The New York State Department of Taxation and Finance has issued guidance explaining its position on how New York’s sales tax applies to sales of computer software, and, in particular, how the Department applies the sales tax rules to software accessed remotely. Tax Bulletin TBST- 128 (N.Y.S. Dep’t of Taxation & Fin., Aug. 5, 2014).
The Tax Bulletin restates many established – and relatively uncontroversial – rules governing the application of sales tax to computer software. The sale of prewritten computer software is subject to tax, whether delivered on a physical medium, by electronic transmission or remote access, while the sale of custom software is not subject to tax. Custom software has to be designed and developed to the specifications of a particular customer in order to qualify as exempt, and it becomes subject to tax if it is transferred to someone other than the person for whom it was originally designed and developed.
Many services related to computer software are exempt from tax, such as installation, programming, maintenance and servicing, as long as the charge for the service is reasonable and is separately stated on the invoice. Sales of software upgrades are generally subject to tax, unless the upgrade is designed and developed to the specifications of a particular purchaser. Prewritten software used directly in the production of tangible personal property or in research and development is exempt, and customized software is exempt when resold or transferred by the purchaser to a related corporation or partnership, unless the sale is part of a plan designed to avoid tax.
However, on a more controversial issue, the Tax Bulletin also makes clear the Department’s position that sales tax applies to remote access to software over the Internet, on the theory that the purchaser has gained “constructive possession” of the software, and the right to use or control it. Presumably, the Department is relying on its regulation 20 NYCRR 526.7(e)(4), which applies to “transfer of possession with respect to a rental, lease or license to use” and provides that transfer of “custody or possession of the tangible personal property, actual or constructive” or “the right to use or control or direct the use of tangible personal property” amounts to a sale for purposes of the New York sales tax law.
The Tax Bulletin also states that, for sourcing purposes, the situs of the sale of remotely accessed software is “the location from which the purchaser uses or directs the use of the software, not the location of the code embodying the software.” The seller of the software should collect sales tax based on the proportion of the receipts attributable to the users located in New York.
The Department appears to have issued this Bulletin, in part, as a vehicle to confirm its position that a business providing a service over the Internet is actually selling prewritten computer software that has been “constructively” transferred to customers. The Department has previously taken this position on audit and in Advisory Opinions, although it has never been upheld by any decision by an Administrative Law Judge, the Tax Appeals Tribunal or any New York court. Many taxpayers believe the Department’s position is not well-founded, and that its apparent reliance on a regulation discussing “rental, lease or license to use tangible personal property” does not support the Department’s treatment of services provided through software. In one recent case regarding software, Matter of SunGard Securities Finance LLC, DTA No. 824336 (N.Y.S. Div. of Tax App., Feb. 6, 2014), exception filed, Mar. 10, 2014, the ALJ concluded that the taxpayer, a business providing data processing services, was using its own proprietary software to furnish a service, and not selling or licensing that software to its customers. Older cases, decided in other contexts, have discussed the degree of control and possession that a customer must obtain in order for the transaction to qualify as a sale, such as American Locker Co. v. City of New York, 308 N.Y. 264 (1955), in which the Court of Appeals held that temporary use of coin-operated lockers was found not to amount to the transfer of actual, exclusive possession, and Darien Lake Fun Country Inc. v. State Tax Commission, 68 N.Y.2d 630 (1986), in which the Court of Appeals concluded that the use of amusement rides by a ticket holder did not qualify as a sale because the use was limited and temporary. Constructive transfer of possession of tangible personal property still requires exclusive control, as is recognized by Example 12 to one of the regulations cited by the Department, 20 NYCRR 526.7(e)(5), which notes that a contract to use a computer for 10 hours weekly constitutes a sufficient transfer of rights for the sales tax to apply, since during the 10-hour period, no one else may use the machine.
The Department’s position on sourcing the transaction also does not seem to follow the statute and regulations, which unequivocally provide that sales of tangible personal property are sourced to where the property is delivered. 20 NYCRR 525.2(a)(3). The Bulletin states that the “location of the code embodying the software” is not relevant in determining where the property is delivered, which leaves unanswered the question of what exactly is the “tangible personal property” that the Department believes is being delivered and where it is located.