By Terry Barrett, CPA
Tax Senior Manager
Keiter, Glen Allen
Software is a routine purchase for most businesses. Fortunately, Virginia (and some other states) provide an exemption from the retail sales and use tax for certain types of software. This can be a much-appreciated cost-saver, whether you are implementing a costly new enterprise resource planning system or just getting started with Quickbooks. However, unwary taxpayers may find themselves denied an exemption due to documentation issues.
Software exemption definitions
Exempt software falls into two general categories: custom computer programs and prewritten software delivered electronically (or in other than tangible format). Custom programs are generally defined as those that are specifically designed and developed only for one customer. Virginia law goes further in its distinction between prewritten and custom software by including within the definition of “custom programs” the statements “[t]he combining of two or more prewritten programs does not constitute a custom computer program. A prewritten program that is modified to any degree remains a prewritten program and does not become custom.” Thus, custom programs meeting the above criteria typically are not purchased by most businesses.
On the other hand, virtually every business purchases some form of prewritten or canned software. “Prewritten software” is defined by Virginia law for sales tax purposes as ”that which is prepared, held or existing for general or repeated sale or lease, including a computer program developed for in-house use and subsequently sold or leased to unrelated third parties.” This includes your everyday, off-the-shelf prewritten software.
While few software vendors today sell software (prewritten, custom or otherwise) in tangible format — on CDs or “tapes” or another tangible medium — if the software is sold in tangible format it is subject to Virginia’s sales tax. Therefore, software purchased at stores like OfficeMax, Best Buy or from a value-added reseller in CD format is subject to the tax — clearly something tangible is received by the purchaser. In addition, prewritten software that is preloaded on hardware prior to the delivery to the customer is also taxable since the software is transferred on something tangible.
Software delivered electronically, downloaded with a “key” or code or loaded by the seller onto a business’s computers is not taxable in Virginia. Virginia law specifically provides an exemption from the tax, in part, for “services not involving an exchange of tangible personal property which provide access to or use of the Internet and any other related electronic communication service, including software, data, content and other information services delivered electronically via the Internet.” Similarly, software as a service (SaaS), where users remotely access software on a vendor’s or third party’s server and do not receive anything tangible in the process, is not taxable. This sounds relatively straightforward: tangible equals taxable; electronic equals exempt.
Documentation is key
A problem, however, may arise in documenting the electronic delivery/remote access of the software. State auditors are quick to deny an exemption and assess tax if sufficient documentation is not provided. The Virginia Department of Taxation’s minimum documentation requirements for confirming the electronically delivery of software products is set forth in Public Document (P.D.) 05-44 (April 4, 2005). P.D. 05-44 provides that “at a minimum a sales invoice, contract or other sales agreement must expressly certify the electronic delivery of the software and that no tangible medium for that software has been furnished to the customer.” (Emphasis added.)
While this policy was clarified years ago, many software sellers still do not specify on their invoice, contract or sales agreement that the software is delivered electronically AND that no tangible property is delivered. Contractual language may state that the software may be provided electronically or in tangible format at the customer’s request, however, this permissive language is not sufficient to render the sale of software exempt. There must be a definitive statement that the software is delivered electronically and no tangible medium is provided. Most buyers believe that the mere fact that the software was delivered electronically (because that’s how everyone does it) renders the software exempt. That’s not the case.
Virginia follows the letter of the law
Over the years, taxpayers have appealed tax assessments on software due to failure of the vendor’s contracts to meet the minimum documentation requirements, and quite frequently have been denied relief by the Tax Commissioner. Most recently, in P.D. 18-111 (June 8, 2018), in an appeal of the assessment of tax on electronically received software, the taxpayer provided copies of the vendor's quote, the purchase order, the sales invoice and correspondence from the vendor for the transaction at issue. The vendor's correspondence referenced the purchase order number for the contested transaction and stated that the software and related maintenance were delivered electronically and were not physically delivered to the taxpayer.
The Tax Commissioner, however, responded that Virginia law requires that “[a]ny assessment of a tax by the Department shall be deemed prima facie correct” and the burden was on the taxpayer to prove the assessment was erroneous. He denied the exemption for the transaction. The Commissioner maintained that although the taxpayer had provided correspondence from the vendor that referenced the purchase order number for the contested transaction, that fact alone was insufficient evidence that electronic delivery was the only method available for delivery of the software. The Tax Commissioner further maintained that because the taxpayer did not provide any of the types of documentation, i.e., a sales invoice, contract or sales agreement, which contained the required certification language discussed in P.D. 05-44, no exemption was allowed. It was also noted in the letter that the vendor's sales invoice listed a “ship to” address and stated that the delivery method was “ground,” which indicated the possibility that the software and maintenance agreement may have been delivered by a tangible medium.
In P.D. 11-70 (5/11/11), there was a similar situation in which a taxpayer contested an audit assessment on the purchase of software and provided email correspondence from the software vendor stating that there was no delivery of software via tangible media. The Tax Commissioner ruled that the vendor's email correspondence alone was not sufficient evidence to support the removal of the purchase from the taxpayer's audit.
The takeaways from the recent Tax Commissioner rulings are:
- In order to qualify for the exemption from the tax, the documentation requirements of P.D. 05-44 should be met. Namely, the sales invoices or a contract/sales agreement for the purchase of electronically delivered software should state that the software is delivered electronically and no tangible medium is provided to the customer. Further, the invoices should not reference “ship to” addresses or physical delivery modes.
- If the documentation provided in connection with a purchase of software does not clearly state the above, it is recommended the buyer reach out to the vendor to seek a revised invoice, contract or sales agreement that does.
- If a software buyer cannot obtain such documentation, consider self-assessing and reporting use tax directly to TAX; if audited, TAX likely will assess the tax, interest and possibly penalties.
This issue frequently arises in audits and because a recent appeal letter was on point, odds are the issue is receiving renewed attention by auditors. If you have purchased any software recently you may want to review the invoices/contracts to see if they meet the documentation tests — and if not, take action.
Terry Barrett is a Tax Senior Manager at Keiter. Terry focuses on state and local tax consulting, with emphasis on non-income tax issues, such as sales and use tax, and business license and personal property tax, in Virginia and other states.