When an optional warranty is mandatory – Wacky Tax Wednesday

Warranties are often considered a service, and since many states don’t tax services, many states don’t tax warranties. However, the taxability of a warranty often depends on the conditions of the sale: whether it is optional or mandatory, for example, or sold separately or as part of the product it covers.

You’d think it would be easy to determine if a warranty is optional or mandatory. Not so. The Illinois Department of Revenue recently encountered a business that makes the purchase of an optional extended warranty a mandatory condition of an optional product upgrade. The taxpayer, quite understandably, didn’t know whether those contracts should be taxable or exempt.

Mandatory vs. optional computer software maintenance contracts

In Illinois, the taxability of a maintenance agreement depends in part upon whether charges for the agreement are included in the selling price of the tangible personal property it covers. The taxability of the maintenance agreement, in turn, affects whether the service provider owes use tax on maintenance services or parts performed under the agreement’s terms:

• If charges for maintenance agreements are included in the selling price, those charges are taxable and the service provider does not owe use tax on maintenance services or parts provided per the agreement

• If purchase of a maintenance agreement is not optional and not sold separately, the charges are part of the gross receipts and taxable, “regardless of whether the charges are separately stated,” and the service provider does not owe use tax on maintenance services or parts provided per the agreement

• If a maintenance agreement is optional and sold separately, it is not taxable, and the service provider owes use tax on maintenance services or parts provided under the maintenance agreements

This is relatively straightforward, if a mouthful. But it doesn’t explain all possible scenarios. For this reason, a seller of smartphones and other products asked the Illinois Department of Revenue the following: Is the sale of its optional extended warranty contract subject to the Illinois Retailer’s Occupation tax or Service Occupation tax (i.e., sales tax) when it is a mandatory condition of participation in the company’s optional Product Upgrade Program*?

The Product Upgrade Program is for consumers who must have the latest and greatest smartphone available. Under the terms of the Product Upgrade Program, consumers must:

• Pay “all applicable taxes and fees which relate to the Upgrade Option on the new eligible product, … in their entirety, with the first installment payment of the new installment loan”
• Purchase an extended warranty contract
• Trade in the old smartphone

For eligible consumers, there’s no cost to enroll in the Product Upgrade Program, and enrollment is not listed on the invoice. However, invoices do include the cost of the required extended warranty contract.

So, is that optional but mandatory extended warranty taxable or exempt? The Illinois Department of Revenue determined that sales of the required extended warranty are not taxable at the time they are sold, even if the sale is not optional, because it’s a condition of participating in the Product Upgrade Program. The department explains: “This conditional requirement does not change the fact that the purchase price of the product itself does not include the extended warranty contract or that the extended warranty contract must be purchased separately from the product.”

The taxability of maintenance contracts is complicated

The taxability of maintenance contracts can be complicated in all sales tax states, in part because they can be so different from one another. To help facilitate tax compliance, the Streamlined Sales and Use Tax Agreement (SSUTA) created a definition for it and allows states to further define it in enumerated ways. SSUTA was created with a mission to “simplify and modernize sales and use tax administration in order to reduce the burden of tax compliance.” It currently has 23 full member states and one associate member state.

The Agreement breaks “computer service maintenance contract” into two distinct categories: mandatory and optional. States then determine which of the many enumerated optional and mandatory maintenance contracts are taxable and exempt. In some cases, SSUTA asks states to define what percentage of the maintenance contract is taxable or exempt (100 percent? 50 percent? 25 percent?) To see an SSUTA taxability matrix in action, click here.

Illinois is not a member of SSUTA and it isn’t required to comply with the taxability matrix. Yet it can’t avoid confronting the complexity of sales and use tax or the questions that complexity inevitably sparks. No one that deals with sales tax can.

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*The letter ruling issued in response to this question applies only to the company and situation in question. However, it illustrates how the department interprets tax laws.