In most states, sales tax is imposed on the sale of tangible personal property and certain specifically enumerated services. Since each state, and many cities and counties, have their own sales tax system, numerous variations exist in the types of items subject to sales tax. The distinction between items subject to sales tax and items that are exempt from sales tax is mainly the result of the politics and the economy of each state. For example, a state that has a strong manufacturing base might exempt manufacturing machinery and equipment from tax. Similarly, a state that has an agricultural base may enact exemptions for farming machinery and equipment. In general, however, all sales of tangible personal property are considered taxable unless a specific exemption applies.
In moving from a manufacturing-based economy to a service-based economy, the challenge of complying with antiquated statutes has increased, a problem that is illustrated by the application of sales tax rules to the taxing of computer software. More than 30 years have passed since state courts first struggled with whether computer software constituted tangible personal property subject to sales tax. In the 1980s and 1990s, computer software was often sold on portable storage devices, such as disks and CDs, which were usually taxed as tangible personal property under state sales tax laws. More recently, however, software is downloaded through the Internet where no tangible product is physically exchanged. What is the treatment of the “electronic” delivery or transfer of such products? Further, does it matter if the software is created from scratch or prewritten? And, how do the tax rules apply to software maintenance and upgrades?
Despite the fact that you cannot see, feel, or touch it, software has been deemed to be tangible personal property. In New York, prewritten or “canned” computer software, whether sold as part of a computer package or as a separate component, is taxable regardless of the method of transfer of the software. In New York, the delivery of the software, whether through a tangible device or by electronic download, will not affect the taxability of the software. However, software custom-designed and developed for a specific purchaser is exempt from New York sales tax. This is true regardless of the method of delivery of the software.
In New Jersey, the sale of canned computer software, including prewritten software transmitted electronically, is subject to sales tax. However, when software is created, written and designed for the exclusive use of a specific customer, it is treated as a nontaxable professional service transaction and is not subject to New Jersey sales tax. New Jersey largely differs from other taxing jurisdictions with regard to software that is used directly and exclusively in the conduct of the purchaser’s trade or business. In such situations, New Jersey exempts prewritten software delivered electronically only if no storage device containing the software is transferred.
Connecticut follows the majority of taxing jurisdictions and imposes its 6.35% sales tax on canned software. However, custom software or existing software that is substantially modified to the particular needs of a customer is considered a taxable computer processing service for which a special 1% sales tax rate is applied. Connecticut also imposes this special tax rate to downloaded software. It should be noted that when Connecticut purchasers download software upon which no tax is charged, they are required to self-assess and remit a 1% use tax with respect to their purchases.
States become even more divergent in their tax laws regarding computer software, in the treatment of software maintenance and upgrade services. In New York, the charges for software installation, on-site training and customer support services are not taxable if reasonable and separately stated on a customer invoice. Therefore, for software maintenance contracts pertaining to the sale of both taxable items (such as canned software) and exempt services (such as customer support), sales tax is applicable to the total charge of the contract, unless the charges for the nontaxable items are reasonable and separately stated and billed to the customer accordingly.
New Jersey, on the other hand, takes a more taxing approach to software service charges. Service fees for the installation of software are subject to sales tax. Moreover, charges for software maintenance services including delivery of updates for prewritten software are generally taxable. However, maintenance contracts that only provide support services for canned software are not taxable. Likewise, maintenance contracts covering specific custom-made updates of custom software are also nontaxable.
In Connecticut, software maintenance, installation and training are taxable services at the 1% special rate, regardless of whether they pertain to canned or custom software. Maintenance of computer software typically includes consulting with a customer in the form of technical support, software support, user support or telephone support.
In conclusion, as illustrated by the sample of states listed above, each jurisdiction applies its sales tax laws uniquely with regard to computer software and maintenance services. But this is only the “tip of the iceberg.” As technology evolves, sales tax rules become more obscure and further interpretation is needed. For example, what are the sales tax implications of “Cloud Computing”? What about software downloaded to a corporate server located in state X, but used by an employee in state Y? How are “Common Databases” and on-line market research services treated? These and a myriad of other questions will continue to arise as electronic commerce grows more mainstream.
For more information on the impact of sales tax on the computer software sales and purchases of your business, contact Alan Goldenberg, Manager of Tax Controversy and State and Local Tax, at firstname.lastname@example.org or 212-897-6421, or contact your Friedman LLP tax professional.