Subscription-based billing models increase sales tax compliance complexity

Editor's note:Mike Beach is theChargebeeChief Financial Officer, and Liz Armbruester is theAvalaraSenior Vice President of Global Compliance. The views expressed in this article are solely those of the authors.

Subscription-based business models have existed for decades, dating back to early monthly book deliveries and automobile clubs. However, in today's digital-first economy, many businesses that traditionally did not sell on a subscription basis—including apparel retailers and food suppliers—have also begun to adopt this model.

But in adopting the model, they also take on the higher sales tax risks that come with it. Because subscriptions are recurring, this risk also recurs and accumulates.

To avoid sales tax risks, businesses need to focus on a range of complex factors, chief among them the so-called "nexus"—the location where sales tax obligations arise. Many factors can trigger sales tax collection obligations, such as goods stored in a warehouse, customer locations, and more.

Another compliance consideration is the variation in how states, counties, and cities interpret ambiguous rules. There are more than 13,000 sales and use tax jurisdictions in the United States, and different jurisdictions may apply rules in vastly different ways.

Take, for example, the sales tax rules for software and software-as-a-service (SaaS), where differences are extremely significant. In the United States, software and SaaS products and services are taxed in 450 ways across 45 categories. This wide variation stems from jurisdictions trying to keep pace with technological changes. Every time a jurisdiction determines how to tax a type of product or service, new types or variations emerge, leading to more questions. For international businesses serving cross-border customers, complexity further intensifies.

Delivery mode—physical or digital—can also affect the taxability of software products, as some states tax physical software sales but exempt digital sales. In areas where digital sales are taxed, determining the applicable rate can be very difficult, as the rate may be based on the location of the customer, the vendor, or even the server.

The next important consideration is the correct sales tax rate to apply. In some jurisdictions, sales tax rates vary by street, so knowing the exact rate at the customer's location is crucial. For example, a customer purchasing in downtown Seattle is subject to a different rate than one purchasing elsewhere in Washington State.

Some states also impose additional tax rules based on how a product is prepared, so understanding these nuances can affect tax calculations. Different preparation methods often lead to different tax rates. If a customer subscribes to a bagel delivery service and wants the bagels sliced rather than whole, the tax amount is likely to differ. Similarly, how a product is manufactured and its ingredients can also affect the tax rate.

Predictable revenue, greater risk

All this complexity grows exponentially under a subscription billing model. With a high volume of subscription items shipped each month, subscription businesses face the challenge of ensuring tax rates remain current based on address verification and other factors. Some businesses are too small to have a dedicated tax team. Even with a tax team, keeping up with highly complex and ever-changing regulations is resource-intensive. Ultimately, the responsibility falls on the CFO or the person in charge of revenue, who must manage tax liabilities and guard against penalty risks.

Although recurring billing models are attractive, one often-overlooked aspect is the significant sales tax compliance risk faced by businesses adopting them. In most cases, recurring billing means a recurring source of sales tax issues. Tax may seem simple, but the effort required to track ever-changing rules, rates, boundaries, and other factors is a resource drain that most businesses can hardly afford.

Focus on the business

In a world where subscription billing is increasingly common, compliance management is best handled through integrated, automated solutions to reduce risk and minimize time spent on sales tax changes. In many cases, recurring billing systems and automated tax solutions are cloud-based and pre-integrated, requiring minimal effort. This allows businesses to focus on what matters: growing annual recurring revenue, improving customer relationships, and enhancing customer lifetime value.