June 30, 2025
Re: § 58.1-1821 Application: Retail Sales and Use
Dear *****:
This will respond to your letter in which you seek correction of the retail sales and use tax assessment issued to ***** (the “Taxpayer”) for the February 2017 through the January 2020 period.
FACTS
An audit was conducted on the books and records of the Taxpayer, a supplier of staffing and supply chain management services, for the period at issue. As a result of the audit, the Taxpayer was assessed sales and use tax for the purchase of software, maintenance contracts, licensing fees, and set-up fees that were not taxed. The Taxpayer paid the assessment and filed an application for correction, contending that the purchases and fees were not subject to tax.
ANALYSIS
The Department has the authority to interpret and enforce the laws of the Commonwealth governing taxes in accordance with Virginia Code § 58.1-203. With regard to such interpretations, the Virginia Supreme Court requires strict construction of sales tax exemptions. Where there is any doubt as to the application of an exemption, the doubt is resolved against the one claiming the exemption. See Commonwealth v. Research Analysis Corporation, 214 Va. 161 (1973), Commonwealth v. Community MotorBus, 214 Va. 155 (1973), and Golden Skillet Corp. v. Commonwealth, 214 Va. 276 (1973).
Sales of Software
Virginia Code § 58.1-609.5 1 exempts from sales and use tax services that provide access to or use of the Internet and any other related electronic communication service, including software, data, content and other information services delivered electronically. In Public Document (P.D.) 96-192 (8/6/1996), the Department determined that the medium in which the computer software is transferred is critical to the taxable status of the transaction. Thus, when software is provided in tangible form, the sale and all charges in connection transaction are deemed to be a taxable sale of tangible personal property. Conversely, if the software is transmitted via electronic means, the transaction is generally deemed to be a nontaxable service, and any additional charges included in the electronic transfer take on the same nontaxable status.
The taxability of a transaction involving both the sale of tangible personal property and the provision of services is generally applied to the full amount charged, regardless of whether the charges for the service and property components are separately stated. The Department will use the "true object" test, as explained in 23 VAC 10-210-4040 D, to determine the taxability of these transactions. If the object of a transaction is to obtain a software program and any tangible personal property included is not critical to the transaction, then the transaction may constitute an exempt sale. However, if the object of a transaction is to procure tangible property, then the entire charge, including the charge for any software provided, is taxable. See P.D. 24-40 (3/27/2024) concerning the true object tax with regard to services and intangible property.
Documentation Requirements
The Department historically imposed a rebuttable presumption that software was conveyed in tangible form and, therefore, taxable. See P.D. 83-90 (5/11/1983), P.D. 88-20 (1/4/1988), P.D. 05-44 (4/4/2005), P.D. 11-112 (6/20/2011), P.D. 15-118 (6/16/2015), P.D. 15-153 (7/16/2015), and P.D. 19-24 (4/8/2019). To rebut this presumption, the taxpayer was required to provide a sales invoice, contract, or other sales agreement expressly certifying the electronic delivery of the software and that no tangible medium for that software was to be furnished to the customer. See P.D. 05-44. If the taxpayer could demonstrate that the software was delivered electronically and that no tangible medium was provided to the customer before or after the electronic download of the software, the transaction was exempt from sales tax.
The process of delivering computer programs and software updates has evolved significantly since its inception. While it was once commonplace to pick up a box containing a desired software application from a local retailer, the development and widespread use of the internet has transformed how software is bought and sold. Additionally, the Circuit Court for the City of Richmond found that only minimal evidence was required to meet the burden of proof necessary to show that software was delivered electronically. See Alcatel-Lucent USA Inc. v. Virginia Department of Taxation, CL20-3591-7, (10/26/2021), published as P.D. 21-171 (5/11/2022).
Accordingly, the Department finds it necessary to update the documentation standards concerning the delivery of software. Going forward, the Department will not require the taxpayer to provide documentation expressly certifying the electronic delivery of the software. However, software programs provided in connection with sales of tangible personal property will remain taxable. The Department may request, and taxpayers may be required to provide, documentation demonstrating that software was not provided in connection with the sale of tangible personal property.
Invoice ***** (Invoice A)
The Taxpayer purchased a software upgrade from ***** (Vendor A). Relying on P.D. 12-6 (2/23/2012), the auditor included the purchase of this software in the audit on the basis that there is a “ship to” address on the invoice and that the Taxpayer has not provided evidence that the original software was sent electronically. The Taxpayer contends that the upgrade was shipped electronically.
In P.D. 12-6, the Department ruled that if the purchase of software was made via tangible means, any subsequent renewal or update is also taxable even if transferred electronically. As such, the auditor asserts that the upgrade from Vendor A is subject to tax since the Taxpayer is unable to provide proof that the original software was sent electronically.
