When is Illinois sales tax due on computer software licenses and software maintenance agreements?

Plain-English summary

Illinois taxes "canned" (prewritten) computer software as tangible personal property, but a properly structured software license and a genuinely optional maintenance agreement can escape tax. This GIL responded to a value-added reseller that had been told by an auditor its maintenance agreements were exempt and wanted the rules confirmed.

Canned vs. custom software

• Canned software is taxable tangible personal property regardless of how it is transferred — tape, disc, card, electronic download, or other media.
• Custom software (prepared to the customer's special order) may not be a taxable retail sale. Simply selecting and assembling prewritten programs into a package is not custom software unless real and substantial changes are made or program-interfacing logic is created (86 Ill. Adm. Code 130.1935(c)(3)).

When a software license is not taxed

A license to use canned software is not a taxable retail sale if the agreement meets all five criteria in 86 Ill. Adm. Code 130.1935(a)(1):

1. it is evidenced by a written agreement signed by the licensor and the customer;
2. it restricts the customer's duplication and use of the software;
3. it prohibits the customer from licensing, sublicensing, or transferring the software to a third party (except a related party) without the licensor's permission and continued control;
4. the licensor has a policy of providing another copy at minimal or no charge if the customer loses or damages the software, or of permitting an archival copy (stated in the agreement, supported by the licensor's books and records, or a notarized statement); and
5. the customer must destroy or return all copies of the software at the end of the license period (deemed met for a perpetual license without being stated).

Maintenance agreements

Under 86 Ill. Adm. Code 140.301, an optional maintenance agreement or extended warranty is generally not a taxable transaction. Instead, the service provider incurs use tax on its cost price of any tangible personal property it transfers to the customer to complete the service (140.301(b)(3)). A patch or bug fix inserted to correct a defect is handled the same way (provider owes tax on the item transferred).

There is an important exception. If a maintenance agreement includes charges for updates of canned software — new releases or versions that replace an older version with enhancements — those update charges are fully taxable as sales of software under 130.1935(b). If the update charges are not separately stated and taxed from charges for training, telephone assistance, installation, consultation, or other maintenance services, then the whole agreement is taxable as a sale of canned software. (Updates that qualify as custom software may not be taxable.)

Common questions

Q: Is downloaded software tax-free because nothing physical changes hands?

A: No. Canned software is taxable regardless of the medium, including electronic delivery.

Q: How do I keep a software license from being taxed?

A: The license must meet all five criteria in 130.1935(a)(1). Missing any one can make the transfer a taxable sale.

Q: Are my maintenance agreements taxable?

A: An optional maintenance agreement is generally not taxable, but if it bundles in canned-software updates without separately stating and taxing those update charges, the entire agreement becomes taxable.

Q: What about bug fixes versus version updates?

A: A patch or bug fix is treated like other items transferred under a maintenance agreement (provider owes use tax on the item). Charges for new releases/versions of canned software are fully taxable as software sales.

Citations and references

• 86 Ill. Adm. Code 130.1935 — computer software; (a)(1) five-criteria license test; (b) canned software; (c) custom software
• 86 Ill. Adm. Code 140.301 — maintenance agreements; (b)(3) use tax on tangible items transferred

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/sales-tax/2014.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/sales-tax/2014/st-14-0017.pdf

Original ruling text

ST 14-0017-GIL 04/04/2014 COMPUTER SOFTWARE
This letter discusses the taxability of computer software licenses and maintenance agreements. See 86 Ill. Adm.
Code 130.1935 and 86 Ill. Adm. Code 140.301. (This is a GIL.)

