Issues/Questions

How does Texas tax computer software i.e. systems software, application software and contract programming? Does Texas’ tax statute provide for an exemption or exclusion for software that is designed and created to the specifications of a particular customer but the exclusive rights are not transferred to the customer? If an exemption or exclusion exist, what is the appropriate documentation to adequately and efficiently demonstrate the exempt-nature of the transaction?

Practical Takeaways:

- Don’t sweat it, vendor and customer tax disputes are not uncommon.

- Evidence in the form of documentation is a critical component to successfully winning a taxability position, so keep good records.

- Make sure to look closely into a state’s definitions and never make assumptions when determining if an item is taxable or not.

Facts

Company ABC has engaged a vendor, “Software Co.”, to provide software development and has collected tax on its software development charges to Company ABC. Company ABC challenged the validity of the tax on the software development by Software Co.

Research & Findings

In Texas, software is considered tangible personal property (TPP) for sales tax purposes and thus is subject to tax. Software means basic operating software and application software delivered electronically or via a tangible medium. Rule §3.308 of the Texas Administrative Code provides:

(c) Computer programs and related services.

(1) Computer programs.

(A) The sale, lease, or license of a computer program is a sale of TPP. Tax is due when the computer program, or a license to use the computer program, is transferred for consideration in Texas, or stored, used, or consumed in Texas, in electronic form or on physical media.

Rule §3.308 further provides:

(4) Contract programming services.

Contract programming may result in the creation of tangible personal property, but it does not constitute the sale thereof. Charges for contract programming are charges for a service and are not taxable.

Examples may include writing a new computer program to execute a specific function, tailoring an existing computer program held by a customer or licensed to the customer by a third-party, and adjusting a computer program that the programmer wrote under a prior contract programming agreement.

A “contract programming agreement”, for purposes of this rule, is entirely dependent upon the transferring of the rights upon the completion of the program. In order for the “program in inquiry” to be considered a nontaxable contract programming services, the contract programming service provider must transfer all rights to the newly created program or modification to the purchaser of the service.

The information above is reiterated in Comptroller’s Hearing 44,668.

“If a programmer’s customer obtains exclusive or legal rights of ownership of the created program, then the programmer is not considered to have sold the computer program, but instead is considered to have performed a service that is nontaxable by nature”. That is, services are never subject to tax unless specifically identified in the code.

One final thought pertains to the commonly misunderstood topic of “custom computer program or custom software” for Texas’ sales tax purposes. Originally, Texas defined TPP to include “a computer program that is not a custom program”. However, the definition above was removed in 1987, which effectively caused both canned software and custom software to be considered TPP for sales tax purposes.

Based on the documentation provided by Company ABC, it could not be determined that Company ABC had been given exclusive rights to the program being created and thus it was not considered to be a nontaxable contract programming service. Software co. had correctly charged tax on its development fees to Company ABC.

Relevant Authority

Tax Laws

Texas Administrative Code Rule §3.308

Comptroller’s Hearing No. 44,668

Conclusion

State Tax Advisors is your trusted source for state and local tax advisory, audit representation, and compliance management. Our team continually helps growing companies achieve compliancy and stay current with constantly changing sales and use tax laws. We are standing by to provide quality, value-added state and local tax consulting services to meet your needs.

If you have any questions or need additional information, please contact us by calling (281) 358-1060 or visiting www.statetaxadvisors.com.