Tax Type
Retail Sales and Use Tax
Description
Licensing and billing of software program ,maintenance fees for service support
Topic
Assessment
Exemptions
Nexus
Date Issued
06-01-2007
June 1, 2007
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This is in response to your letter requesting correction of the retail sales and use tax assessment issued to ***** (the "Taxpayer") as a result of an audit for the period May 1997 through December 2000. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer provides software solutions for carriers in the telecommunications industry. At issue is the Taxpayer's licensing of its billing software program (Software B). During the audit period, the Taxpayer entered into agreements to license Software B to four customers. Along with the licensing of Software B, the Taxpayer entered into separate service, maintenance and preliminary agreements in connection with the licensing of Software B. As a result of the Department's audit, the Taxpayer was assessed sales tax on software license fees, maintenance fees and charges for various support services provided in connection with the licensing of Software B.
The Taxpayer protests most of the assessment and maintains that the agreements at issue are separate and distinct legal instruments with separately negotiated fees. As such, these agreements stand-alone and should be taxed accordingly. To support its position, the Taxpayer primarily focuses on the Tax Commissioner's discussion of this issue in Public Document (P.D.) 03-61 (8/19/03).
DETERMINATION
Virginia Code § 58.1-609.5 6 provides an exemption from the retail sales and use tax for "[a]n amount separately charged for labor or services rendered in connection with the modification of prewritten programs as defined in § 58.1-602." The Department has issued several rulings addressing the application of this exemption. For example, P.D. 03-61 discusses the modification labor exemption as follows:
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- The exemption has broad application and applies not only to the direct costs, such as programming and consulting services used to design, write, test and document modified software programs, but also to necessary associated costs, such as travel and living costs for programmers, engineers and consultants involved in the modification work, and incidental administrative costs related to the modification effort. [Emphasis added.]
Furthermore, P.D. 03-61 addresses how to determine whether two agreements are one transaction or separate and distinct transactions for sales and use tax purposes based on the law of contracts in Virginia. In that case, two contracts were determined to be one transaction because they were executed on the same day, between the same parties, and in reference to the same subject matter.
In light of these authorities, I will address the agreements at issue.
***** (Company C)
Multiple agreements with Company C were executed on the same date. A software license agreement and a separate service agreement were among the agreements executed that day. The Taxpayer does not contest the tax assessed on the licensing fees and the maintenance fees. Rather, the Taxpayer contests the tax applied to the service agreement. The Taxpayer contends that the fact that the license and service agreements were executed simultaneously does not mean that all service related charges are taxable as additions to the charges for the licensing of Software B. The Taxpayer believes that the services provided relate to the modification and installation of Software B, and as such are exempt in accordance with P.D. 03-61.
In section 2.1 of the statement of work for the service agreement, the Taxpayer contracted to provide Company C with the services necessary to implement and operate Software B. The services provided include "software development, software installation, software configuration, software testing, formal training and project management." The development effort is for the provision of customized features to meet the specific needs of the customer.1 The installation task consists of the installation of kernel and non-kernel software modules at the Taxpayer's Georgia facilities and the customer's Virginia facilities. The configuration task establishes the specific reference data to use for processing customer data. Initial configuration enables data to be tested. The testing task validates standard and customized features. The training task is formal instructions in the use and maintenance of the software. The project management covers the entire effort.
According to the auditor, no modification or installation charges were knowingly included in the audit. Rather, all known and clearly identifiable charges for installation 2 and modification services were excluded from the audit. In some cases, however, I understand that the auditor was unable to distinguish exempt modification labor from labor used to perform other services based on the documents provided. For example, a labor charge for testing does not show what portion of that charge represented taxable testing of the core software program and generic interfaces and what portion represented exempt testing of the customized enhancements. The same applies to the remaining service charges at issue, such as training, configuration, project management, and consulting services. Absent credible evidence to distinguish exempt labor charges from taxable labor charges, and in accordance with the policy set out in P.D. 03-61, I find no basis to revise this part of the audit assessment.
***** (Company I)
The Taxpayer entered into a software license agreement with Company I for Software B. Company I separately contracted with a third party to customize and implement Software B. In addition, the Taxpayer entered into a maintenance agreement with Company I. The Taxpayer does not contest the tax on certain license and maintenance fees billed to Company I. However, the Taxpayer disputes the tax assessed on various services provided to the third party on the basis that:
- 1. The first designated location for delivery of the core software was in Georgia. [On the contrary, Schedule 1 of the Software License Agreement lists Arizona as the first designated location and Virginia as the location of the test software.]3
- 2. Company I separately contracted with the third party with respect to customizing and implementing its overall billing system, including the customization of the Taxpayer's software product. The third party was designated the prime contractor and the Taxpayer's role was limited to a subcontractor. In the Department's audit, the tax deficiency includes charges for customized services that the Taxpayer actually billed to the third party, not Company I.
- 3. The time and expense charges are nontaxable as they only relate to customization and installation of the Taxpayer's Software B.
Because the Taxpayer contracted with Company I for the software license and subcontracted with a third party for the provision of services, I find basis for treating the two agreements as separate and distinct agreements. Accordingly, the third party billings will be removed from the Department's audit. However, please note that a maintenance agreement (invoice #2221) in October 1998 taken as a credit in error and direct billings from the Taxpayer to Company I will remain in the audit.
