Law Journal: The devil is in the definition
The sales-and-use tax now covers services, but which ones?
by Fred Parker
Fred Parker is a partner with the law firm James, McElroy & Diehl PA in Charlotte. His practice includes representing individuals and businesses with tax controversies against the IRS, state departments of revenue and local tax assessors. A graduate of UNC Chapel Hill, he earned his law degree from Campbell University.
The General Assembly regularly strikes fear into service providers by threatening to make them sales-tax collectors. State expenses increase every year, and revenue never catches up, so the deficit widens and fair-minded individuals vehemently disagree over solutions. Instead of raising rates, it seems easier for the state legislature to expand the scope of what is taxed. Regardless of your perspective
on whether the changes reflect good policy, everyone must consider the enacted changes.
Last summer, the legislature negotiated, drafted and established a tax law — An Act to Simplify the North Carolina Tax Structure and to Reduce Individual and Business Tax Rates. Most folks learned of the Tax Act because of its amendments impacting their income taxes, corporate taxes or the unfortunate death of the much-loved tax-free shopping weekend. However, its reach has other less-publicized impacts. For example, the sales-and-use tax now applies to certain service contracts sold by retailers. Services were not previously subject to sales tax; now some of them will be. As is often the case, the difficulty is in the definitions.
The Tax Act amended the N.C. General Statutes to levy the general state (currently 4.75%) and applicable local and transit sales-and-use tax rates on the sales price of a service contract sold by a retailer. The service contracts affected are defined as “[a] warranty agreement, a maintenance agreement, a repair contract, or a similar agreement or contract by which the seller agrees to maintain or repair tangible personal property.”
By authority granted to it under the General Statutes, the N.C. Department of Revenue issued a precedential directive on Dec. 23, 2013, (later revised on Jan. 17). The directive includes a summary that explains the applicable terms (such as retailer, tangible personal property, engaged in business, etc.), exemptions, sourcing principles and offers examples of applying the tax. Most of the examples address standard situations that would trigger the Service Contract Tax, including sales of an extended automobile warranty and an all-terrain vehicle maintenance agreement. It also includes one that wouldn’t — an HVAC service contract, which is exempt because HVAC systems attach to real property.
However, a seemingly innocuous example, combined with the statutory terms, potentially extends sales tax to unsuspecting businesses. An individual purchases a $500 repair contract for a laptop from a computer-repair shop on Jan. 1, 2014. The shop agrees to provide all parts and labor for the period of the repair contract. The shop must collect and remit the state and local sales taxes on the price of the contract. This example appears straightforward. I imagine visiting a big-box retailer, purchasing a new computer and succumbing to the well-rehearsed sales pitch for the extended warranty that covers all parts and labor for a three-year period, subject to exclusions. As of Jan. 1, I would expect to pay sales-and-use tax on both the computer and extended warranty.
Now consider a situation not involving your typical electronics store. Instead, this particular company provides computer-, software- and network-related information-technology support to commercial customers. Typically this company enters into a multiyear contract during which it provides all levels of IT services to a customer in exchange for a one-time or periodic fee. The customer’s business typically does not involve technology-based services, so it does not have the necessary knowledge, time or interest to maintain its own computer system. So the company’s services include ensuring that the customer’s IT system operates properly, the internal and external networks and connected computers communicate, the operating and application software packages play nice and the actual hardware and software perform as designed. However, the company does not actually repair hardware or write code for the software. It helps the customer make use of the warranties and customer service provided by the computer manufacturer and the software licensor. The company may merely act as the customer’s representative in working with the hardware and software vendors, resolving problems and obtaining needed replacements.
If my client spends two hours under an IT-support contract figuring out settings that will allow his sales manager’s computer to talk to the printer, is that the same as repairing a washing machine under a service contract? How about if the tech-support company spends those two hours on hold with Dell or Microsoft trying to get a replacement product sent to the customer? How about if they need a replacement hard drive, which they will install?
This circumstance appears quite different from the one involving electronics retailers. But, if we cut away the business-to-business aspect and the potentially broader range of services involved, do you end up with an agreement like the washing-machine service contract that is subject to the Service Contract Tax? There is a retailer, and the retailer and its customer enter into a contract under which the retailer agrees to maintain and fix the customer’s computer network (albeit not the actual computer and software) for a period of time. The seemingly black and white applicability of the Service Contract Tax turns gray.
I encountered a similar predicament with a client who sought guidance on the Service Contract Tax. After digesting the limited resources available on the subject, I contacted the Department of Revenue requesting general advice. Given the immediacy of the issue, we initially did not pursue a private-letter ruling or letter of general applicability, both of which can be expensive. Over the course of about two weeks, I spoke with four representatives, each from increasing levels within the agency. They all were pleasant and took time to discuss the issue, making every effort to offer guidance about the extent and scope of the Service Contract Tax and its potential application in my hypothetical situation. The conclusion to each conversation was, effectively, IT support seems different from the typical purchase of a computer-repair contract from an electronics store. At some level the business really is maintaining tangible personal property under a contract. I would collect and pay the tax — better to be safe than sorry.
The Department of Revenue representatives were right — the safe bet is to collect the tax from customers, prepare and file the sales-and-use tax returns and turn over the collections. But that’s always the safe bet. I love North Carolina as much as anyone, but my love is not unconditional, and paying more tax than necessary is not my idea of loyalty. My clients tend to agree. Further, what if their competition is not collecting sales tax? That’s unfair.
Any statute, old or new, inevitably creates gray areas between the intended scope of the law and the interpretation of the actual language. The problem with tax laws is they can have an immediate impact, so we must plan accordingly. This is particularly so for sales-and-use tax laws that require urgent attention — effective Jan. 1 means we must deal with sales occurring from that day forward, compared with, for example, income- and estate-tax issues, which have more compliance time.
Thousands of businesses, including many of the world’s leading technology companies and universities, call North Carolina home. In this day and age, nearly every one of them needs technology to operate efficiently. However, most do not have internal IT staff. They require and engage third-party providers. Do those services fall within the service-contract tax? Based on existing resources and my research and experience thus far, the answer is not as clear as those IT-support providers would hope.
There is substantial financial risk for a business and its people in the sales-and-use tax arena. Liability — tax, interest and penalties — not only attaches to the business but also to certain “responsible persons” within the business such as the president, treasurer, financial officers and owners. Careful consideration and planning are required to understand, minimize and avoid that risk, if at all possible. It is well worth a few minutes spent with your professional advisers to determine if the Service Contract Tax applies or if it maybe applies.