Taxation of Software

State tax laws are generally old and the state taxation is governed by the laws which were enacted at that time. Those laws are unchanged till date. Therefore, many states don't have the tax or revenue codes for the manufacturing and the sale of tangible property. Moving toward a developing economy, the information based service economy has merged under the service sector. The old methods of taxation have become rusty and, in some cases, unworkable when applied to developing economy. This is particularly true when this old law is applied to industries that were not even anticipated at the time of the statutes enactment.
Over the past fifteen years, the software industry has exploded into a high growth and extremely productive business. Traditionally, sales/use tax has applied only to the sale of tangible personal property . Thus, the sale of services is a transaction exempt from sales/use taxation . Similarly, sales of non-tangible goods are also exempt from taxation. In the software realm, programs written for a client's specific needs are not taxed since what is sold is treated as a service . Programs which are otherwise goods but are sold intangibly (e.g., over a modem) also are not taxed because they do not conform to the tangibility requirement

This essay will review three issues of current interest to software companies in focusing on how these issues can and should be analyzed:
1. Taxation of sales of computer software for sales and use tax purposes.
2. Taxation of software for ad valorem tax purposes.

Background on Software
Although computer software has no specific definition but it is generally referred to as the predetermined set of instructions or programs that the computer carries out . Software, which is of course inherently intangible, is physically manifested by electronic pulses arranged on a magnetic disk or magnetic tape or, in some cases, on a computer chip. Generally speaking, there are three distinct varieties of software: (1) operating systems, (2) application programs, and (3) files.
i. Operating Systems:- Operating systems, as the name implies, are programs that actually instruct the computer on how to operate. These systems are written under various codes such as MS DOS.

ii. Application Programs:- Application programs are the instructions which are actually manipulated by the computer and tell it how to perform various tasks. These include the word processing software with which all attorneys are familiar as well as the Lotus and Excel spreadsheet type software.
iii. Files:- Finally, there are files which are maintained. Files are not instructions but are simply compilations of data. For instance, for a lawyer these would include stored documents which have been prepared. Software can be "canned", i.e. pre-written or standardized, "custom", i.e. specifically coded for a specific user for a specific purpose, or a modified form of pre-existing software. It can be stored and delivered in many forms (i.e. on disk, by telephone line, via modems, within the memory of a computer, through computer punch cards). Perhaps it is because of the multiplicity of forms which can embody software that much of the difficulty arises in the tax area. Software can assume at various times aspects of a service transaction, tangible personal property or intangible property. Because tax statutes often tax each of these differently, this often results in confusion under the tax regimes.

Taxation of Software For Sales Tax Purposes

There is some uncertainty in taxation of software for sales tax purpose because of lack of rules and regulations for treating software as tangible property. By this, the question arises that whether the software is to be treated as a tangible property for application of the rules regarding sales tax.

(A) "Tangible personal property" means personal property which may be seen, weighed, measured, felt, or touched or is in any other manner perceptible to the senses. "Tangible personal property" does not mean stocks, bonds, notes, insurance, or other obligations or securities.

Historically, the statutory difference between "tangible" and "intangible" has been relatively easy to apply in the sales tax arena. Advances in technology, however, have done much to blur this line between tangible and intangible property.

Computer software ranks as perhaps the leading technology which defies easy classification. One problem is that the industry itself does not clearly define the term software. Moreover, information contained in "software" can be transmitted through several media:

• On a computer through disc
• Digital transmission over telephone lines
• Through direct input by an individual
• Through a magnetic tape transfer
• In some old fashioned cases, punched cards

The law in this area became confused early in its development. Initially, taxpayers sought to characterize software as tangible personal property to claim an investment tax credit for expenditures on software for federal income tax purposes.

In the early years, taxpayers contesting sales tax liability utilized precedent to argue successfully that software was not subject to sales tax because the intangible information, not the tangible media, was actually what was being sold.

As the technology developed and software was more frequently sold to the general public in shrink-wrapped packages, the courts began to view software as tangible personal property in a manner more analogous to:

• Books
• Records
• Photographs
• Video cassettes

One court has held that the arrangement of instructions on a tangible medium constitutes a "corporeal body", and hence, tangible property. Another case found that computer software is ordinary common tangible property, at least where delivered on disks.

