Tax Type
Retail Sales and Use Tax
Description
Tax on royalty payments of computer software
Topic
Appropriateness of Audit Methodology
Assessment
Date Issued
10-06-2004
October 6, 2004
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *********************:
This is in reply to your letter in which you seek correction of the sales and use tax assessments issued to ***** for the period July 1998 through June 2000 and ***** for the period November 1999 through June 2001. It is my understanding that effective June 2000, ***** merged with *****. Therefore, I will refer to the companies collectively as the "Taxpayer." I apologize for the Department's delay in responding to your letter.
FACTS
The Taxpayer provides information services to the automobile industry. The Taxpayer entered into a licensing agreement with an automobile dealer association (the "association") to provide two software programs, Software A and Software B. The programs were transferred via disk. The association incorporates both software programs into its database software and develops a proprietary software system that is sold to its industry customers. The Taxpayer charges the association a lump-sum royalty for the use of both programs.
As a result of the Department's audit, the auditor assessed the tax on the royalty payments. The Taxpayer asserts that Software A is a prewritten program and that Software B is a custom program. As such, the Taxpayer contends that Software B is exempt from tax in accordance with Virginia Code § 58.1-609.6(7). The Taxpayer offers to bifurcate its agreement in order to assign a value to Software A for purposes of applying the tax. immaterial. To support its position, the Taxpayer cites the "true object" test and a number of prior rulings of the Tax Commissioner.
DETERMINATION
Prewritten v. Custom Software
The first issue to be resolved in this appeal is whether the software programs constitute prewritten or custom programs. Virginia Code § 58.1-609.6(7) provides an exemption from the sales and use tax for custom programs as defined in § 58.1-602. A "custom program" is defined as "a computer program which is specifically designed and developed only for one customer. Combining two or more prewritten programs does not result in a custom computer program. A prewritten program that is modified to any degree remains a prewritten program and does not become custom." A "prewritten program," also defined in § 58.1-602, means "a computer program that is prepared, held or existing for general or repeated sale or lease . . . ."
The Taxpayer's agreement in section 14(A) states that the Taxpayer may market Software A to any third party. In no event, however, is the Taxpayer allowed to market Software B. In addition, section 7(H) requires that the Taxpayer destroy all copies of Software B upon termination of the agreement with the association. Based on these statements and in accordance with the above authorities, Software A is a taxable prewritten software program, while Software B is an exempt custom software program.
Single v. Separate Agreements
The next issue to resolve is the application of the tax to the provision of both software programs in a single agreement for a single charge.
Generally, when an exempt transaction is combined with a taxable transaction, the entire transaction becomes taxable. To resolve such issues, the Department looks to the structure of the transaction or agreement. See Public Document (P.D.) 03-37 (4/15/03). As stated in that ruling, "if there are two or more contracts that are separately negotiated and can stand alone, the Department recognizes these as separate contracts and taxes them accordingly." In this instance, there is only one agreement that was negotiated between the Taxpayer and the association with the intent to provide the software programs as a combined package. This is evident in the Definitions section of the agreement, which defines the Taxpayer's software systems as the two software programs. Further, the agreement does not separately itemize the charges for Software A and Software B. It is clear from the agreement that the Taxpayer intended to offer the two programs together. To allow the Taxpayer to bifurcate the agreement after the fact is contrary to the intent of the agreement at the time of negotiation. Given that Software A is clearly taxable, I find the entire transaction is taxable.
Services v. Tangible Personal Property
With regard to the Taxpayer's contention that the provision of both software programs constitutes an exempt service transaction, Va. Code § 58.1-609.5(1) exempts from the sales and use tax "[p]rofessional, insurance, or personal service transactions which involve sales as inconsequential elements for which no separate charges are made . . . ." Title 23 of the Virginia Administrative Code (VAC) 10-210-4040 addresses the application of the tax to service transactions and provides that "charges for services generally are exempt from the sales and use tax. However, services provided in connection with sales of tangible personal property are taxable." The regulation goes on to apply the "true object" test in determining whether a transaction involving both the rendition of services and the provision of tangible personal property constitutes an exempt service or a taxable retail sale.
The Taxpayer contends that the "true object" of its transaction is to obtain the intangible software rather than the material disk used to transfer it. I disagree. The Department's long-standing policy is that the sale of computer software transferred in tangible form (e.g., tape, disk, CD) is the taxable sale of tangible personal property. See P.D. 83-90 (5/11/83). The "true object" of the transaction in this instance is to obtain the tangible disk that contains the software program. The disk is critical to the transaction because without it there would be no receipt of the program.
You cite an example in Title 23 VAC 10-210-4040(D) to support your position. The example describes a training program in which workbooks and tapes are included in the charges for training services. The regulation states that the object of this transaction is to obtain the training services. You contend that the workbooks and tapes are more material than a disk, and because of this the transaction at issue should also be considered an exempt service. Again, I must disagree. The training services in the example could be provided without the workbooks and tapes. In the instant transaction, the software programs cannot be provided without the disk, unless they are provided by some intangible means (i.e., over telephone lines or keyed directly in a computer through its keyboard). This is not the situation in this case.
Furthermore, the Taxpayer's transaction is different from the transactions addressed in the prior rulings cited by the Taxpayer. In P.D. 99-80 (4/21/99) and P.D. 96-143 (6/20/96), a software product was provided by loading it directly onto a computer system by the vendor. In both instances, this was determined to be a nontaxable service transaction because there was no exchange of tangible personal property in transferring the software. In P.D. 01-61, software was loaded directly onto a file server by the software vendor. In addition to the software, a manual was furnished at no separate charge. The transaction was determined to be an exempt service because the "true object" was to obtain the software that was provided without the exchange of any tangible personal property. The manual was considered incidental to the transaction because it was not critical to the transference of the software.
Royalties
Rulings of the Tax Commissioner have consistently held that royalties paid in connection with the licensing of prewritten computer software constitute a taxable lease or sale when the licensing agreement conveys not only the right to use the software but also the software itself in tangible form, such as on disks, tapes and CDs. See P.D. 96-72 (5/1/96).
Conclusion
Based on the determinations in this letter, the auditor properly applied the tax to the lump-sum royalty payments received in connection with both software programs. Therefore, both assessments are upheld. The Taxpayer will receive updated bills shortly that will include accrued interest to date. No further interest will accrue provided the outstanding assessments are paid within 30 days from the date of this letter. (See attached insert for penalty information). Please remit your payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Attn: *****, Richmond, Virginia 23230. If you have any questions concerning payment of the assessments, you may contact ***** at *****.
The Code of Virginia sections, regulation and public documents cited are available on-line in the Tax Policy Library section of the Department's web site, located at www.tax.state.va.us. If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
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- Sincerely,
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- Kenneth W. Thorson
Tax Commissioner
- Kenneth W. Thorson
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AR/41534J
Rulings of the Tax Commissioner