Are an out-of-state software company's analysis, adaptation, training, and license fees taxable in Connecticut?

Plain-English summary

An out-of-state software company sold a product used to develop custom software on midrange computers. For each customer it analyzed the customer's requirements and adapted the program so it would run on that customer's system, then licensed the product under an agreement that barred the customer from copying, licensing, sublicensing, or transferring it and required the software to be destroyed or returned when the license ended. It also offered an optional maintenance agreement — telephone support, user-group conferences, software upgrades, and general support. Although it had no Connecticut office, it sent employees into Connecticut to solicit orders, analyze customer needs, and run training sessions. DRS was asked which of these charges are taxable.

Taxable: the services. The company's analysis of customer requirements, its program adaptations, and its training fall within the regulatory definition of computer and data processing services — "designing, implementing or converting systems" and "providing consulting services" — and are taxable under Conn. Gen. Stat. § 12-407(2)(i)(A) and Conn. Agencies Regs. § 12-426-27(b)(1). All of the maintenance features (telephone support, user-group conferences, upgrades, support and assistance) are taxable computer and data processing services too.

Not a sale. The license didn't transfer ownership. Borrowing Black's Law Dictionary's definition of a "sale" (a transfer of "the general and absolute title," not "a special interest falling short of complete ownership"), DRS found the restrictions on copying and transfer, plus the destroy-or-return requirement, gave the customer only permission to use the software for a limited time — a special interest short of ownership. So there was no taxable sale.

Not a taxable lease either — custom software is intangible. A lease is taxable only if it's a lease of tangible personal property (§ 12-407(2)(j)). But Connecticut courts (Northeast Datacom v. City of Wallingford; Grolier Enterprises v. Groppo) hold that custom computer software is intangible personal property. So licensing custom software is not a taxable lease of tangible personal property.

The bottom line on the license fee. A fee for the mere license to use and possess custom software, by itself, is not taxable — but only to the extent it is separately stated from the charges for taxable services. If the license fee includes taxable services and the charges aren't separated, then the entire charge is presumed taxable, subject to the taxpayer's ability to rebut that presumption.

Nexus / who collects. Computer and data processing services are taxed where they are delivered or used. Because the company rendered services in Connecticut it was "engaged in business" here (§ 12-407(15)(c)), and the presence of its employees established the physical presence then required under National Bellas Hess and Quill. So it had to register to collect and remit Connecticut use tax on services its Connecticut customers received. (That physical-presence nexus standard has since been overtaken by later developments in nexus law — see the disclaimer.)

This Ruling is cited in Rulings 93-13, 94-3, and 95-2.

What this means for you

Separate your service charges from your license fee

This ruling is a strong reason to itemize. In Connecticut, the services around custom software — needs analysis, adaptation/implementation, training, and maintenance — are taxable computer and data processing services, while a pure license to use and possess custom software is not. If you bundle them into one price, DRS can treat the entire charge as taxable unless you can rebut that presumption. A clearly separated license line preserves the non-taxable treatment.

Custom software vs. the services around it

The non-taxable piece here is narrow: the license of custom (intangible) software itself. The moment you're paid to analyze, adapt, implement, convert, consult, train, or maintain, you're likely selling a taxable computer and data processing service. Characterize each line of your invoice accordingly.

Out-of-state sellers can still owe Connecticut collection duties

Sending employees into Connecticut to sell, analyze, or train can make an out-of-state provider "engaged in business" here and obligate it to collect Connecticut use tax on services used in the state. Note, though, that the nexus threshold has changed since 1993 — the physical-presence rule the ruling applied is no longer the whole story, so confirm current nexus law for your footprint.

Common questions

Q: Is licensing custom software taxable in Connecticut?
A: Under this ruling, a fee for the mere license to use and possess custom software is not taxable — provided it's separately stated. But the analysis, adaptation, training, and maintenance services around that software are taxable computer and data processing services.

Q: Why isn't the license a taxable "lease of tangible personal property"?
A: Because Connecticut courts treat custom software as intangible personal property, and only leases of tangible personal property are taxable. The license also isn't a "sale," because the customer never gets ownership.

Q: What happens if I don't separate the license fee from the services?
A: DRS said that if a license fee includes taxable services and the charges aren't separated, the entire charge is presumed taxable, and the burden is on the taxpayer to rebut that.

