As the range of digital goods and services expands every day, the tax issues associated with them have only grown, and one of the most complicated issues that retailers, providers, and tax authorities are facing currently involves digital bundling.
Since the beginnings of sales taxation, retailers have been tasked with collecting the total tax from customers and remitting it to the proper tax authorities, according to Scott Peterson, vice president of U.S. tax policy and government relations for Avalara — a fairly straightforward proposition.
"Over time, retailers began putting different products together to sell as a bundled item," Peterson said. "For example, at Christmas, grocers put together gift baskets with fruit, cheese, a knife, cutting board, etc. When that was done in a state that exempts groceries (and most states do so) fruit and cheese are exempt, but other items are subject to sales tax. States and retailers have struggled to come to consensus on what should be charged for bundled items."
"Predominant use" is the phrase typically used in taxation. The state wants to determine the motivation driving purchases to arrive at a relatively uniform direction to determine taxation.
And then came digital products, and with those products, a greater number of things to be bundled together that are treated quite differently from state to state. This started with the telephone industry, and the companies looked to states and Congress to find a rational way to tax, given that some items on the phone bill were exempt from sales tax. And states were all over the board in terms of how they taxed or exempted what was on the telephone bill.
For example, phone companies used to have warranties to cover phone lines in a user's house in addition to outside the house. After years of this, telephone companies convinced states to support congressional legislation to allow them to use books and records to prove they remitted the right amount of tax to states, regardless of what was listed on a telephone bill. The telephone companies provide a bill to consumers that shows the portion subject to sales tax — but it's confusing to consumers, since the companies don't have to itemize the tax on their bill.
The current landscape
Today, states have rules in place specific to digital goods and services, according to Peterson.
"The Multistate Tax Commission has been studying digital goods to figure out if a definition actually represents what's being sold," he said. "The MTC has written a research paper on the digital goods industry, and now they are trying to figure out digital goods bundling — whether it's a bundle of all digital goods, or digital goods bundled with hardware. "
"It's very complicated because businesses are so creative, constantly trying to find ways of selling goods produced," Peterson explained. "The marketing department often doesn't care what the tax department thinks when a product is in development. This is easy if you're selling shoes, but in selling digital goods, it becomes very complex."
"Marketing is driving complexity on the tax side, as there are so many things that can be sold together," he noted. "Many states exempt real-time digital classes, such as webinars for CPE, for example. But if you record that class and make it available on demand, it's no longer live. States then treat it as taxable — it's no longer education, it's something else, and states are working to determine how to characterize that 'something else.'"
The MTC's primary concern is that this situation will only get worse as everything goes digital.
"The SST [StreamlinedSalesTax] attempted to put together a bundled transaction rule 20 years ago, but it's now out of date," said Peterson, who was previously executive director of the SST Governing Board. "MTC is in the discovery phase now of looking at digital goods bundling and taxation. States should be thinking about the complexity that goes with how to charge tax on a portion of a sales price for a bundle with taxable and exempt items. How does a seller prove to an auditor that they charged tax on the one taxable item in a bundle? The safest practice in selling a bundled package is to itemize each item and only charge sales tax on taxable items."
"Businesses need to be able to break the bundle apart," said Peterson. "The fruit and cheese board was an easy exercise in tax and invoicing, but bundled digital goods is a brave new world for businesses and tax authorities. CPAs would recommend having an invoice that is crystal-clear — 'I'm selling you A,B,C and D. A and D are exempt, so no tax was charged.' Every day, some retailer creates a new product/service bundle, and it has the potential to reset the taxation conversation. There are no simple answer in this area."
And things are only getting more complicated: Peterson further referenced a private letter ruling in which the South Carolina Department of Revenue stated that a company's sales and rentals of digital textbooks purchased for and used in institutions of higher learning as part of a prescribed course of study are exempt, regardless of the format. (Private Letter Ruling #24-3, South Carolina Department of Revenue, March 18, 2024.)
This is only the latest in a series of state developments, including a California case, Bekkerman, that ruled last month on how the state should
