United States: Texas Sales Tax: Pitfalls and Opportunities for Software Licenses

Prior to 2002 the Texas Comptroller ruled that non-taxable services would become taxable if they were provided in connection with the sale of tangible personal property (or goods) and the charges for the services and goods were presented on a single invoice. In late 2001, the Comptroller announced a change in its policies on "mixed transactions," so that under some circumstances the non-taxable services would remain non-taxable.

This change in policy may be of particular interest in connection with software licenses, since many companies purchase implementation and training services with software from the same provider. It is important to consider these new policies in connection with both new and prior software acquisitions because payments of Texas sales and use taxes may be reduced on future purchases or claimed as refunds on prior purchases.

Under Texas law, computer software is treated as tangible personal property for purposes of Texas sales and use tax. As such, software licenses are treated the same as a sale of goods, and support and maintenance fees can be subject to sales tax. And it is not uncommon for companies to purchase computer software together with non-taxable services (such as consulting and training services) under a single contract.

There has been a change in Texas sales tax policy relating to mixed purchases of tangible personal property and services. Prior to the announced change of policy, the Texas Comptroller took the position that (i) purchases of tangible personal property and services under a single contract were taxable even if invoiced separately, and (ii) purchases of tangible personal property and services which were contracted for separately, but invoiced on a single invoice, were taxable.

The Comptroller articulated a revised policy in the September 2001 Tax Policy News with regard to whether a mixed transaction can be separated into taxable and non-taxable elements:

If there is a fixed and ascertainable relationship between the values of tangible personal property and of the nontaxable service, and each is a significant element capable of a separate and distinct transaction, then the sale should be treated as two separate transactions. A separately-stated charge for the nontaxable service is not taxable. A lump-sum charge for the bundled transaction is presumed to be taxable, but this presumption may be overcome by the submission of appropriate documentation to retroactively break out charges for tangible personal property and nontaxable service.

The Comptroller’s change in policy was prompted by the decision in San Antonio SMSA Limited Partnership v. Rylander, 11 S.W.3d 484 (Tex. App. – Austin 2000). This case involved the taxability of line-engineering services rendered in connection with telecommunications equipment, where both services and equipment were sold under a single contract. The services at issue were engineering services to configure and interconnect equipment purchased to update a mobile telephone network operated by Southwestern Bell Mobile Systems, Inc. The court found that these line-engineering services were commonly provided on a stand-alone basis and that the price of the equipment was not affected by acquiring these services from a different vendor. AT&T had separately stated the charges for engineering and the equipment, but the charges were shown on a single invoice. Because of the single invoice, the Comptroller argued that the engineering services were part of the sale of the equipment with the consequence that the entire transaction was taxable. The court concluded, however, that when a mixed transaction could be readily separated into two elements, then the two elements should be analyzed as separate transactions for tax purposes.

The recent change in policy may affect how companies purchase software and related services. When planning new transactions, consideration should be given to clearly segregating taxable and non-taxable services and license fees to avoid incurring excess Texas sales and use tax.

It is especially important to analyze all of the different elements of the services and to identify those that are not subject to Texas sales and use tax. In some cases, it might also be advisable to confirm with the software provider that it offers its implementation and consulting services separately and on a "stand alone" basis if its software is purchased from authorized resellers.

There is also the possibility of tax refunds on completed transactions. We recommend that companies review prior transactions to determine if they should pursue refunds based on a retroactive fragmenting of a mixed transaction into taxable and non-taxable components. Examples of transactions that might yield significant refund claims could include ERP licenses and the related integration services, and services and equipment upgrades related to Y2K compliance. These transactions would typically include (i) purchases of hardware (e.g., computer mainframes and desktops, networking equipment, telecommunications equipment) and services from the same vendor; (ii) purchases of mixed taxable and nontaxable services, such as data processing and applications programming; or (iii) contracts covering licenses of computer software and services (such as programming, implementation, integration or customization services) from the same vendor.

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