The Alabama Tax Tribunal (the “Tribunal”) ruled in a recent case that the taxpayer-hospital was entitled to a refund of the sales tax paid on the purchase of software that had been customized for its particular functions (Russell County Community Hospital, LLC & Medhost of Tennessee, Inc. v. Alabama Department of Revenue, Dkt. No. S. 15-1683 (Ala. Tax Trib. June 13, 2016)). The hospital contracted with a well-known healthcare management company to provide the hospital with various computer software programs. The company started with canned software, and then customized it to meet the specific needs of the hospital. The hospital paid sales tax to the company on the software, and the hospital and the company later jointly petitioned for a refund. The Alabama Department of Revenue (the “Department”) denied the petition, and the hospital/company appealed to the Tribunal.

In ruling for the taxpayer, Chief Tribunal Judge Bill Thompson found that the software was indeed custom software, and thus not subject to sales tax. His ruling relied heavily on the Alabama Supreme Court's decision in Wal-Mart Stores, Inc. v. City of Mobile and County of Mobile, 696 So 2d 290 (Ala. 1996), which held that unmodified, “canned” computer software sold to nonexempt customers was subject to Alabama sales or use tax. Following that ruling, the Department issued Administrative Rule 810-6-1-.37 (the “Regulation”), which the Department cited in support of its refund denial. Judge Thompson found the regulation to be internally inconsistent.

Paragraph (5) of the Regulation states that software is entirely exempt from sales tax if it is customized, but the same paragraph also states that only the itemized charges for customizing the software are exempt from sales tax. The Department had denied the joint petition in issue in full because the charges to the hospital were not itemized between the canned software and the customized portion. Judge Thompson added a footnote explaining that it’s extremely difficult to determine whether software is custom or canned and, citing the Hellerstein treatise on state and local taxation, that he would support the imposition of sales tax on all software.

Apparently relying on Judge Thompson’s footnote, the Department argued in its appeal to Russell County Circuit Court that sales tax should apply to the purchase of all software, whether canned or customized. This position, if adopted, would not only remove the court-mandated exemption for custom software, but would also mean that the Department is disavowing its own regulation, which specifies that custom software is not subject to sales tax. For the Department to disavow its own regulation and argue against long-standing precedent is a bold move, to say the least. The Wal-Mart case was decided 20 years ago, and the ensuing regulation has been in effect since that time. Should the Department ultimately prevail, it would mean that any software sold or licensed in Alabama is subject to sales or use tax – even if it was substantially or entirely customized to fit the taxpayer’s particular needs.

Whether that new position -- if judicially approved -- would be retroactively applied, must also be decided. Readers may recall that the Alabama Supreme Court quickly modified its first ruling in Wal-Mart to clarify that it would only be applied prospectively.