April 4, 2014
Dear Xxxxx:
This letter is in response to your letter dated January 24, 2014, in which you request
information. The Department issues two types of letter rulings. Private Letter Rulings (“PLRs”) are
issued by the Department in response to specific taxpayer inquiries concerning the application of a
tax statute or rule to a particular fact situation. A PLR is binding on the Department, but only as to the
taxpayer who is the subject of the request for ruling and only to the extent the facts recited in the PLR
are correct and complete. Persons seeking PLRs must comply with the procedures for PLRs found in
the Department’s regulations at 2 Ill. Adm. Code 1200.110. The purpose of a General Information
Letter (“GIL”) is to direct taxpayers to Department regulations or other sources of information
regarding the topic about which they have inquired. A GIL is not a statement of Department policy
and is not binding on the Department. See 2 Ill. Adm. Code 1200.120. You may access our website
at www.tax.illinois.gov to review regulations, letter rulings and other types of information relevant to
your inquiry.
The nature of your inquiry and the information you have provided require that we respond with
a GIL. In your letter you have stated and made inquiry as follows:
We have recently undergone a State of Illinois sales tax audit and the auditor involved
found that our maintenance agreements were tax exempt. However, we think it
advisable to have a letter from the Department validating that finding before announcing
the taxability of maintenance agreements to our clients in Illinois.
Therefore, we would like to request a Letter of Ruling regarding Illinois Sales and Use
Tax on Computer Software and Hardware Maintenance agreements to Credit Unions.
We are a value added reseller of technology-related equipment, software, etc. We also
sell maintenance agreements for the products we sell and maintain staff in Indiana to
provide service and support on those products.
In reviewing the Illinois regulations regarding sales tax on maintenance agreements, we
were left unclear about exactly whether or not our maintenance agreements are subject
to sales tax. We found 5 criteria that we understand to be used to determine whether or
not computer maintenance agreements are taxable and we cite areas in our purchase
agreements that we believe fulfill these criteria for tax exemption:
A)

it is evidenced by a written agreement signed by the licensor and the
customer;

• We have this with every customer.

B)

it restricts the customer’s duplication and use of the software;

• we are covered here by this provision.

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April 4, 2014

7.1

C)

it prohibits the customer from licensing, sublicensing or transferring the
software to a third party (except to a related party) without the permission
and continued control of the licensor;

• we are covered here by this provision.
  3.1

D)

License. During the term of this Agreement, COMPANY grants to
Customer and Customer accepts from COMPANY, a nonexclusive, nontransferable, license to use the Software Products
and Enhancements at the Installation Site and on the Equipment.

the licensor has a policy of providing another copy at minimal or no charge
if the customer loses or damages the software, or of permitting the
licensee to make and keep an archival copy, and such policy is either
stated in the license agreement, supported by the licensor’s books and
records or supported by a notarized statement made under penalties of
perjury by the licensor; and

• we are covered her by this provision.
  7.1

E)

Software Products, Enhancements and New Products.
Customer agrees that COMPANY owns the exclusive proprietary
rights in the Software Products, Service Bureau, Enhancements
and New Products. Customer agrees to avoid any action which
might diminish the proprietary rights of COMPANY in the Software
Products, Service Bureau, Enhancements and New Products.
Without limiting the foregoing, Customer agrees that it will not
make or have made any copies of the Software Products,
Enhancements for New Products, or any part thereof, except
as necessary for its own internal use. Customer shall cause all
such copies to bear affixed copyright or other proprietary notices.

Software Products, Enhancements and New Products.
Customer agrees that COMPANY owns the exclusive proprietary
rights in the Software Products, Service Bureau, Enhancements
and New Products. Customer agrees to avoid any action which
might diminish the proprietary rights of COMPANY in the Software
Products, Service Bureau, Enhancements and New Products.
Without limiting the foregoing, Customer agrees that it will not make
or have made any copies of the Software Products, Enhancements
for New Products, or any part thereof, except as necessary for its
own internal use. Customer shall cause all such copies to bear
affixed copyright or other proprietary notices.

the customer must destroy or return all copies of the software to the
licensor at the end of the license period. The provision is deemed to be
met, in the case of a perpetual license, without being set forth in the
license agreement.
-

we are covered here by this provision.

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April 4, 2014

3.4

Termination of License. The License granted by this Agreement
shall terminate simultaneously with this Agreement.
Upon
termination of the License, Customer agrees:
3.4.1 to destroy the Software Products (and any permitted
internal use copies) and certify to COMPANY in writing that
such destruction has taken place; and