***** (Company T)
Company T and the Taxpayer entered into a software license agreement and then entered into an agreement with a third party, in which the third party agreed to provide integration and customization of Software B, similar to the arrangement addressed in the preceding discussion. The Taxpayer does not contest the license fees charged to Company T because Software B was delivered to Company T in Virginia. Rather, the Taxpayer contests all amounts billed to Company T (which you classify as purely service transactions) pursuant to the software service agreement executed between Company T, the third party and the Taxpayer.
Although the software license agreement and the software service agreement were executed on the same day and reference the same subject matter, I must recognize that both agreements were not signed by all of the same parties. Based on this fact and the additional information provided, I find that the software license agreement and software service agreement should not be construed together as one transaction. Accordingly, the charges assessed in connection with the software service agreement will be removed from the audit.
The Taxpayer also contests certain billings included in the audit that predate the software license agreement. Prior to entering into the software license agreement, an interim agreement was made between the third party and the Taxpayer. The purpose of the interim agreement was for the third party to engage the Taxpayer to perform a gap analysis, which involved no exchange of tangible personal property. Because the same parties did not execute the interim agreement and the software license agreement, I find that the interim agreement was a separate and distinct agreement from the software license and service agreements. Accordingly, the contested charges made to Company T prior to the signing of the software license agreement, the software service agreement, and the maintenance contracts on November 3, 1998, will be removed from the audit.
***** (Company N)
Company N and its affiliates entered into a number of agreements with the Taxpayer. The issues are as follows:
Letter of Intent (LOI). Months prior to entering into software license, service and maintenance agreements (the Definitive Agreements), the Taxpayer and Company N executed a LOI to begin a gap analysis. The Taxpayer contests the inclusion of invoices relating to the gap analysis and maintains that the LOI was clearly separate from any future license agreement and, therefore, should stand on its own for sales and use tax purposes.
The purpose of the LOI was for the Taxpayer to perform a gap analysis to determine requirements for the implementation of Software B. Upon execution of the LOI, Company N was to pay the Taxpayer a specified sum. This sum was to be applied against the Taxpayer's Software B license fee pursuant to the Definitive Agreements. In addition, the Taxpayer was allowed to deduct and retain from such sum any amounts payable by Company N pursuant to the gap analysis services upon termination of the LOI. Pursuant to the LOI, this sum of money was refundable in the event the Definitive Agreements were not executed and the LOI was terminated in writing. The Definitive Agreements, however, were executed and the LOI was not terminated.
The LOI is a preliminary arrangement made prior to the actual implementation of the software licensing agreement. Furthermore, the LOI expressly states that neither party to the LOI is obligated to enter into any subsequent agreements. Those subsequent agreements expressly state that they supersede all prior oral or written agreements, commitments and understandings. Based on these facts, I find that the LOI is a separate and distinct agreement from the Definitive Agreements. In accordance with the policy set out in P.D. 03-61, charges made pursuant to the LOI will be removed from the audit.
Memorandum of Understanding ("MOU"). Company N and the Taxpayer executed this MOU with the intent to enter into Definitive Agreements for the licensing, customization, implementation and maintenance of Software B. These parties also intended that the MOU would govern the services to be performed until the Definitive Agreements were executed.
Like the LOI, the MOU is a preliminary step towards entering into a software license agreement that binds both parties to a definite commitment. Similar to the LOI, I find that the MOU is a separate and distinct agreement from the Definitive Agreements. Accordingly, the charges made pursuant to the MOU will be removed from the audit.
Master Services Agreement. There is only one invoice included in the audit in connection with this service agreement. Upon review of the Statement of Work and other agreements, it appears that the services were performed outside of Virginia. Accordingly, this contested charge will be removed from the audit.
Company N Affiliates (NIl Affiliates). I understand that the Taxpayer entered into several separate software license and service agreements with NII Affiliates located outside of the United States. The actual software installation occurred outside of the United States.
The Taxpayer contends that the software license charges included in the audit are not the original license fees for the affiliates. Rather, they constitute additional license fees for added subscribers served by the affiliates, i.e., the next license tier. Because Software B was already residing on the hardware of the affiliates located outside the United States when the next license tier charges were made, the Taxpayer maintains that such charges, and the related maintenance fee, lacks nexus with Virginia and should be removed from the audit.
Based on the documents provided, it appears that the NII Affiliates' transactions lack any nexus with Virginia. Accordingly, the next license tier charges and related maintenance fee will be removed from the audit.
CONCLUSION
The assessment will be revised in accordance with this determination. Upon completion of the revisions, an updated bill, with interest accrued to date, will be sent to the Taxpayer. The outstanding balance should be paid within 30 days of the bill date to avoid additional interest charges. The Taxpayer should remit its payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attn: *****. If you have any questions concerning payment of the assessment, you may contact ***** at *****.
Please note that failure to remit full payment within the 30-day period may result in the imposition of an additional 20% penalty on the tax due under the terms of Virginia's recent Amnesty. See the enclosure entitled "Important Payment Information."
The Code of Virginia sections and the public document cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. For questions about this determination, you may contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at *****.
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- Sincerely,
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Janie E. Bowen
Tax Commissioner
AR/49826R
1 In contrast, section 3.1 of the statement of work states, "No software modifications will be made to [Software B] being implemented at [Company C] under the terms of this document."
2 Virginia Code § 58.1-609.5 2 provides an exemption from the retail sales and use tax for separately stated installation charges.
3 Because the first designated location for the software was outside Virginia, you claim that is why the audit does not reflect a license fee to Company I for Software B. On the contrary, it is my understanding that such license fees were not included in the audit because they were invoiced prior to the audit period, i.e., in October and December 1996.
Related Documents
Rulings of the Tax Commissioner