If a software company accepts a customer's tax-exemption certificate that doesn't actually fit the transaction, can it avoid the negligence penalty when the deduction is later disallowed?

Plain-English summary

Sybase, a software company, licensed its software to Presbyterian Healthcare Services in Albuquerque under a roughly $2 million deal — about $1.64 million for the site license, plus software updates, $85,000 for a year of support and technical services, shipping, and initially $102,673 in New Mexico gross receipts tax on the invoice. Presbyterian objected to the tax and handed Sybase a Type 9 nontaxable transaction certificate. Sybase accepted it, credited the tax back, and claimed a deduction. On audit, this was the only exception the Department found, and it assessed about $108,898 in gross receipts tax, $10,890 penalty, and $36,753 interest (Assessment No. 2052732).

Sybase paid the tax and interest and protested only the penalty, arguing it wasn't negligent. The Hearing Officer disagreed and upheld the penalty. The problem: a Type 9 certificate is valid only for a government or 501(c)(3)'s purchase of tangible personal property — as printed on the back of the certificate itself — and this transaction was not that.

• Software licenses aren't tangible property here. New Mexico regulations in effect since 1991 (Regulations 3(F):64 and GR 3(I):5) drew a clear line: a prepackaged software sale is tangible personal property only if the buyer can resell/transfer the license, but is a sale of a license (taxable property, not TPP) when it's nontransferable. Sybase's own agreement barred resale or transfer, so it was a license — outside the Type 9 certificate. Had Sybase simply read the Department's regulations, it could have seen this.
• Part of the deal was plainly services. The $85,000 for support and technical services wasn't a sale of any property, tangible or intangible, which should have further flagged that the Type 9 certificate didn't fit.
• "First mistake / good record" is no defense. There is no "one free bite of the apple." The penalty exists precisely to give taxpayers an incentive to understand the rules in a self-reporting system.
• "The software rules are confusing" fails too. Even if characterization is hard in the abstract, New Mexico's rules were clear, and a company that sells and services one product — software — for $2 million had a duty to investigate before accepting a tax-free certificate (Tiffany Construction).
• The advice-of-counsel defense fails. Sybase pointed to Presbyterian's own Vice-President of Legal Services. But the reliance defense (Regulation TA 69:4, example 4) requires reliance on your own competent tax professional after full disclosure — not the counterparty's lawyer, who owes his duty to the buyer and has a conflict of interest. There was also no proof he was even consulted before the audit. Tellingly, Sybase's sales office, not its tax office, made the taxability call.

What this means for you

Sellers who accept exemption or nontaxable transaction certificates

A certificate only protects you if it actually fits the transaction. Read what the certificate covers — a Type 9 is for government/charity purchases of tangible personal property only, not services or licenses — and compare it to what you're actually selling. Accepting a facially inapplicable certificate to avoid charging tax is negligence, and you (the seller) end up owing the tax plus penalty and interest. When a customer pressures you to treat a large sale as tax-free, verify it against the Department's rules first.

Software and technology companies

New Mexico taxes the sale of a license to use software as a sale of property, and a nontransferable license is not tangible personal property. Bundled support and technical services are separately taxable services. If you sell software into New Mexico, know how the Department characterizes your product before relying on any exemption, and route taxability decisions through your tax department, not your sales team.

Accountants and tax professionals

Two durable points. First, the reliance-on-advisor penalty defense (Regulation TA 69:4 / 3 NMAC 1.11.11(4)) requires reliance on the taxpayer's own competent tax professional after full disclosure — a counterparty's counsel won't do, and there's an inherent conflict. Second, a clean prior compliance record does not, by itself, negate negligence; the analysis is the totality of circumstances, including whether the taxpayer had adequate procedures to determine taxability on a material transaction.

Common questions

Q: Sybase paid the tax — why did it still owe a penalty?
A: Because the penalty is a separate charge for negligence. By accepting a Type 9 certificate that plainly didn't fit a nontransferable software license and bundled services — without checking the Department's regulations — Sybase failed to exercise ordinary business care, so the penalty was proper even though it later paid the tax.