Q: Does an out-of-state company have to collect Connecticut tax?
A: This ruling said yes for a company whose employees came into Connecticut, applying the physical-presence nexus rule of its day. That rule has since been superseded — check current Connecticut nexus law for your situation.

Citations and references

Statutes and regulations:

• Conn. Gen. Stat. § 12-407(2)(i)(A) (computer and data processing services); § 12-407(2)(j) (lease or rental of tangible personal property); § 12-411(3), (8) (use tax collection by out-of-state providers); § 12-407(15)(c) ("engaged in business")
• Conn. Agencies Regs. § 12-426-27(b)(1) (definition of computer and data processing services); § 12-426-27(b)(11)(k) ("includes" is not exclusive)

Case law (as cited by the ruling):

• Northeast Datacom, Inc. v. City of Wallingford, 212 Conn. 639 (1989); Grolier Enterprises, Inc. v. Groppo, No. CV 87-0331744S (Super. Ct. Feb. 26, 1992) (custom software is intangible)
• AirKaman, Inc. v. Groppo, 221 Conn. 751 (1992); National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967); Cally Curtis Co. v. Groppo, 214 Conn. 292 (1990); SFA Folio Collections, Inc. v. Bannon, 217 Conn. 220 (1991); Quill Corp. v. North Dakota, 504 U.S. ___ (1992)

Related guidance (described in prose, not linked):

• Rulings 93-13, 94-3, 95-2 (cite this Ruling)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 93-1

Original ruling text

Ruling 93-1, Sales and Use Taxes / Computer and Data Processing Services

This Ruling has been cited in Ruling 93-13 , 94-3 , 95-2

FACTS:

A business located outside Connecticut (hereinafter "the Company") designs and markets a computer software product (hereinafter "the Software Product"). The Software Product is intended to be used in the process of developing custom software in midrange computers.

The Company analyzes a customer's requirements and makes necessary program adaptations to facilitate the customer's use of the Software Product on the customer's central processing unit. The Company conveys the Software Product to the customer under a licensing agreement. This licensing agreement restricts the customer from duplicating, licensing, sublicensing or transferring the Software Product to a third party. The Software Product is to be destroyed or returned to the Company upon termination of the license period.

The Company also offers an optional maintenance agreement with the Software Product. The maintenance provided includes telephone support, user group conferences, software upgrades and general support and assistance in response to temporary difficulties with the Software Product.

Although the Company does not maintain an office in Connecticut, it sends personnel into Connecticut from its regional office to solicit orders for the Software Product, to analyze the customer's individual requirements and to conduct training sessions.

ISSUE:

Whether any or all of the Company's charges for its activities with respect to its Connecticut customers are subject to sales and use taxes.

DISCUSSION:

The Sales and Use Taxes Act, Conn. Gen. Stat. §12-406 et seq. , imposes sales and use taxes, inter alia , on certain enumerated services. Conn. Gen. Stat. §12-407 provides in pertinent part:

(2) "Sale" and "selling" mean and include: . . . (i) the rendering of certain services for a consideration, exclusive of such services rendered by an employee for his employer, as follows: (A) Computer and data processing services, including but not limited to, time . . .

Conn Agencies Regs. §12-426-27(b)(1) defines computer and data processing services as follows:

Such services mean and include providing computer time, storing and filing of information, retrieving or providing access to information, designing, implementing or converting systems, providing consulting services, and conducting feasibility studies. The transfer of dominion and control of computer hardware and software for a consideration does not come within the purview of this section, since such transfer shall constitute a lease or rental of tangible personal property and be subject to tax under Section 12-426-25.

The list of services provided in the regulatory definition is meant to be illustrative, but not all-inclusive. As is noted elsewhere in the regulation:

The term "includes" when used in a definition contained in this regulation shall not be deemed to exclude other things otherwise within the meaning of the term defined.

Conn. Agencies Regs. §12-426-27(b)(11)(k). See also AirKaman, Inc. v. Groppo , 221 Conn. 751, 759 (1992).

The Company's analysis of its customers' requirements and the making of the necessary program adaptations, as well as any training that it provides to its customers, fall within the definitional language in the regulation of "designing, implementing or converting systems," and "providing consulting services," and are taxable computer and data processing services. All of the features provided under the maintenance agreement, including telephone support, user group conferences, software upgrades and general support and assistance in response to temporary difficulties, are taxable computer and data processing services as well.

