How does Illinois sales/use tax apply to a software license/maintenance agreement, including annual licensing fees and charges for updates or maintenance?

Subject

Computer Software

Plain-English summary

A taxpayer wrote to the Illinois Department of Revenue explaining that its company had a software licensing/maintenance agreement with another company dating back to about 1998, paying roughly a set dollar amount per year in software licensing fees, with invoices reflecting a State Tax due amount. The taxpayer asked what the rules are for charging tax on an agreement to lease and maintain software.

The Department responded with a General Information Letter rather than a ruling on the taxpayer's specific facts, and walked through the general framework instead.

Under the Retailers' Occupation Tax Act, Illinois taxes retailers on their gross receipts from selling tangible personal property (86 Ill. Adm. Code 130.101). Generally, sales of "canned" (pre-written) computer software are taxable retail sales, because canned software counts as tangible personal property no matter how it's delivered (tape, disc, card, electronic transmission, etc.). Custom computer programs — those prepared to the special order of a customer — may not be taxable retail sales. Simply assembling pre-written or canned programs into a software package does not make it "custom" unless real and substantial changes are made, or interfacing logic is created (86 Ill. Adm. Code 130.1935(c)(3)).

However, a software license is not a taxable retail sale, even for canned software, if the license meets all of these conditions under 86 Ill. Adm. Code 130.1935(a)(1):

• it's evidenced by a written agreement signed by the licensor and the customer;
• it restricts the customer's duplication and use of the software;
• it prohibits the customer from licensing, sublicensing, or transferring the software to a third party (other than a related party) without the licensor's permission and continued control;
• the licensor has a policy of providing a replacement copy at minimal or no charge if the software is lost or damaged (or lets the licensee keep an archival copy), documented in the agreement, the licensor's books and records, or a notarized statement; and
• the customer must destroy or return all copies of the software to the licensor at the end of the license period (this is automatically deemed satisfied for a perpetual license).

If all five conditions are met, neither the initial transfer of the software nor subsequent software updates are subject to Retailers' Occupation Tax.

On maintenance agreements, the Department explained that agreements covering computer software are generally treated the same as maintenance agreements for other tangible personal property (86 Ill. Adm. Code 130.1935(b) and 140.301(b)(3)). If maintenance/repair charges are bundled into the selling price of the tangible personal property, those charges are part of the taxable gross receipts, and no separate tax applies later when the maintenance is actually performed. If a maintenance/repair agreement is sold separately from the property, the sale of the agreement itself is not a taxable transaction — but the service/repair company then incurs Use Tax on its cost price of any parts transferred to the customer while performing the maintenance.

For software specifically, the letter draws a distinction between (1) a "patch" or "bug fix" — a piece of object code that corrects an error or defect — which is taxed under the general maintenance-agreement rules described above, and (2) charges for "updates" that are new releases or versions of canned software with product enhancements, which are always fully taxable as sales of canned software under Section 130.1935(b) (unless the update itself qualifies as custom software). If a maintenance agreement bundles charges for canned-software updates together with other charges (training, phone support, installation, consultation, etc.) without separately stating and taxing the update charges, the Department treats the entire agreement as taxable as a sale of canned software.

The letter does not apply this framework to the taxpayer's specific facts (e.g., it doesn't say whether the taxpayer's own 1998 agreement is a qualifying license or whether the annual fees are for updates versus a bug fix) — it is limited to describing the general rules, consistent with its status as a GIL rather than a Private Letter Ruling.

What this means for you

Businesses licensing or leasing software

If your business licenses canned (non-custom) software, check whether your license agreement satisfies all five conditions in 86 Ill. Adm. Code 130.1935(a)(1) (written agreement, duplication/transfer restrictions, replacement-copy policy, and return/destroy-at-end-of-term terms). If it does, the license itself and subsequent updates delivered under it are not subject to Retailers' Occupation Tax. If your agreement doesn't meet all five conditions, the software is more likely to be treated as a taxable sale of canned software.