Regarding Invoice A, neither the audit report nor auditor’s correspondence with the Taxpayer indicate that corroborating evidence was requested to show the method of transferring the original software. Even though an assessment of tax by the Department is deemed to be prima facie correct under Virginia Code § 58.1-205, any such assessment should be supported by documentation, or lack thereof, contained in an audit report provided to a taxpayer. The audit report, in this case, fails to meet this requirement.
Maintenance Contracts
Virginia Code § 58.1-609.5 10 provides that maintenance contracts, the terms of which provide for both repair or replacement parts and repair labor, are subject to tax upon one-half of the total charge for such contracts. Title 23 of the Virginia Administrative Code (VAC) 10-210-910 defines the term “maintenance contract” as “an agreement whereby a person agrees to maintain or repair an item of tangible personal property over a specified period for a fee that is determined when the agreement is made. A maintenance contract may provide for labor only, parts only, or labor and parts.”
Invoice ***** (Invoice B)
The Taxpayer purchased computer equipment and a maintenance contract from ***** (Vendor B) which is separately stated on the invoice. The maintenance contract included both the hardware, software updates, customer support, and maintenance. The auditor concluded that the entire purchase price for the computer hardware and maintenance contract was subject to tax because the software was delivered in tangible form. The Taxpayer asserts that the maintenance contract should be subject to tax at one-half the contract price since it includes both parts and labor.
The Taxpayer has provided a data sheet from Vendor B that specifies the provisions of the maintenance contract. This contract covers maintenance, replacement parts, and software updates. The Taxpayer indicates that the software updates are electronically delivered. A review of the invoice and data sheet does not show how the software is to be shipped.
In P.D. 96-143 (6/20/1996), the Department determined that licensing fees for software that was included in the purchase of a computer is subject to tax because the license allowed the continued usage of the computer. Further, when computer equipment is sold with the software and software updates installed, the software and software updates are a component part of the taxable sale of computer equipment. See P.D. 05-44. Because the maintenance contract included both hardware repair and integrated software updates, the full contract price is subject to tax even though software was electronically delivered and specified as a separate line item on the invoice.
Invoice ***** (Invoice C)
The Taxpayer purchased a maintenance contract from Vendor B for a computer network switch. A computer network switch is a device that connects multiple devices with a network and directs data between them. The maintenance contract provides for new software releases, knowledgebase access, web support, and phone consulting. The auditor asserts that the Taxpayer acknowledges this purchase to be related to switches and indicated that that the purchase was for the licensing of both hardware and software. The Taxpayer asserts that the maintenance contract was not subject to tax because it is for labor only. As with Invoice B above, however, the language of the subscription license includes the provision of services essentially the same as a maintenance contract for hardware and software together. Because maintenance contracts sold in conjunction with the purchase of computer hardware are subject to tax, Invoice C was properly included as an exception in the audit.
Invoice ***** (Invoice D)
The Taxpayer purchased an agreement from ***** (Vendor C) for software updates, product support, online knowledgebase, license changes, access to videos and tutorials, and a report template. The Taxpayer contends that the purchase of this package is for a non-taxable labor-only maintenance contract. The auditor asserts that the purchase of this package is for a license renewal based upon the original delivery of the product in tangible or electronic form.
While the invoice records the purchase of a maintenance contract, the accompanying document provided by the Taxpayer defines the package as a software license. Research into Vendor C’s business operations indicates that it provides reporting, analytics, and budgeting solutions for Microsoft software applications. Based on this information, the maintenance agreement did not include the provision of tangible personal property. While listing Invoice D as an exception initially appears warranted, a minimal amount of additional investigation shows that inclusion in the final audit was not warranted.
As stated above, for software to be subject to tax it must be connected with the transfer of tangible property. Labor-only maintenance contracts are not subject to tax. There is no evidence that the transfer of the software recorded in Invoice D was related to the transfer of tangible personal property or that the maintenance contract required anything other than labor.
Setup Fees
The Taxpayer contends that it was erroneously assessed sales tax on inbound freight or setup fees. The auditor agrees that these fees are not subject to tax. As such, they will be removed from the audit.
DETERMINATION
Therefore, sales of software products and software maintenance contracts are presumed to be sent electronically unless there is documentation to show physical delivery unless sold as part of a transaction with computer hardware.
Because the evidence fails to show that the delivery of software included the provision of tangible personal property, Invoices A and D will be removed from the audit. Further, the setup fees will be removed as indicated above.
Because transactions involving maintenance contracts that include care for both hardware and software are taxable, Invoices B and C will remain in the audit.
The audit will be returned to the appropriate audit staff to make the necessary adjustments. The Taxpayer will receive a revised report reflecting the adjustments. The assessments at issue have been paid in full. Accordingly, the Taxpayer will receive a refund with accrued interest based upon the audit adjustments required by this determination.
The Code of Virginia sections and regulations cited are available online at law.lis.virginia.gov. The public documents cited are available at tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy and Legal Affairs, Tax Adjudication and Resolution, at ***** or *****.
Sincerely,
James J. Alex
Tax Commissioner
Commonwealth of Virginia
AR/3732.B