Q: Isn't it genuinely confusing whether software is tangible property or a license?
A: The Hearing Officer acknowledged it can be a hard question generally, but found New Mexico's regulations (in effect since 1991) gave clear guidance: a nontransferable license is a sale of a license, not tangible personal property. Sybase simply didn't consult those rules.

Q: Sybase relied on a lawyer — why wasn't that a defense?
A: Because the lawyer was the customer's Vice-President of Legal Services, not Sybase's own tax counsel. The reliance defense requires reliance on your own competent tax professional after full disclosure; the customer's lawyer owes his duty to the customer and has a conflict of interest, and there was no proof he was even consulted before the audit.

Q: Does this decision apply to my situation?
A: Not directly. A Decision and Order resolves one taxpayer's protest on its specific facts and the law in effect at the time. It illustrates how New Mexico treats software licenses and exemption certificates and applies the negligence penalty, but your facts may differ.

Citations and references

Statutes and regulations:

• § 7-1-69(A) NMSA 1978 — penalty for negligent failure to pay (2% per month, up to 10%)
• § 7-9-54 NMSA 1978 — deduction for sales of tangible personal property to governments and 501(c)(3) organizations (the deduction claimed via the Type 9 certificate)
• § 7-9-47 NMSA 1978 — deduction for sale of tangible personal property for resale
• 3 NMAC 1.11.10 — definition of negligence; TA 69:4 example 4 (also 3 NMAC 1.11.11(4)) — reliance on competent tax counsel or accountant as a penalty defense
• Regulation 3(F):64 and GR 3(I):5 — when prepackaged software is a sale of tangible personal property (transferable) versus a sale of a license (nontransferable)

Case law cited:

• Tiffany Construction Co. v. Bureau of Revenue, 90 N.M. 16, 558 P.2d 1155 (Ct. App. 1976), cert. denied, 90 N.M. 255, 561 P.2d 1348 (1977) — every person has a duty to ascertain the possible tax consequences of their actions

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Sybase, Inc.
• Decision PDF: D&O 98-06

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
SYBASE, INC.
ID. NO. 02-235041-00 1 NO. 98-06
PROTEST TO ASSESSMENT NO. 2052732

DECISION AND ORDER

THIS MATTER came on for formal hearing before Gerald B. Richardson, Hearing

Officer, on January 16, 1998. Sybase, Inc., hereinafter, “Taxpayer”, was represented by Ms.

Kathy Kobayashi, Tax Manager for the Taxpayer. The Taxation and Revenue Department,

hereinafter, “Department”, was represented by Bruce J. Fort, Special Assistant Attorney General.

Based upon the evidence and the arguments presented, IT IS DECIDED AND ORDERED AS

FOLLOWS:

FINDINGS OF FACT

1. The Taxpayer is a Delaware corporation with its headquarters located in

Emeryville, California.

2. In approximately March of 1994, the Taxpayer entered into a software licensing

agreement with Presbyterian Healthcare Services of Albuquerque, New Mexico. Under the terms

of this agreement, the Taxpayer grants a perpetual, non-exclusive, non-transferable, fully paid

license to use the Taxpayer’s software at its business site. The agreement also provides that the

software remains the exclusive property of the Taxpayer.

3. On March 30, 1994, the Taxpayer invoiced Presbyterian Healthcare Services a

total of $1,953.937.22 for the software license. The invoice broke down the charges as

$1,639,595 for the site license, $122,969 for software updates, $85,000 for support and technical

services for a year, $3,700 for shipping and $102,673.22 for New Mexico gross receipts taxes.

4. After receiving the invoice, Presbyterian Healthcare Services contacted the

Taxpayer’s sales office, which handled the transaction, and disputed that the transaction was

subject to New Mexico gross receipts tax. Presbyterian Healthcare Services provided the

Taxpayer with a Type 9 nontaxable transaction certificate in support of their contention that the

transaction should not be subject to New Mexico gross receipts tax.