Businesses with software maintenance or update agreements

Look closely at how your invoices break out charges. Under this GIL's reasoning, a maintenance agreement bundled into the original purchase price is taxed upfront (with no further tax when service is performed), while a separately sold maintenance agreement is untaxed at sale (though the servicer may owe Use Tax on parts used). Critically, if your maintenance agreement includes charges for canned-software updates that are not separately stated and taxed apart from other services (training, phone support, installation, consultation), the Department's position is that the whole agreement becomes taxable as a sale of canned software.

Anyone relying on this letter

This is a General Information Letter (GIL), not a Private Letter Ruling (PLR). A GIL only points taxpayers to relevant regulations and is not a statement of Department policy and is not binding on the Department (2 Ill. Adm. Code 1200.120). The Department did not rule on the taxpayer's specific invoices or agreement — it described the general legal framework. A taxpayer wanting a binding answer on their own facts would need to request a PLR under the procedures in 2 Ill. Adm. Code 1200.110.

Common questions

Q: Is software subject to Illinois sales/use tax?
A: Generally, yes for "canned" (pre-written) computer software, which is treated as tangible personal property regardless of how it's delivered (disc, card, electronic transmission, etc.). Custom software prepared to a customer's special order may not be a taxable retail sale.

Q: Can a software license avoid Illinois tax entirely?
A: Yes, if the license meets all five conditions in 86 Ill. Adm. Code 130.1935(a)(1): a signed written agreement, restrictions on duplication/use, restrictions on sublicensing/transfer without the licensor's control, a replacement-copy policy, and a requirement to return or destroy all copies at the end of the license (automatically satisfied for perpetual licenses). If all five are met, neither the license nor later software updates are taxed.

Q: Are charges for software maintenance agreements taxable?
A: It depends on how the charges are structured. If maintenance charges are included in the software's selling price, they're taxed upfront as part of that sale. If the maintenance agreement is sold separately, the agreement itself isn't taxed, but the servicer may owe Use Tax on parts used while performing service.

Q: What's the difference between a "patch" or "bug fix" and an "update" for tax purposes?
A: A patch or bug fix (object code correcting an error/defect) is taxed under the general maintenance-agreement rules described above. An "update" — a new release or version with product enhancements — is fully taxable as a sale of canned software under 86 Ill. Adm. Code 130.1935(b), regardless of the general maintenance rules, unless the update itself qualifies as custom software.

Q: What happens if update charges aren't separately stated from other maintenance charges?
A: The Department's position is that if a maintenance agreement provides for canned-software updates and the charges for those updates aren't separately stated and taxed apart from other charges (training, phone assistance, installation, consultation, etc.), the entire agreement is treated as taxable as a sale of canned software.

Q: Did the Department decide whether this specific taxpayer's agreement is taxable?
A: No. This is a General Information Letter, so the Department described the general rules on canned vs. custom software and maintenance-agreement taxation rather than applying them to the taxpayer's specific 1998 agreement or invoices. It is not binding on the Department and is not a statement of Department policy.

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/sales-tax/2018.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/sales-tax/2018/st-18-0027-gil.pdf

Original ruling text

ST 18-0027-GIL 11/19/2018

COMPUTER SOFTWARE

This letter references the Department’s administrative rules on computer software and
maintenance agreements. See 86 Ill. Adm. Code 130.1935. (This is a GIL.)

November 19, 2018

Dear Xxxxx:
This letter is in response to your letter dated October 1, 2018, in which you requested
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:
I have a question about tax on the following invoices.
COMPANY has had a software agreement with COMPANY 1 since about 1998.
We pay approximately $$$ per year for software licensing fees. Invoices reflect a State
Tax due amount.
What are the laws for charging taxes when you have an agreement to lease and
maintain software?

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

ST 18-0027-GIL
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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).
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 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

ST 18-0027-GIL
Page 3

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.
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,

Richard S. Wolters
Associate Counsel

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