United States: Texas ALJ Holds Software Delivered To Texas Is Taxable Use

On July 2, 2015, a Texas Comptroller Administrative Law Judge (ALJ) denied a taxpayer's refund request for a multistate exemption on the purchase of software licenses and software maintenance services.1 The taxpayer claimed that sales and use tax was erroneously paid on the purchase of software licenses used on computers located outside Texas and software maintenance services that benefited computers located outside Texas. This ruling upholds the Comptroller's long-standing interpretation of software licenses as tangible personal property, and the policy that a multistate benefit of use exemption is only applicable to certain taxable services which benefit an identifiable segment of the business.

Procedural Background

The taxpayer, a provider of telephone and data services, originally filed a refund claim in 2012 for the September 30, 2003 – December 21, 2006 period, for sales and use tax paid on software and software maintenance that was invoiced as delivered to Texas, but for which the taxpayer contended was for use outside Texas. The Comptroller Audit Division initially denied this refund claim based on expiration of the statute of limitations. Ultimately, the Comptroller upheld the denial of the refund claim, but rejected the Audit Division's argument that the statute of limitations had run. The taxpayer subsequently filed a second refund claim in 2013, covering the April 1, 2005 – December 31, 2006 period, again based on the argument that the taxpayer erroneously paid sales and use tax on the purchase of software and software maintenance services used on computers located outside Texas. The Audit Division rejected this claim as well, on the grounds that such claim was a prohibited "second refund claim," without addressing the taxability argument.2

Sales Tax Treatment of Software

Before analyzing the ALJ's decision, a review of how Texas treats software for purposes of the state's sales and use tax is appropriate. The taxability question often turns on the location to where the software is delivered, the ability to allocate use of the software within and outside Texas, and the potential applicability of the multistate benefit exemption.

Software Shipped to Texas

When software is delivered or downloaded to a Texas location, Texas sales or use tax is due, regardless of where use of the software occurs. The basis for this determination is the presumption that a purchaser who brings tangible personal property into Texas purchased the property for use in Texas.3 Software is considered tangible personal property in Texas.4 Therefore, a Texas sale has occurred and Texas tax is due.5 In 2001, the Texas legislature added language to the existing statute to clarify that the form in which a taxable item is sold does not alter the item's tax status.6 A book sold in electronic form is still a book and tangible personal property that is subject to tax. Likewise, software delivered electronically in Texas is considered tangible personal property. It should be noted that the temporary storage exemption from the sales and use tax may be available, but only if the software is purchased from an out-of-state vendor and the first use is not in Texas.7

Software Shipped Outside Texas

Software purchased outside Texas that is delivered, downloaded or installed on a server located outside of Texas, is subject to Texas use tax for the portion of use in Texas only. An allocation can be made for the licensed Texas users or sites. For example, a taxpayer located in California and Texas purchases software that is installed on a server in California. The California license is not subject to Texas tax.8

One ALJ decision highlights the need for the taxpayer to show that an out-of-state use of the software is being made. In the decision, an auditor assessed tax on a software license purchased from an out-of-state vendor and placed on an out-of-state server owned by a third party. The Texas taxpayer performed testing in Texas and used the software in Texas. Since no other use was documented or proven, the software was subject to Texas tax and no allocation was made. The ALJ ruled the taxpayer did not prove any out-of-state use occurred. Therefore, 100 percent of the purchase price was subject to Texas tax.9 However, had use occurred in other states, the amount subject to Texas tax would be limited to the use of the Texas license.

Multistate Benefit Exemption

Texas offers a multistate benefit exemption for certain services that are performed both within and outside Texas, to the extent the services are for use outside Texas. Services are presumed to be used at the customer's principal place of business. If a service is used to support a separate, identifiable segment of a customer's business, the service is presumed to be used at the location where that part of the business is located. The taxpayer may use any reasonable method for allocating non-Texas use that is supported by business records.10

However, the exemption applies only to services that became taxable on or after September 1, 1987, and does not apply to tangible personal property.11 Therefore, with respect to software sales, only the maintenance of custom created software will qualify for the multistate benefit exemption. Effective October 1, 1987, the legislature amended Tex. Tax Code Ann. Sec. 151.009 to include custom computer programs in the definition of tangible personal property.12 As a result of this amendment, the repair, maintenance or restoration of custom computer programs became a taxable service as the repair of tangible personal property on or after September 1, 1987.13 The repair of tangible personal property became an enumerated taxable service in 1984 when Tex. Tax Code Ann. Sec. 151.0101(a)(5) was enacted. Therefore, before the multistate benefit test can be applied, it must be proven that the software is a custom created program.

