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Introduction
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. For example, the
information can be delivered on a computer through disc, digital
transmission over telephone lines, through direct input by an
individual, through a magnetic tape transfer or, 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 in order 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 and 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:-
In all cases a taxpayer should make an initial determination as to
whether a purchaser of software is exempt from sales tax. For
example, sales to certain non-profit organizations, governmental
institutions and schools are exempt from tax.
Differentiate
between various softwares:-
Some general guidelines may also be of assistance in determining
whether writing of software fits within the personal service
exemption. First, computer consultants who write software for a
specific customer clearly provide personal services which are not
subject to the tax. In such cases, the purchaser often acquires
title to the copyright for the specific application written by the
consultant.
A closer case
arises if a computer consultant retains the copyright to the
software. In such a case, the services for the first customer may
be exempt as a personal service transaction, but the license of
the software to a second customer with slight modifications on the
original software may be subject to sales tax.
Electronic
transmission of Software:-
With some customers, it may be possible to transmit the software
electronically without the use of tangible media. The Department
of Revenue does not appear to address the issue of whether
electronic transmission is exempt from sales tax as not involving
a transfer of
"tangible
personal property".
Differentiation of charges between Software and Consulting
Services:-
The sale of software often involves uniform prewritten software
which is transferred to the customer. Substantial consulting
services are generally involved in applications which may exempt
from sales tax. In fact, it is not uncommon that the cost of the
standardized software is less than the charges for overall
services provided to the customer. In these circumstances, it will
be important to document and allocate the costs between the
software and the consulting services.
Even assuming
the transfer of the software may be subject to sales tax, the
consulting services should be exempt from tax as personal service
transactions. Of course, the Department of Revenue may attempt to
reallocate costs if it appears the taxpayer is making an
unreasonable allocation to services.
Taxation Of
Computer Software For Ad Valorem Tax Purposes
Another issue of great current interest and concern to the high
tech community is the taxation of the capitalized cost of computer
software for ad valorem tax purposes.
A. The
Taxability Issue.
Taxation for ad valorem taxes varies. In some states, all tangible
personal property is subject to ad valorem tax but intangible
property is not. In other states, both tangible and intangible
personal property are subject to tax. Thus, the question arises
whether the software is tangible or intangible property. If the
software is utilized in the state where only tangible personal
property is taxable but intangibles are not taxable, the question
arises as to whether software will be categorized as a taxable
tangible personal property or a nontaxable intangible personal
property. In states where both tangible and intangible personal
property are taxable, the classification nonetheless remains
important because in many states intangible property is taxed at a
lower or different rate base than tangible personal property.
B. Taxation of
Off -The Shelf-Software.
There is an argument that since the software can (and does) exist
separately from the physical media, that it is not tangible
personal property . Alternatively, taxpayers may contend that such
inventories should only be valued based upon the value of the
actual media on which embodied. The analogy of such off-the-shelf
software to inventories of books, cassettes, compact discs, or
videos is difficult to avoid, however. If such software is
tangible personal property, under appropriate circumstances such
software inventory may qualify for a Freeport exemption.
C. Taxation of
Software as an Intangible.
As
noted by at least one commentator, there are at least three
different schemes for ad valorem taxation:
(1) the taxation of all property, both tangible and intangible,
(2) the taxation of all tangible personal property, and
(3) taxation of only selected classes of tangible personal
property.
In several
states that issue remains opens and, certainly, it does not take a
vast extension of existing case law to argue that the physical
embodiment of software in a tangible form, such as in a diskette,
should no more make the underlying software taxable as tangible
personal property than embodiment of the copyright words of Gone
With the Wind in the covers of the book or in the form of a
videotape makes the copyright of Gone With the Wind separately
taxable as tangible personal property.
D. Taxation of
Capitalized Software Costs.
Even assuming that inventories of off the shelf canned software
may be taxable, this does not address the taxability of other
software, particularly capitalized development costs.
Historically, the capitalized development costs of software has
generally not been assessed or taxed as tangible personal
property. The majority of states which have addressed the issue
and have concluded that software (at least unbundled software) is
not tangible personal property for ad valorem tax purposes and
therefore is generally not taxable . However, in states where
intangible property is separately taxable, the issue will remain.
E. Legislative
Responses.
As noted previously, most of the problems of ad valorem taxation
of software are solved. Steps have been taken by some of the
states either by explicit exemption or classification of software
as non-taxable intangible property. In some states, there were
essentially three alternatives that were available to a state to
address the taxation of software. States which do tax intangible
property has to define software as an intangible, and subject to
its intangible tax which generally is lower than the personal
property tax rate. Other alternative is to define software as
taxable (either as tangible personal property or intangible
personal property) but only to tax it on the valuation of the
physical embodiment.
F. Issues.
In addition to the threshold question of whether software is
tangible personal property or intangible personal property, the
whole issue raises other interesting questions. Most basic, if
software is taxable, where is such software taxable?
Broadly stated the question of wherever software is "sit used" for
ad valorem tax purposes is the real one.
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.
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Taxation Of Software 
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The
author can be reached at: romit@legalserviceindia.com /
