Virginia sales tax treatment of electronically provided software.

Virginia Pub. Doc. Ruling No. 05-44 (4/4/05), issued by the Department of Taxation (DOT), provides a practical perspective on that state's sales and use tax treatment of computer software.

Statutory Treatment

In determining the sales and use tax treatment of a sale of software, one issue is whether the software is a custom or prewritten program. Virginia provides an exemption from the retail sales and use tax for a "custom program" defined as a computer program specifically designed and developed only for one customer. The combining of two or more prewritten programs does not constitute a custom computer program. Further, a prewritten program that is modified to any degree remains a prewritten program and does not become custom; see VA Code Ann. [subsection] 58.1-602 and 58.1-609.5.

In contrast, a "prewritten program" is "a computer program prepared, held or existing for general or repeated sale or lease, including a computer program developed for in-house use and subsequently sold or leased to unrelated third parties." (Emphasis added.) (In this context, "prewritten" evidently means written before a commercial contract for the use or sale of the software is in place between the owner/developer and third parties. Query: when can a determination be made as to when software developed for in-house use becomes taxable, because it is subsequently sold or leased to unrelated third parties? Presumably, tax is triggered when the software is licensed or sold, not when the decision is made to sell or lease it. Note: sale or lease transactions between related parties may not trigger Virginia sales or use tax taxation.) A blanket sales tax exemption is not available for prewritten programs.

However, prewritten software may quality for exemption from sales tax if it is provided in electronic format. Virginia exempts from sales tax "services not involving an exchange of tangible personal property which provide access to or use of the international network of computer systems commonly known as the Internet and any other related electronic communication service, including software, data, content and other information services delivered electronically via the Internet"; see VA Code Ann. [section] 58.1-609.5.

Prewritten Software

Virginia has issued significant guidance on the application of sales tax in the form of policy determinations. In Pub. Doc. Ruling 05-44, the taxpayer, a leading software provider, delivered prewritten software to customers over the Internet in order to provide quicker delivery. The ruling noted that, because the sale of prewritten software delivered electronically to customers is not a sale of tangible personal property, it is generally not subject to sales and use taxation. This exemption is available as long as no tangible medium is provided to the customer before, during or after the electronic download (including tangible copies of the software, as well as any hardware). The same policy applies to electronic software updates.

In the ruling, the DOT addressed nine common situations in which the sales tax treatment of electronically provided prewritten software may be called into question:

1. Software electronically downloaded onto equipment purchased by the customer. The entire transaction (including the electronically delivered software) is subject to sales tax.

2 Electronic upload of software from vendor's equipment to customer's computers. The software is not taxable if it is not sold in connection with the sale of computer equipment and no tangible medium is furnished.

3. Addition of tangible software documentation or publications in connection with the sale of prewritten software transferred electronically. The documentation and/or publications provided in connection with the electronically prewritten software do not affect the exempt transfer of the software; see VA DOT, Pub. Doc. Ruling No. 01-61 (5/15/01).

4. Furnishing of prewritten software releases as entitlement following an original sale of electronically delivered software. The provision of new releases does not affect the exempt nature of the original software transaction if electronically delivered. However, if the prewritten releases were provided via tangible means, the "true object" test is used to determine whether the sale of tangible personal property is taxable. (The DOT uses the true object test to determine the taxability of transactions involving both the sale of tangible personal property and the provision of services. If the true object of the transaction is to secure a service and the tangible personal property transferred to the customer is not critical to the transaction, it may be deemed an exempt service. However, if the object of the transaction is to obtain the tangible personal property, the entire charge (including the charge for any services provided) is taxable; see 23VA Admin. Code 10-210-4040(A) and (D).)

5. Provision of repairs and patches to software (whether as an entitlement following an original sale of electronically delivered software or under a separate maintenance agreement). The repairs and patches to software do not affect the exempt nature of the original software transaction if electronically delivered. However, if they were provided via tangible means, the true object test is used to determine whether the sale of tangible personal property is taxable. If the software is exempt from sales and use tax, the associated maintenance agreement is also exempt.