When claiming the multistate benefit exemption, the burden is placed on the taxpayer to prove by clear and convincing evidence that the taxpayer operates in more than one state, and that the purchased service supports a separate, identifiable segment other than general administration or operation of the business. The mere existence of out-of-state offices, divisions or stores is not sufficient by itself to establish a separate, identifiable business segment.14 The term "separate identifiable segment" is not defined in any of the rules containing the service benefit location test.15 One must look to existing policy letters and Comptroller hearing decisions to determine the agency's construction of the test. "Identifiable segment" has been defined as a part of a business that has its own identity apart from and must perform a function that is separate from the general administration or operation of the company.16

Treatment of Software as a Service

One software purchase that normally should qualify for the multistate benefit exemption is the purchase of software as a service (SaaS). SaaS is purchased when a license to access a software application is owned, operated, and maintained by a SaaS provider. The consumer accesses the application over the Internet. The software is located on a server that is owned or leased by the SaaS provider. The software is not transferred to the customer, and the customer does not have the right to download, copy, or modify the software. The Comptroller's office has deemed this to be the provision of taxable data processing services.17 Such services are taxed at 80 percent of the tax rate normally applicable to taxable sales,18 and are eligible for the multistate exemption.19

ALJ's Substantive Analysis

In reviewing the validity of the taxpayer's refund claim, the ALJ summarily refuted the Audit Division's "second refund claim" argument, since the Audit Division failed to demonstrate that the refund claim submitted in 2013 was identical to the prior refund claim advanced in 2012.

Moving to the substantive analysis, the taxpayer argued that it erroneously paid sales and use tax on software licenses used by employees in offices outside Texas, even though the licenses may have been temporarily stored in Texas. In rejecting this argument, the ALJ noted that the software was shipped to the taxpayer's office in Texas based on invoices. In this circumstance, the ALJ held that the item is presumed to be used in Texas, and since a software license is taxable as tangible personal property, no allocation is available for the use of license in other states.20 The ALJ referenced a 2012 hearing decision to support his ruling that software purchased for a Texas location is subject to Texas sales and use tax, even if it provides support to an out-of-state location.21

The ALJ then rejected the taxpayer's attempt to utilize the multistate benefit exemption. The taxpayer contended that it was a separate, identifiable business segment of a larger company and should be entitled to the multistate benefit exemption for that reason. The ALJ disagreed as the purchases in the refund claim were not made by the larger company for the benefit of a segment of the business. Rather, the specific taxpayer made the purchase for its general business operations.

Commentary

Software licenses shipped out of state by a Texas or out-of-state vendor are available to be allocated based on location of users. Historically, in audit situations, Comptroller auditors have been willing to allow an allocation of software delivered into Texas by an out-of-state vendor, only assessing tax on the licenses used in Texas. However, this ALJ hearing decision strictly construes the requirements necessary to allow for an allocation, and may make it more difficult for a taxpayer to prove that an allocation is appropriate. This strict construction arguably differs from the approach taken in past Comptroller letter rulings, hearing decisions, and audit treatment.

Taxpayers may need to consider potential remedies to the consequences of the strict construction approach. For example, as a member of the multistate compact, Texas will allow an offset of any tax legally due and paid on the purchase in another state, preventing double taxation situations.22 Another area to consider is the delivery of software into a state that exempts electronic delivery, so that tax will only be imposed on the use of the software in Texas.

Footnotes

1. Decision, Hearing No. 111,499, Texas Comptroller of Public Accounts, July 2, 2015.

2. TEX. TAX CODE ANN. § 111.107(b). Since the taxability argument was not addressed, the facts in this decision are not well-established regarding the locations of the software vendors.

3. TEX. TAX CODE ANN. § 151.105(a).

4. TEX. TAX CODE ANN. § 151.009.

5. See Letter No. 9809798L, Texas Comptroller of Public Accounts, Sep. 8, 1998; Letter No. 200110565L, Texas Comptroller of Public Accounts, Oct. 19, 2001; Letter No. 2002062L, Texas Comptroller of Public Accounts, Feb. 18, 2000.

6. TEX. TAX CODE ANN. § 151.010.

7. TEX. TAX CODE ANN. § 151.011; see Decision, Hearing No. 39,101, Texas Comptroller of Public Accounts, July 28, 2003.

8. See Letter No. 9809798L, Texas Comptroller of Public Accounts, Sep. 8, 1998.

9. Decision, Hearing No. 44,040, Texas Comptroller of Public Accounts, Mar. 24, 2005.

10. 34 TEX. ADMIN. CODE § 3.330(f).

11. TEX. TAX CODE ANN. § 151.330(f).

12. TEX. TAX CODE ANN. § 151.009.

13. TEX. TAX CODE ANN. § 151.0101(a)(5).

14. See Decision, Hearing No. 46,844, Texas Comptroller of Public Accounts, June 15, 2007; Decision, Hearing No. 102,780, Texas Comptroller of Public Accounts, May 4, 2011.

15. 34 TEX. ADMIN. CODE §§ 3.330; 3.342; 3.343.

16. Decision, Hearing No. 36,649, Texas Comptroller of Public Accounts, Aug. 10, 1998.

17. Letter No. 200805095L, Texas Comptroller of Public Accounts, May 28, 2008.

18. TEX. TAX CODE ANN. §§ 151.0035; 151.351.

19. 34 TEX. ADMIN. CODE §§ 3.330(f).

20. TEX. TAX CODE ANN. § 151.105(a).

21. Decision, Hearing No. 104,615, Texas Comptroller of Public Accounts, Mar. 29, 2012.

22. TEX. TAX CODE ANN. § 151.303(c).

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