Changes to Taxation of Software to Apply Prospectively and Challenges to Eliminating Alabama's Controversial Grocery Tax
SALT Alert: Alabama Edition
As previously reported, in Ex parte Russell County Community Hospital, the Alabama Supreme Court announced that all software, including customized software created for a particular user, is "tangible personal property" and therefore subject to Alabama sales and use tax. The Court added, however, that there are certain nontaxable services that can accompany the conveyance of software, such as designing and programming the new software for a particular user, modifying or configuring existing software programs to meet a particular user's needs, installing the software, and training users to operate the new software – as long as they are separately stated and invoiced. The “pertinent distinction” is how the transaction is documented and invoiced, which is left in the hands of the seller and purchaser.
In light of that landmark ruling, the Alabama Department of Revenue (the “Department”) issued a notice of proposed rulemaking to amend Administrative Rule 810-6-1-.37, which governs the sales and use taxation of computer hardware and software. The Department determined that the Court’s decision and reasoning was “consistent with existing law regarding the taxability of computer software.” That statement left taxpayers and tax advisors with some concerns over the ramifications of the Department’s determination, including whether the proposed amendments would be applied prospectively only or retroactively. Initial indications by Department officials confirmed our concerns.
Thankfully, due in part to a comment letter filed on behalf of the Alabama Society of CPAs (ASCPA) by our law firm and other comments, including from key legislators, the final rule includes a provision specifically applying the changes prospectively only, from its effective date of January 13, 2020. Alabama taxpayers and tax advisors alike should be relieved that they or their clients will not be assessed back state or local taxes on the sale or use of customized computer software prior to the effective date of the final rule. ASCPA President Jeannine Birmingham thanked Department officials saying, “We commend Commissioner Vernon Barnett, Sales & Use Tax Division Director Randy Winkler, and their staffs for understanding the concerns of Alabama taxpayers and advisers who have been treating customized software as exempt from sales tax for decades.” The rule does not address whether the Department intends to extend the Alabama Supreme Court’s ruling to digital goods and SaaS. That may require a legislative resolution soon.
Will Alabama Finally Join the Majority of States on the “Grocery Tax”?
Alabama remains one of only three states that levy the full sales tax on groceries, without some type of break, whether an exemption, rate reduction, or income tax credit. The state tax alone is 4% but can be as high as 11% in some parts of the state when combined with local taxes. Some members of the Alabama Legislature, including Sen. Clyde Chambliss (R-Prattville) and Rep. Steve Clouse (R-Ozark), have indicated recently that lawmakers will again take a hard look at eliminating or at least reducing the tax this session, which convenes February 4. But the initial consideration presents more problems than solutions.
Here’s the primary issue with eliminating the tax: It currently generates approximately $400 million in revenue annually, which flows to the state’s Education Trust Fund budget. The state would likely need to appropriate a large portion of the somewhat unpredictable windfall resulting from increased sales/seller’s use tax revenue following the U.S. Supreme Court’s landmark “economic nexus” ruling last year in South Dakota v. Wayfair or make up for the lost revenue elsewhere. Either approach will likely garner opposition from both K-12 and higher education advocates, the Alabama Education Association teachers’ union, concerned parents, etc.
Some of the possible sources to fill the lost funding for the Education Trust Fund may be to increase ad valorem property tax rates or state income taxes, or perhaps add a sales/use tax on services, digital goods, and the like. Since changes to the rate of the statewide property tax or the income tax or changes to the base of the property tax would require a statewide referendum, one can expect significant voter opposition. Other changes would require at least a statutory amendment by the Legislature and approval (generally) by the Governor.
Some skeptics express concern that if the tax is reduced or eliminated at the state level, some localities may take advantage of that reduction and, instead of following suit, vote to increase their sales/use tax a percent or two to generate some additional revenue for their communities, including their local school systems. Members of both our SALT team and Governmental Affairs team will be monitoring these developments closely.
If readers have any questions regarding these topics, they should contact the authors at email@example.com or firstname.lastname@example.org or another member of our SALT team.