Addressing Taxes on IT Outsourced Services Requires Teamwork

Roadblocks can get in the way of pursuing savings in locations where the authorities tax information technology services, though it should not get in the way moving forward with the potential opportunity.

In the past, services such as hardware and software maintenance have been taxed by most states, though data processing services have largely been exempt. Jurisdictions such as Texas, Ohio and a few others have taken an aggressive stance extending sales and use tax on outsourced data processing services as one method to increase revenue.

In other countries, Value Added Taxes (VAT), Goods and Services Tax (GST), Provincial Sales Tax (PST), etc. also impact savings from IT outsourcing arrangements. Countries that do not have export taxes for offshore outsourced services may consider it in the future.

These taxes can be legally minimized through thorough preparation and proper documentation. As you approach an outsourcing analysis, it is important to consider potential data processing services taxes and how they affect your contract negotiations with suppliers; preparation for addressing the auditing aspects; and having the right team involved in the process. Listed below are some areas for consideration when outsourcing IT services.


Engage the Company Tax and Accounting Department
VAT can be upward of 25 percent in some countries and assessed on the price of services provided. In some cases, countries have reduced rates for services. VAT Recovery significantly reduces the potential negative savings impact of VAT when outsourcing IT services.

VAT Recovery focuses upon reducing the impact of taxing on top of taxing that increases the final price of the product and/or service. Companies providing costs into the final product are able to offset its VAT by receiving relief, thus lowering their cost included into the final price of consumption.

Even the final consumer of the service may receive a form of VAT relief. A global company’s tax and accounting departments will understand the concept, assess the impact and handle the filing for recovery aspects.

Within the U.S. borders, each state has its own tax laws. Many do not impose sales tax on data processing services though, some do. Making sure the correct amount is paid, not more than required, is the goal. Although services may be delivered in a state that assesses taxes on IT services, or by a provider performing services onsite, the entire invoice may not be subject to tax.

Part may not be taxable at all, and often, the portion that is taxable is determined by where the benefit is actually received, much akin to the filing of taxes based upon income derived from a specific state and apportionment rules using an approved formula for central office cost allocations to derive taxable income. Analyze where the benefit of the service is received and understand the tax laws and their intent.

Understand the Provider

Some states may interpret providers differently and how their services may be subject to sales tax. For instance, if the provider sells the software, performs maintenance and development work on the same, all services from that provider may be viewed as a total software package in which everything invoiced may be subject to sales tax.

Using another independent outsource provider performing maintenance and development services may be viewed as a professional services contract, therefore incurring no additional taxes, except for those incurred for the cost of software and base recurring maintenance charges from the software provider.

What are the services being delivered and where?

Data processing is a service performed with a computer using the customer’s data. Entering, storing, manipulating, or retrieving a customer’s data is taxable. But merely using the computer as a tool to help perform a professional service is not taxable1.

Leverage tax and legal advisors to determine if the service being delivered is actually defined as data processing under the code and what is considered the attributed taxable portion of the IT service. For example, desktop maintenance and performance of an IMAC (Installation, Move, Add or Change), may generate a taxable event.

To the contrary, providing defined project work may be a professional service and not taxable. Additionally, solicit advice concerning taxability, whether data processing is impacted by who owns the hardware and software associated with the mainframe, servers, and network equipment or if it can be considered as staff management augmentation to manage existing operations to achieve savings through labor arbitrage.

In the case of the provision of leveraging offshore resources, there are countries that have taxes on services delivered outside of its borders. Within some of these countries, regional zones may be set up to encourage economic growth. In some cases, the taxes are not assessed on services delivered out of this economic zone, even though it is for services outside the country’s border. Find out where the services are being delivered from within the offshore country.

Contract Language and Potential Liability

Language in the final negotiated agreement may trigger or lead the taxing authorities to believe an IT service may be taxable, even though it may not be. Exercise care in service descriptions including clearly defining what the expectations are of the deliverables and outputs.

Once again, engage the tax department with the legal team. Make sure the tax department clearly understands the agreement because they will be representing the company for justification at audit time.

With the tax department and legal team working together, they will craft the language to make sure that the agreement states the services being delivered to withstand the audit process.

Additionally, experienced IT providers have tax departments that cannot offer tax opinions to their customers, though they understand the intricacies of the laws and language and are willing to cooperate to share their experiences with customers without disclosing client confidentiality.

Provide language in the agreement to protect both sides against changes in export tax laws for services delivered offshore. Both sides should comprehend their respective liability if this should occur.


The invoice document is the first view by the taxing authorities of what is taxable. Working with the provider, make sure that the IT services invoice clearly breaks out the taxable portion of the invoice and is consistent with the outsourcing services delivered under the agreement. There are situations where the customer can work the taxing authority for pre-approval of the allocation of services that are to be taxed for its jurisdiction.

Although the provider has the fiduciary responsibility for collecting and remitting taxes to the respective government agencies, it still remains a customer liability. In some cases, it may be beneficial for the customer to set up a “direct pay” of the taxes to the taxing authority since it is in the best position to determine the proper taxes to be paid and where they should be remitted.


For IT services tax, determination of potential tax impact, understanding the provider and services to be delivered, legal agreement development, and complying afterward is a Team Effort to make sure that only the actual taxes due are paid. Members of the team include:

  • Business team
  • Tax department and advisors
  • Accounting department
  • Legal team and advisors
  • Provider
  • Vendor Management Office
  • And an outside sourcing advisor who understands the taxing nuances of outsourcing arrangements

Planning is the first step to prevention of unexpected occurrences.


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