5. As a result of the discussions between the Taxpayer’s sales office and

Presbyterian Healthcare Services, and the acceptance by the Taxpayer of the nontaxable

transaction certificate from Presbyterian Healthcare Services, the Taxpayer’s sales office issued a

credit memo with respect to the invoice to Presbyterian Healthcare Services for the gross receipts

tax invoiced and the Taxpayer claimed a deduction from gross receipts tax upon its receipts from

its software licensing agreement with Presbyterian Healthcare Services when it filed its monthly

tax report with the Department.

6. The nontaxable transaction certificates issued by the Department have information

on the back with respect to the types of certificates and the transactions to which they apply.

With regard to Type 9 certificates, the certificate states as follows:

TYPE 9 certificates may be executed by GOVERNMENTAL
AGENCIES and 501(c)(3) ORGANIZATIONS for the purchase
of TANGIBLE PERSONAL PROPERTY ONLY. These
certificates may not be used for the purchase of services or for the
lease of property. (emphasis and capitalization in original.)

2

7. The Taxpayer did not consult with the Department to determine whether it

considered the sale of software pursuant to a software licensing agreement the sale of tangible

personal property or the sale of a license.

8. Subsequent to the transaction with Presbyterian Healthcare Services, the Taxpayer

was audited by the Department. The only audit exception picked up by the Department’s

auditors was the sale of the software license to Presbyterian Healthcare Services for which the

Taxpayer had claimed a deduction from tax.

9. As a result of the Department’s audit, on July 25, 1996 the Department mailed

Assessment No. 2052732 to the Taxpayer, assessing $108,897.88 in gross receipts tax,

$10,889.79 in penalty, and $36,753.03 in interest.

10. On August 23, 1996, the Taxpayer made a written request for a sixty day

extension of time in which to file a protest to Assessment No. 2052732.

11. The Department granted the Taxpayer’s request for an extension of time, and

granted the Taxpayer until October 23, 1996 to file its protest.

12. On October 20, 1996, the Taxpayer filed a written protest to the penalty portion

only of Assessment No. 2052732 and paid the remaining portion of the assessment.

DISCUSSION

The sole issue to be determined herein is whether the Department properly assessed the

Taxpayer penalty based upon its claim of an improper1 deduction in calculating the amount of

gross receipts tax it paid to the Department.

1
Because the Taxpayer chose not to dispute the amount of gross receipts tax assessed upon the transaction at issue,
it is proper to conclude that the Taxpayer has agreed that the transaction did not qualify for the deduction claimed
pursuant to Section 7-9-54 NMSA 1978 for the sale of tangible personal property to a 501(C)(3) organization.

3
The imposition of penalty is governed by the provisions of NMSA 1978, Section 7-1-

69(A)(1995 Repl. Pamp.), which imposes a penalty of two percent per month, up to a maximum of

ten percent:

In the case of failure, due to negligence or disregard of rules and
regulations, but without intent to defraud, to pay when due any
amount of tax required to be paid or to file by the date required a
return regardless of whether any tax is due,....

This statute imposes penalty based upon negligence (as opposed to fraud) for failure to timely pay

tax. Thus, there is no contention that the failure to report and pay taxes was based upon any

conscious attempt by the Taxpayer to underreport taxes. What remains to be determined is whether

the Taxpayer was negligent in failing to report its taxes properly. Taxpayer "negligence" for

purposes of assessing penalty is defined in Regulation 3 NMAC 1.11.10 (formerly TA 69:3) as:

1) failure to exercise that degree of ordinary business care and
prudence which reasonable taxpayers would exercise under like
circumstances;
2) inaction by taxpayers where action is required;
3) inadvertence, indifference, thoughtlessness, carelessness,
erroneous belief or inattention.

