United States

Alabama Tax Tribunal finds custom software regulation contradictory

Determines modified software with "canned components" fully exempt

INSIGHT ARTICLE  | 

The debate on how to treat the sales and use taxability of canned versus custom software has been raging for well over a decade. With the ever-present digital economy, states have evolved their positions from considering software as an intangible to focusing more on whether software is “canned,” i.e., off-the-shelf, or “custom,” created specifically for a user. That distinction allows a jurisdiction to consider the “professional service” of creating the customization and carving out an exemption to the extent the software is customized. While a trend, there has clearly been no model approach as states make a number distinctions such as whether the software is canned, customized, or electronically downloaded, and where the software or the license holder is located. These positions continue to develop, Alabama providing a recent case study of a state of where the debate has yet to be settled.

In the Alabama Tax Tribunal decision, Russell County Community Hospital & Medhost of Tennessee v. State of Alabama, Russell County Community Hospital (Community Hospital) entered into a contract with Medhost of Tennessee (Medhost, and collectively with Community Hospital, “taxpayers”) for Medhost to provide Community Hospital with various computer software programs. The purchase included patient flow management software, physician documentation software, and radiology imaging software. The implementation of the programs consisted of a five step process that allowed Medhost to customize the software to Community Hospital’s unique workflow and environment.

After the purchase, Community Hospital paid Alabama sales tax to Medhost, which was appropriately remitted to the Alabama Department of Revenue. The taxpayers subsequently filed a joint petition for refund of the taxes paid asserting that the software at issue should have been classified as custom software because it was modified for the exclusive use by the hospital. In denying the petition, the department relied upon Alabama Regulation 810-6-1.37, taking the position that the software contained both canned software and customized software, and because the nontaxable customized portion was not separately stated, no refund could be provided.

Opinion

The Alabama Tax Tribunal’s analysis began with a brief review of the evolution of the taxability of software in Alabama. In State v. Central Computer Services, Inc. (1977), the Alabama Supreme Court focused on whether the essence of the transaction was for the purchase of a tangible or an intangible. The Court ultimately held that the taxpayer’s use of eight computer programs that provided data processing services were nontaxable because the essence of the transaction was the purchase of nontaxable intangible information.

Next, in Wal-Mart Stores v. City of Mobile and County of Mobile (1996), the Alabama Supreme Court determined whether computer software sold off the shelf constituted a taxable sale of tangible personal property. As a result of what the court described as a “proliferation of canned software,” the court shifted its approach in determining the taxability of software by abandoning the tangible versus intangible distinction. In its place, the court established the bright-line rule that the sale of canned computer software is taxable and the sale of custom computer software is nontaxable.

As a result of the Wal-Mart Stores, the department amended Regulation 810-6-1.37 to recognize the distinction between taxable canned software and nontaxable custom software. According to the revised regulation, custom software included programs that contain “pre-existing routines, utilities or other program components that are integrated in a unique way to the specifications of a specific purchaser.” The new regulation also included a provision that “modification to a canned computer software program to meet a customer’s needs” qualifies as custom software programming only to the extent of the modification.

The tax tribunal identified a contradiction in the revised regulation between those two new provisions. First, the definition explains that custom software includes programs that contain pre-existing routines integrated for a specific purchaser. On its face, the provision suggests that when canned software is “integrated in a unique way,” it would constitute custom software, despite the existence of canned software components.

The definition further states that a canned computer software program that is modified to meet the customer’s needs is custom software programming only to the extent of the modification. The latter statement – that modifications to a canned computer software program is custom software only to the extent of the modification – is directly contrary to the former sentence that states that custom software can include software with pre-existing routines, utilities or other components. In addition to the contradiction, the tribunal was unable to find statutory law or case law that supported the position taken by the revised regulation.

In resolving the question of whether the taxpayers purchased custom software, the tax tribunal did not rely on the regulation, instead turning to the Wal-Mart case and its bright line rule that canned software is taxable and custom computer software is nontaxable. Because the department conceded that modifications were made to the software sold by Medhost to Community Hospital, the tribunal determined it had no choice but to hold that the software was nontaxable custom software. Therefore, according to the tribunal, if software has been modified in any manner it should be treated as completely custom, and therefore nontaxable.

The department has appealed the tribunal’s holding to the Russell County Circuit Court.

Takeaways

It is important to note that while the tribunal found in favor of the taxpayers, Chief Tax Tribunal Judge Bill Thompson also included a footnote in the opinion which criticized the approach of distinguishing between canned software and custom software, noting software has both custom and canned components, creating uncertainty of any software taxability analysis. Additionally, he noted that nearly all software must be customized in some manner by the end user to properly operate. Instead of distinguishing between custom and canned, Judge Thompson suggested that both custom and canned software should be fully taxable – a point that will likely be discussed on appeal.

Many states have taken the “custom versus canned” approach to determining the sales and use taxability of computer software. However, as technology continues to advance and the line between custom and canned continues to blur, states may begin to call into question this traditional bifurcation of software. Taxpayers that sell and or purchase software should be aware that the states are continually evolving on the issue. Alabama software providers and purchasers of software with any type of customization should contact their tax advisers to discuss the impact of the Russell County Community Hospital decision.

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