Virginia's 'tech tax' ignites debate on business taxes

Many states in recent years have extended their sales tax to include digital services consumers use in an effort to bring their tax codes into the 21st century. But Virginia ventured into unexplored territory earlier this year when budget negotiations also applied the tax to business-to-business transactions.

The plan was to modernize the definition of taxable goods to include not just physical products but also digital or online services, a practice adopted by many other states. Currently, for example, a Virginia resident pays a sales tax on the purchase of a DVD, but not a download of the movie. Businesses pay sales tax on IT equipment like servers and laptops, but not on cloud services. 

Gov. Glenn Youngkin’s two-year budget initially proposed a sales tax on digital services—like Netflix subscriptions, cloud storage, ebooks and music downloads—a practice. Taxable digital services would also have included software application services, website hosting and design, data storage and streaming services. Critically, businesses would be exempt from the proposed digital sales tax.

The budget passed the House of Delegates, but the Senate edited out two words: “Taxable [digital] service does not  includes any service transaction where the purchaser or consumer of the service is a business, or any other service otherwise exempt under this chapter.” 

Democratic Sen. Louise Lucas, chair of the Senate Finance & Appropriations Committee, explained the change while unveiling her chamber’s budget proposal. “I find it only fair that the same taxes apply to individuals and businesses when consuming the same services,” she said.

According to The Commonwealth Institute, including both consumer services and business software services in the tax would add over $1 billion to the general fund.

But applying the tax to business-to-business, or B2B, transactions, is a move that would be potentially “dangerous and harmful” to the state’s tech sector, argued Andrey Yushkov, a senior policy analyst at the center-right Tax Foundation. 

The change lit a fire under the business community, concerned that the tax would affect Virginia tech companies’ competitiveness. The state has one of the strongest tech economies in the country, generating $21 billion in gross domestic product and accounting for almost 20% of Virginia’s workforce, according to the Information Technology Industry Council, a trade association. 

The Virginia Chamber of Commerce said that applying the sales tax to business-to-business software transactions would cost Virginia businesses over $360 million each year. It would raise business costs across industries and “discourage economic development and business investment in Virginia by making the Commonwealth’s tax system less competitive.”

The tax would also endanger the growing tech industry, the Northern Virginia Technology Council told the General Assembly. In a February letter, the group stated that businesses “would be harmed by this extraordinary shift in Virginia’s tax structure.” They urged legislators to reject the “tech tax” outright or at the very least remove the part about business-to-business transactions. 

If that business-to-business provision were not removed, a company buying software application services from a Virginia-based business would have to pay the sales tax, Yushkov explained. But if it bought those services from a North Carolina-based company, where such services are tax-exempt, it wouldn’t face the additional fee.

While Virginia lawmakers continue to debate the issue, taxes on digital services are becoming widespread. 

The B2B provision notwithstanding, nearly 40 states have sales taxes on digital goods, demonstrating sound tax policy that reflects modern consumption practices, Yushkov said. Back in 1930, when Mississippi became the first state to levy a sales tax to increase revenue during the Great Depression, people consumed more goods than services. 

Today, however, the reverse is true. Now “many states want to transition from the system where they only tax goods to the system where they tax goods and services,” Yushkov said. “But there are smart ways to do that, and there are not-super-smart ways to do that.”

Staff at any state revenue department should be looking at taxing digital products in general, said Jonathan White, counsel at the Multistate Tax Commission, whose members include state agencies that oversee tax administration. 

Although the commission has no response or position on Virginia’s proposed budget, it doesn’t find the criticism of its B2B provision surprising, White said. 

“When I saw that there was so much pushback on the B2B taxation that might be involved in Virginia … I wasn’t surprised because we got the same kind of feedback, too,” in researching a white paper on the topic, he said. “My gut reaction is that it’s definitely an important issue for all the states that have sales tax.”

The commission’s project page lists almost 30 states’ digital tax information, but Virginia’s inclusion of business-to-business transactions is new. 

“We expect that more and more states will try to make this transition happen,” Yushkov said of taxing digital goods and services. “We encourage them to be really careful. It’s a good idea to expand the sales tax base to final consumption, but not to business input.”

Virginia’s budget is not yet passed. The governor and lawmakers in both chambers will meet in a special session on May 13 to consider the revamped budget and prevent a shutdown ahead of July 1.