The Taxpayer argues that it was not negligent in claiming the erroneous deduction at

issue and posits several grounds in support of its argument. First, the Taxpayer argues that other

than the transaction at issue, it has had an excellent record of compliance with the tax laws of

New Mexico, the transaction at issue being its first and only instance of failure to comply with

the tax laws. Second, the Taxpayer argues it exercised ordinary business care with respect to its

handling of this transaction. This is especially so because the law is confusing with regards to

whether selling packaged software is the sale of tangible personal property or the sale of a license

to use property, and the availability of the deduction claimed in this case turns upon the nature of

what the Taxpayer sold its customer. Finally, the Taxpayer argues that it was not negligent

4
because it relied upon advice of legal counsel, in this case, an employee of Presbyterian

Healthcare Services. These arguments will be addressed individually, below.

With respect to the first argument, I have found no statutory language or case law which

supports the theory that taxpayers get one “free bite of the apple”, in the form of one opportunity

to incorrectly report taxes. At most, it may be indicative that a taxpayer exercises ordinary

business care, when viewed with the totality of circumstances surrounding a transaction,

including the procedures a taxpayer may have in place to ensure proper reporting and payment of

taxes.

In addition to there being no statutory or case law support for this argument, the argument

overlooks the purpose behind the enactment of a penalty provision for negligent failure to

properly report taxes. There are sound policy reasons for the legislature to have provided for the

imposition of penalty. A self-reporting tax system relies upon taxpayers accurately reporting their

tax liabilities to the government. There are insufficient government resources to audit every

taxpayer periodically to otherwise assure tax compliance. The imposition of penalty provides

taxpayers with an incentive to understand the tax consequences of their actions and to implement

procedures to assure that taxes are accurately reported. Otherwise, if the only consequence of an

audit and determination of underpayment of tax was the payment of the tax which was owed, it

would always advantage a taxpayer who underreports taxes, whether due to a failure to understand

the law or due to failure to have sufficient procedures in place to assure the proper payment of

taxes, to regard its obligation to properly report and pay taxes casually, and to simply pay the taxes

if the underreporting is discovered upon audit.

The Taxpayer argues that it was not negligent because it exercised the degree of ordinary

business care and prudence a reasonable taxpayer would exercise under like circumstances. One

5
of the circumstances the Taxpayer believes is significant with respect to this argument is that it

was selling packaged software and whether such a sale is treated as a sale of tangible personal

property or as the sale of a license is a complicated legal issue which affected the determination

of taxability with respect to the transaction at issue.

While the Department agreed that the characterization of what was being sold may be

considered a confusing or difficult issue, it argues that the Taxpayer had the obligation to

investigate these legal issues and to investigate how the Department treats such transactions

prior to claiming the deduction at issue. The Taxpayer response to the Department’s position is

that as a taxpayer doing business in many different states with different tax statutes and

requirements, it would be unreasonable to expect the Taxpayer to know how each state would

characterize the product it sells in order to assure compliance with the tax laws of the various

taxing jurisdictions.

Although the issue of whether the sale of pre-packaged software programs are the sale of

a tangible or the sale of a license may be the subject of disparate treatment among taxing

jurisdictions, New Mexico provides rather clear guidance on this issue through its regulations,

which have been in effect since 1991. Regulation 3(F):64 provided as follows:

When a computer company sells a pre-packaged software program
where:
1) no extraordinary services are performed in order to furnish
the program;
2) the buyer pays a fixed amount for the software package and
the license to use the software; and
3) the buyer is allowed to resell the license to use the program
with the software package itself;
such a transaction constitutes a sale of tangible personal property.
Sale of such property for resale is subject to the deduction provided
in Section 7-9-47.

6
This regulation sets out three conditions to be met for the sale of software to be the sale of

tangible personal property. The terms of the agreement at issue herein, titled a “software license

agreement” characterize the license as nontransferable. Specifically, paragraph 2.2 of the

agreement provides that:

The Program and all copies (in whole or part) shall remain the
exclusive property of Sybase and its licensors and may not be used
except as expressly authorized by this Agreement. Customer shall
not modify, reverse engineer, reverse assemble or reverse compile
any Program or part thereof, except Customer may modify date file
portions of the program as described in the user manuals.
Customer shall not Use the Program in a service bureau or time
sharing arrangement nor distribute, rent, lease or transfer the
Program to any third party. (capitalization in original).