The Company's licensing agreement, including as it does restrictions on duplication, licensing, sublicensing or transferring of the Software Product by the customer, and the requirement that the Software Product be destroyed or returned to the Company upon termination of the licensing period, does not confer sufficient indicia of ownership of or title to the Software Product upon the customer to rise to the level of a sale.

Black's Law Dictionary, 5th Ed., defines a "sale" as

[a] contract whereby property is transferred from one person to another for a consideration of value, implying the passing of the general and absolute title, as distinguished from a special interest falling short of complete ownership.

Id. , at 1200.

The licensing arrangement between the Company and its customers is merely permission to use the Software Product for a limited duration, with restrictions on its alienation, and is a "special interest falling short of complete ownership." Id. Therefore, a "sale" of the Software Product has not taken place.

The question remains whether this licensing of custom software is taxable, either as a lease of tangible personal property or as a computer and data processing service. If the license were construed as a lease or rental of the Software Product, it would only be taxable if the software is considered "tangible," since Conn. Gen. Stat. §12-407(2)(j) imposes sales and use taxes upon "the leasing or rental of tangible personal property of any kind whatsoever . . ." Such is not the case. Notwithstanding the last sentence of Conn. Agencies Regs. §12-426-27(b)(1), supra , the courts of this state in  Northeast Datacom, Inc, et al. v. City of Wallingford , 212 Conn. 639 (1989), and more recently in Grolier Enterprises, Inc. v. Groppo , No. CV 87-0331744S (Super. Ct. February 26, 1992), have held that custom computer software is intangible personal property.

As previously indicated, the processes of creating, designing and developing custom software, or of adapting existing software to the particular needs of a customer, including analysis of a customer's needs and consultation and training in the use of software, are considered to be taxable computer and data processing services. However, a fee for a mere license to use and possess software, without more, is not taxable, to the extent that such fee can be stated separately from the charge for clearly taxable services. But if a licensing fee includes taxable services, and the charges are not so separated, then the entire charge is presumed to be taxable, subject to the taxpayer's ability to rebut the presumption.

In Connecticut, computer and data processing services are deemed taxable at the location where they are delivered or intended for use. An out-of-state service provider engaged in business in this state is required to register to collect and remit use tax to Connecticut on behalf of customers who receive and use services in this state; Conn. Gen. Stat. §12-411(3) and (8). "Engaged in business" is defined to include "rendering in this state any service described in any of the subdivisions of [§12-407(2)] . . ."; Conn. Gen. Stat. §12-407(15)(c). Therefore, with respect to any of the Company's customers who are located in Connecticut, the Company is "engaged in business" here, as that term is used in the statutes. Further, the presence of the Company's employees in Connecticut for the purpose of selling its services and products and training or otherwise contributing to its services firmly establishes the Company's physical presence in the state, as required by National Bellas Hess, Inc. v. Department of Revenue of Illinois , 386 U.S. 753, 18 L.Ed.2d 505 (1967). This physical presence "nexus" requirement has been acknowledged and adhered to by the Supreme Court of this state in Cally Curtis Company v. Groppo , 214 Conn. 292 (1990) and SFA Folio Collections, Inc. v. Bannon , 217 Conn. 220 (1991), and recently affirmed by the U.S. Supreme Court in Quill Corporation v. North Dakota , 504 U.S. ---, 119 L.Ed.2d 91 (1992).

RULING:

The fees for the analysis of a customer's needs and any necessary program adaptations to facilitate a customer's use of a computer software product, and for consultation with and training of the customer in the use of the product, as well as for maintenance of the software product through the use of telephone support service, user group conferences, software upgrades and support and assistance with difficulties with the software are all taxable as "computer and data processing services" pursuant to Conn. Gen. Stat. §12-407(2)(i)(A) and Conn. Agencies Regs. §12-426-27(b)(1), if the benefit of the services is received in Connecticut. Licensing fees, if they are for the mere use and possession of custom computer software, are not subject to tax, either as a sale or lease of property or as a service, provided such fees can be stated separately from charges for taxable computer and data processing services.

LEGAL DIVISION

April 6, 1993