does the software product or service are perceived in the US? Even though different tax treatment is applied, tax jurisdictions are decided based on the following factors:
· Is the software delivered via a physical medium, for instance, a CD or USB?
· Is the software downloadable?
· Is the software product cloud-oriented?
Managing taxes is complex and cumbersome, from determining where you should register your business to reduce taxes to filing taxes legally. For this reason, we strongly recommend you seek the help of a tax expert.
United Kingdom
With the introduction of Brexit, the United Kingdom no longer relies on the VAT MOSS to tax their citizens selling services in EU member states. This implies that if you are running a
UK-based SaaS Company but selling your services in the EU, you must register for VAT MOSS in an EU member state.
UK VAT is still applicable to your sales in the United Kingdom, although it might be slightly different in both cases.
The Rest of the World
Unfortunately, it isn’t as easy as it sounds ‘the rest of the world’ at all. We have only covered a few major tax territories, but we know that you must explore many other tax territories on your own.
What Tax Deductions Can I Enjoy for my SaaS Company?
No business in this world wants to pay a small chunk of their profit in taxes. However, if you do not comply with the tax laws, you will likely experience lawsuits.
Similarly, no SaaS Company in this world likes to pay their due taxes. However, a tax credit could help you reduce tax liabilities. That is known as an R&D tax credit.
The R&D tax credit is equally beneficial for all SaaS businesses, irrespective of their size. It could reduce your tax expenditures. Eventually, your disposable income goes up, and you have more money in your bank account to reinvest in the business.
In this section of this article, we will discuss what business and expenses quality for this credit and how a can business avail it?
R&D Tax Credit
The R&D tax credit was first coined by the Internal Revenue Service (IRS) in 1981. It was primarily created to stimulate economic growth and force local businesses to generate more technical jobs.
However, it turned out to be temporary credit and has expired fifteen times since 1981. If you own a SaaS business, you’ll be ecstatic to know it becomes a permanent federal tax incentive under the law protecting American citizens from tax hikes (PATH).
By harnessing the benefits of this tax credit, SaaS entrepreneur could significantly reduce their federal and state tax liabilities.
Thus, it is equally beneficial to all businesses regardless of their size. Moreover, you can claim paid taxes and claim all the development expenditures that might have been incurred and unclaimed tax credits. In this way, you can generate some extra cash for your business.
What Businesses Can Claim R&D Tax Credit?
All businesses can claim R&D tax credits regardless of their size. Mainly, if you are running a SaaS Company, fortunately, all the odds are in your favor, and you can easily pass the IRS four-part test and become eligible for the R&D tax credit.
The IRS briefly describes what falls under the category of qualified research initiatives. However, software development is one activity that always remains the topmost criteria for an R&D tax credit. Software companies that invest heavily in the design and development of new software can easily claim the R&D credits.
Four-Part Test for Screening the Company
To evaluate whether a company qualified for the R&D tax credit or not, all the SaaS Companies are screened for the four-part test.
When this credit gained widespread traction, many tax firms have decided to specialize in helping the SaaS companies claim this credit.
The four-part test is discussed below. What’s more appealing about this test is that most SaaS companies quality this test.
1. Intended Purpose
The aim of this activity should be to improve the functionality or performance of a product. For instance, if you make any noticeable upgrade in your SaaS product that could better facilitate your targeted customer, you can claim this credit.
Likewise, if you keep investing time and resources to launch the new and latest version of your existing SaaS product, you can claim the credit.
2. Removal of Uncertainty
The activity should remove uncertainty around your product design and boost its abilities. Since no magic button exists that could fulfill all the customer requirements in one step. The development team are unaware of an optimal code or coding methodology at the beginning of the project. This uncertainty is referred to as technological uncertainty.
3. Product in the Experimentation Stage
The activity includes the process of experimentation that might consist of testing, evaluation of alternatives, or systematic trials and errors. Did you remember the last time you sat down on your computer and wrote a code from start to finish with no compilation error?
Software development is experimental. Moreover, developers always attempt to identify alternative solutions. Eventually, you’ll end up with the desired product.
4. Technological
The activities should solely rely on the hard sciences like Computer Science.
What Expenses Qualify for the Credit?
So far, we have discussed the four-part test to qualify for the tax credit. We will nail down the expenses that could be eligible for the tax credit from now on.
1. Wages
Taxable wages that a company is liable to pay to employees directly involved in the qualified activities and for those employees performing research.
2. Supplies
All supplies are used in creating the prototype of the product or for manual testing.
3. Contract Research
Payment made to the third-party supplier or vendors who perform research on behalf of the
SaaS Company.
4. Renal Cost of Computers or Services
The rental cost of electronic equipment like computers and cloud hosting services like AWS or Microsoft Azure are exempted from tax.
What Taxed Can SaaS Company Avoid Using the R&D Tax Credit?
It’s time to talk about the money. What monetary benefits does this tax credit bring? Leveraging the benefits of R&D tax credits, companies can avoid:
· Federal and provincial tax liabilities.
· Alternative Minimum Tax that is specific to the qualified small businesses
· Payroll tax for Qualified Small Businesses
By enacting the PATH act in 2015, governments worldwide had allowed qualified small businesses to reap the benefits of the R&D tax credit.
Eligible Small Businesses are those:
· Who have at least $5 million in gross receipt in a period under consideration
· Have gross receipts for more than five years.
This is one of the most significant developments in the SaaS industry. Since cash is the backbone of every SaaS company, you no longer need to be in a lucrative position to reap the benefits of the R&D tax credit.
How to Claim the R&D Tax Credit?
While claiming this return, I strongly recommend you seek the help of an accounting firm that specializes in claiming this credit for SaaS companies.
While claiming this credit, the tax experts are likely to provide you with ample documentation so that you won’t experience any difficulty.
External References
https://www.pmba.com/news-and-insights/when-is-saas-subject-to-sales-tax/
https://www.armaninollp.com/articles/top-3-tax-issues-facing-saas-companies/
https://www.statetaxadvisors.com/blog/taxes-for-saas-companies-what-you-need-to-know-2