6. Provision of separate, tangible medium backup copy of the same software originally conveyed electronically. The entire transaction, including the electronically delivered software, is subject to sales tax.

7. Charges for restoration of customer's crashed computer system by using tangible software to reinstall software originally delivered electronically. The restoration charges are not subject to sales tax if the tangible software is not conveyed to the customer.

8. Vendor electronically downloads the software for the customer. The provision of software is not subject to sales tax, unless it is installed on equipment sold by the vendor to the customer or tangible copies are provided. Any charge for installation labor is exempt. If the vendor is installing software in connection with the sale of computer hardware, the software will be subject to sales tax, but the associated labor charge will be exempt if separately stated.

9. Customer pretests a loaned computer system (with software and hardware), and wants to buy the system. The vendor cannot remove and redeliver software electronically in an effort to avoid sales tax on electronically provided software.

Importance of Documentation

In the ruling, the DOT noted that a minimum level of documentation is required to prove that the software was electronically delivered by a taxpayer to the customer. A sales invoice, contract or other sales agreement must certify this fact, and must state that no tangible medium has been or will be provided. The documentation must be retained by both the customer and the vendor. Otherwise, the DOT will assume that the software is delivered in tangible form and is taxable to the extent it is contained on an invoice showing a Virginia destination. Rebutting this "assumption" in administrative procedures and proceedings may prove difficult, if not impossible.

Recommendation

In light of the ruling, software vendors should review their current agreements with customers to determine whether sales tax is required to be paid on their electronically provided transactions, as the DOT will focus on the agreement's specific terms in determining whether a tangible medium has been, will be or even could be provided. (When the contract of sale or license provides the purchaser an option as to how it will take delivery of the software, or is silent on the matter, the DOT will construe the contract as giving the taxpayer the right to receive the software via a tangible medium (whether or not it in fact does so) and, thus, presume the transaction is taxable.)

The DOT recently found that an agreement stating that a software vendor shall "deliver the initial System to Customer and install it at the location determined by the Customer on the date set forth ...," along with a provision that all products are shipped "F.O.B." unless otherwise specified, was sufficient to show that tangible personal property could be received; see VA DOT, Pub. Doc. Ruling No. 05-134 (8/10/05). Because the agreement also stated that software maintenance upgrades would be provided "via remote access within a reasonable amount of time ...," and the agreement failed to make the same provision for the original software, by negative inference, the original software was being provided by tangible means and, thus, was subject to sales tax.

To the extent the original contract says nothing about electronic delivery of software, a contract addendum showing the taxpayer's intent to deliver software electronically can help show that electronically provided software is taxable, except when it is sold in connection with the sale of hardware, or if the software is also conveyed by tangible means.

Other States

While Virginia distinguishes between electronically provided prewritten software and prewritten software provided in tangible format, the same cannot be said in other states. For example, New York subjects all prewritten (canned) software to sales tax, regardless of the medium in which it is distributed; see NY Tax Law [section] 1101(b)(6). Similarly, Massachusetts recently passed legislation requiring all transfers of standardized computerized software to be treated as tangible personal property for sales tax purposes; see Laws 2005, HB 4169, Section 34, amending Mass. Gen. Laws ch. 64H, Section 1. In addition, the Pennsylvania Commonwealth Court struck down a Department of Revenue regulation that had treated canned software in the same manner as Virginia, holding that the sale of all canned software, whether transmitted electronically or on a physical medium, was taxable as the sale of tangible personal property; see Graham Packaging Co. v. Commonwealth of PA, 882 A2d 1076 (2005).Accordingly, practitioners should be aware of the state-by-state distinctions in the sales tax treatment of prewritten software, to ensure that clients are properly collecting and remitting it on a multistate basis.

FROM GILES SUTTON, J.D., LL.M., AND JAMIE C. YESNOWITZ, J.D., LL.M.,WASHINGTON, DC

Editor: Stefan Gottschalk, J.D., LL.M., CPA Senior Manager Grant Thornton LLP Washington, DC