(B) Sales Tax Planning for the Software Industry:
What can the well advised software company do with this information?

Determine Whether the Purchaser is Exempt:

• Taxpayer should make an initial determination as to whether a purchaser of software is exempt from sales tax.
• Sales to certain non-profit organizations, governmental institutions, and schools are exempt from tax.

Differentiate between various softwares:

• Computer consultants writing software for a specific customer provide personal services (not subject to tax).
• If the consultant retains the copyright, licensing to another customer may be taxable.

Electronic transmission of Software:

• Possible to transmit software electronically without tangible media.
• The Department of Revenue may not address whether electronic transmission is exempt.

Differentiation of charges between Software and Consulting Services:

• Uniform prewritten software is transferred to the customer.
• Substantial consulting services in custom applications may be exempt from sales tax.
• Important to document and allocate costs between software and services.
• Consulting services should be exempt as personal service transactions.
• Department of Revenue may reallocate costs if allocation seems unreasonable.

Taxation of Computer Software For Ad Valorem Tax Purposes

A. The Taxability Issue:

• Some states tax only tangible personal property; others tax both tangible and intangible.
• Classification affects whether software is taxable and at what rate.

B. Taxation of Off-The-Shelf Software:

• Argument: software exists independently from physical media → not tangible personal property.
• Alternatively: value should be based only on the media.
• However, software resembles inventory like books or CDs, so it may be taxed similarly.
• Such inventory may qualify for a Freeport exemption.

C. Taxation of Software as an Intangible:

Three schemes for ad valorem taxation:

1. Taxation of all property, both tangible and intangible
2. Taxation of all tangible personal property
3. Taxation of selected classes of tangible personal property

Some courts argue that physical form (e.g., diskette) does not make software tangible for tax purposes.

D. Taxation of Capitalized Software Costs:

• Inventories of off-the-shelf software may be taxable.
• Capitalized development costs historically not assessed as tangible personal property.
• Most states consider unbundled software not tangible and not taxable.
• Issue remains in states where intangible property is taxed.

E. Legislative Responses:

• States may exempt software by defining it as non-taxable intangible property.
• Some define it as taxable, but only based on physical embodiment’s valuation.

F. Issues:

• Main issue: Is software tangible or intangible personal property?
• If taxable, where is software considered "situs used" for tax purposes?

For instance, under the applicable state statute:

• Where is software located?
• Where is it used?
• What if software is used in more than one office?
• What if the taxpayer is a multistate corporation and uses the software throughout the country?
• Can taxpayers avoid taxation by the expedient of transmitting software out of the state or by delivering a hard copy on the assessment date?
• What about setting an affiliated non-resident entity to own and license software to a resident user? Does this avoid ad valorem taxes?

Conclusion
The present tax system focuses on tangibility, an antiquated framework which has been stretched to fit new technology. Although it is desirable to have a universal system for assessing sales tax on all goods and products, a time must come in which the costs--in terms of confusion, inefficiency, and inequity-- outweigh the benefits, and exceptions to universal treatment must be made. Simplicity, certainty, efficiency, equity, and growth are the goals of any tax structure, while universality is but a corollary to these goals. These goals are clearly not met when attempting to apply the tangibility/intangibility distinction to software.

system which is based upon the applications/operational distinction of software promotes most of the goals of an ideal tax system: efficiency, certainty, equity, and economic growth. A functional distinction also creates vertical categories of taxable items rather than the horizontal categories created by the tangible/intangible standard. Using these concepts accepted in the industry, legislatures may easily identify the broad categories of software which it desires to tax. Accordingly, all the industry participants-- programmers, distributors, retailers, and consumers--may accurately and reliably assess the tax treatment which a transaction will incur. Parties will no longer be able to evade taxes by restructuring their transactions. The sales/use tax system will be equitably and consistently applied. Thus, this system presents the best alternative to the current sales/use taxation of software.

The author can be reached at: [email protected] / Print This Article

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