The agreement clearly prohibits the resale of the license to use the program, thereby

contravening one of the listed requirements for the sale to be considered the sale of a tangible.

The Department had another regulation which largely mirrored the above regulation

which was also in effect at the time of the transaction at issue. Regulation GR 3(I):5 provided as

follows:

The definition of property includes licenses. The sale of a
license to use software constitutes a sale of property and comes
within the definition of gross receipts.
The transaction constitutes a sale of a license to use the
software program when a computer software company sells an
already developed software program where:
1) no extraordinary services are performed in order to furnish
the program,
2) the buyer pays a fixed amount for the license to use the
program and use is generally limited to a specific computer,
and
3) the buyer may not resell to any other person a license to use
the program and may not transfer the software package
itself to any other person.

Application of this regulation to the transaction at issue would also result in the conclusion that

the Taxpayer was selling a license to use a software program, which, although constituting the

7
sale of property for gross receipts tax purposes, is different than the sale of tangible personal

property.

With these regulations in place, had the Taxpayer consulted the Department’s regulations,

it could have readily determined that its receipts from Presbyterian Healthcare Services did not

meet the requirements for the use of a Type 9 nontaxable transaction certificate, which are

explicitly stated on the back of the certificate, which provides:

TYPE 9 certificates may be executed by GOVERNMENTAL
AGENCIES and 501(c)(3) ORGANIZATIONS for the purchase
of TANGIBLE PERSONAL PROPERTY ONLY. These
certificates may not be used for the purchase of services or for the
lease of property. (emphasis and capitalization in original).

It should have also been obvious to the Taxpayer that a portion of the sale was not the sale of any

type of property, tangible or intangible. The invoice broke down the components of the sale, and

one of the line items was $85,000 for “alliance support contacts”. The invoice further stated that

the “software support period” was March 29, 1994 to March 28, 1995. Paragraph 3.2 of the

software license agreement requires that the customer purchase technical support for the first year

for all licenses and paragraph 5 characterizes technical support as “support and technical

services”. Thus, the Taxpayer was clearly selling services to Presbyterian Healthcare Services in

addition to the software. This should have further alerted the Taxpayer to the inapplicability of

the Type 9 nontaxable transaction certificate to the sale at issue. With such obvious

discrepancies between the nontaxable certificate tendered and the type of transaction involved, a

person exercising ordinary business care should not have accepted the certificate to shield the

transaction from the application of tax.

This leads us to the Taxpayer’s argument that it is unreasonable to expect a taxpayer

engaging in business in many states to know and understand the tax laws of every taxing

8
jurisdiction. While I do not purport to know how other taxing jurisdictions address this issue, the

law in New Mexico with respect to taxpayers doing business in New Mexico is well established.

New Mexico has a self-reporting tax system which requires that taxpayers voluntarily report and

pay their tax liabilities to the state. Because of this, the case law is well settled that every person is

charged with the reasonable duty to ascertain the possible tax consequences of his actions, and the

failure to do so has been held to amount to negligence for purposes of the imposition of penalty

pursuant to Section 7-1-69 NMSA 1978. Tiffany Construction Co. v. Bureau of Revenue, 90 NM

16, 558 P.2d 1155 (Ct. App. 1976), cert. denied, 90 N.M. 255, 561 P.2d 1348 (1977). It is also

noteworthy that the transaction at issue was not a small and insignificant transaction. This was a

$2 million sale. Considering the significant tax consequences attaching to a transaction of this size,

it does not seem unreasonable to require that taxpayers be diligent in ascertaining how such a

transaction is taxed.

This leads us to the third defense raised by the Taxpayer. The Department recognizes that it

is an indication that a taxpayer has not been negligent for purposes of the imposition of penalty

where they have made a sufficient effort to determine tax consequences, even if it should later be

determined that the answer given was wrong. Thus, Department Regulation TA 69:4 provides as

example four, that lack of negligence is indicated where:

the taxpayer proves that the failure to pay tax or to file a return was
caused by reasonable reliance on the advice of competent tax counsel
or accountant as to the taxpayer’s liability after full disclosure of all
relevant facts....