We appreciate your time and assistance.
DEPARTMENT’S RESPONSE:
The Illinois Retailers’ Occupation Tax Act imposes a tax upon persons engaged in this State in
the business of selling tangible personal property to purchasers for use or consumption. See 86 Ill.
Adm. Code 130.101. The tax is measured by the seller's gross receipts from retail sales made in the
course of such business. "Gross receipts" means the total selling price or the amount of such sales.
The retailer must pay Retailers' Occupation Tax to the Department based upon its gross receipts, or
actual amount received, from the sale of the tangible personal property.
Generally, sales of “canned” computer software are taxable retail sales in Illinois. Canned
computer software is considered to be tangible personal property regardless of the form in which it is
transferred or transmitted, including tape, disc, card, electronic means, or other media. However, if
the computer software consists of custom computer programs, then the sales of such software may
not be taxable retail sales. 86 Ill. Adm. Code 130.1935. Computer software that is not custom
software is considered to be canned computer software, whether it is “stand-alone” or not. Custom
computer programs or software are prepared to the special order of the customer. The selection of
pre-written or canned programs assembled by vendors into software packages does not constitute
custom software unless real and substantial changes are made to the programs or creation of
program interfacing logic. See Section 130.1935(c)(3). The criteria you reference in your letter is
evaluated to determine whether a computer software license is taxable. It is not necessarily
indicative of the taxability of maintenance agreements.
If transactions for the licensing of computer software meet all of the criteria provided in
subsection (a)(1) of Section 130.1935, neither the transfer of the software nor the subsequent
software updates will be subject to Retailers' Occupation Tax. A license of software is not a taxable
retail sale if:
A)

It is evidenced by a written agreement signed by the licensor and the customer;

B)

It restricts the customer’s duplication and use of the software;

C)

It prohibits the customer from licensing, sublicensing or transferring the software to a
third party (except to a related party) without the permission and continued control of the
licensor;

D)

The licensor has a policy of providing another copy at minimal or no charge if the
customer loses or damages the software, or permitting the licensee to make and keep
an archival copy, and such policy is either stated in the license agreement, supported by

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April 4, 2014
the licensor’s books and records, or supported by a notarized statement made under
penalties of perjury by the licensor; and
E)

The customer must destroy or return all copies of the software to the licensor at the end
of the license period. This provision is deemed to be met, in the case of a perpetual
license, without being set forth in the license agreement.

In general, maintenance agreements that cover computer software are treated the same as
maintenance agreements for other types of tangible personal property. See 86 Ill. Adm. Code
130.1935(b). The taxation of maintenance agreements is discussed in subsection (b)(3) of Section
140.301 of the Department’s administrative rules under the Service Occupation Tax Act. See 86 Ill.
Adm. Code Sec. 140.301(b)(3). The taxability of agreements for the repair or maintenance of
tangible personal property depends upon whether charges for the agreements are included in the
selling price of the tangible personal property. If the charges for the agreements are included in the
selling price of the tangible personal property, those charges are part of the gross receipts of the retail
transaction and are subject to tax. In those instances, no tax is incurred on the maintenance services
or parts when the repair or servicing is performed. A manufacturer’s warranty that is provided without
additional cost to a purchaser of a new item is an example of an agreement that is included in the
selling price of the tangible personal property.
If agreements for the repair or maintenance of tangible personal property are sold separately
from tangible personal property, sales of those agreements are not taxable transactions. However,
when maintenance or repair services or parts are provided under those agreements, the service or
repair companies will be acting as service providers under provisions of the Service Occupation Tax
Act that provide that when service providers enter into agreements to provide maintenance services
for particular pieces of equipment for stated periods of time at predetermined fees, the service
providers incur Use Tax based on their cost price of tangible personal property transferred to
customers incident to the completion of the maintenance service. See 86 Ill. Adm. Code
140.301(b)(3). The sale of an optional maintenance agreement or extended warranty is an example
of an agreement that is not generally a taxable transaction.
If, under the terms of a maintenance agreement involving computer software, a software
provider provides a piece of object code (“patch” or “bug fix”) to be inserted into an executable
program that is a current or prior release or version of its software product to correct an error or
defect in software or hardware that causes the program to malfunction, the tangible personal property
transferred incident to providing the patch or bug fix is taxed in accordance with the provisions
discussed above.
In contrast to a patch or bug fix, if the sale of a maintenance agreement by a software provider
includes charges for updates of canned software, which consist of new releases or new versions of
the computer software designed to replace an older version of the same product and which include
product enhancements and improvements, the general rules governing taxability of maintenance
agreements do not apply. This is because charges for updates of canned software are fully taxable as
sales of software under Section 130.1935(b). (Please note that if the updates qualify as custom
software under Section 130.1935(c) they may not be taxable). Therefore, if a maintenance agreement
provides for updates of canned software, and the charges for those updates are not separately stated
and taxed from the charges for training, telephone assistance, installation, consultation, or other
maintenance agreement charges, then the whole agreement is taxable as a sale of canned software.

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April 4, 2014

I hope this information is helpful. If you require additional information, please visit our website
at www.tax.illinois.gov or contact the Department’s Taxpayer Information Division at (217) 782-3336.
Very truly yours,

Cara Bishop
Associate Counsel

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