The Taxpayer argues that this provision applies to them because Presbyterian Healthcare Services’

Vice-President of Legal Services, Mr. Gene Walton, is an attorney, and the Taxpayer alleged that he

was aware of the transaction at issue.

9
There are several problems with this argument. In the first place, there was a failure of

proof on this issue because the Taxpayer’s representative at the hearing, Ms. Kobayashi, testified

that the determination of taxability with respect to the transaction at issue was made by the people

in the Taxpayer’s sales office, rather than its tax office, and Ms. Kobayashi could provide no

details of any discussions between the sales office and representatives of Presbyterian. Not only

could no details be provided, there was no evidence that Mr. Walton was even brought into any

discussions about this transaction until after the Department’s audit. Additionally, although not

explicitly stated in the regulation, I believe it is implicit in the regulations that to avail oneself of

the protection of the regulation, the attorney or accountant consulted must be the taxpayer’s

attorney or accountant. This is because only one’s own accountant or attorney would have a

professional responsibility to his or her client to provide competent advice on the issue.

Obviously, there would be no attorney-client relationship between Mr. Walton and the Taxpayer.

In fact, because Mr. Walton’s professional responsibility would be to his own client,

Presbyterian, he would be in a potential conflict of interest in offering legal advice to the

Taxpayer under the circumstances in this case because of the conflict of interest between

Presbyterian’s interest in the economic benefit of a lower purchase price if it did not include

gross receipts tax and the Taxpayer’s own interest in paying the correct amount of tax. Because

there was no evidence that the Taxpayer made the determination that the transaction at issue was

not taxable based upon consultation with their own tax professional, nor did they prove that

professional tax advice was actually received with respect to this transaction prior to their

determination that the transaction was not subject to tax, the Taxpayer has failed to establish

reliance on a tax professional as a basis for disputing the assessment of penalty.

10
Looking at the totality of the circumstances surrounding the transaction at issue, there is

ample evidence of taxpayer negligence. The Taxpayer sells and services one product, computer

software. It is not unreasonable to expect that a taxpayer engaging in a type of business know

and understand how that business is taxed in the jurisdictions in which it does business.

Although the Taxpayer argues that the characterization of what it is selling is a complicated and

confusing legal issue, the Taxpayer took no steps to resolve its confusion when its customer

requested to make its purchase tax free. The Taxpayer did not consult the Department’s

regulations, nor did it consult the Department, itself. Even the manner in which it handled the

determination of taxability internally raises questions as to the sufficiency of its procedures with

respect to resolving the issue of taxability. Apparently, the determination was made by personnel

in the Taxpayer’s sales office. The Taxpayer does have a tax office, presumably staffed with

personnel with more expertise in knowing and applying the tax laws of the jurisdictions in which

it engages in business. Those people were not consulted, however, prior to determining not to

charge tax on the transaction at issue. Instead, a certificate which, on its face would not apply to

at least a portion of the transaction at issue, was accepted as evidence that tax need not be

charged or remitted on the transaction. This amounts to the type of inadvertent error caused by

inattention or erroneous belief because of the Taxpayer’s own failure to investigate and

understand how the Department imposes tax on the product and services it sells which amounts

to negligence for purposes of imposition of penalty.

CONCLUSIONS OF LAW

1. The Taxpayer filed a timely, written protest to assessment No. 2052732 and

jurisdiction lies over both the parties and the subject matter of this protest.

11

2. The Taxpayer was negligent in failing to pay gross receipts tax upon its sale of a

license to use software and related support services to Presbyterian Healthcare Services and

penalty was properly imposed pursuant to Section 7-1-69 NMSA 1978.

For the foregoing reasons, the Taxpayer’s protest IS HEREBY DENIED.

DONE, this 29th day of January, 1998.

12