Is software licensing, plus separately stated charges for customization, testing, training, and maintenance, subject to New York sales and use tax?

Plain-English summary

SAP America, Inc., a Delaware corporation, licenses accounting, human-resources, and logistics software modules throughout the United States. The base modules are virtually identical for every customer, but they don't actually work for a given business until they're customized -- a process that can take six to eighteen months and cost two to ten times the price of the software license itself. SAP asked whether its software license fees, and its separately stated charges for customization, testing, training, and maintenance/support, are subject to New York sales and use tax.

The Department said the license fee for the software modules themselves is taxable. Even though the modules are later customized to each customer's needs, they still count as "prewritten computer software" -- software not originally designed and developed to one specific purchaser's specifications -- because the base modules are identical across customers. Prewritten software is taxable tangible personal property under New York law regardless of how much it's later modified.

The customization work is different. Configuring the software, migrating data, adjusting charts of accounts, and even re-engineering the customer's business processes are treated more like consulting than like a sale of software, so SAP's separately stated charges for customization (along with testing and training) are exempt -- as long as the charges are reasonable and actually broken out from the software license price on the bill. One exception: SAP's "interface logic" that lets different software modules talk to each other is itself likely prewritten software (since the modules are virtually identical for every customer), so that charge may be taxable even if separately stated.

Maintenance is the trickiest piece. SAP's extended maintenance agreement bundles together new software updates and releases (taxable, since they're prewritten software) with hotline phone support and online support (not taxable services). Because the agreement charges one combined annual fee for both, the Department ruled the entire maintenance fee is taxable -- unless SAP splits out the nontaxable support portion as its own reasonable, separately stated charge.

What this means for you

Software vendors licensing prewritten, later-customized software

Selling a standardized software product that you later configure or customize for each buyer doesn't make the underlying software "custom" and therefore exempt -- it's still prewritten software, and the license fee is taxable. To get exemption for your customization, testing, training, or consulting work, that work has to be billed as its own reasonable, separately stated charge, not folded into the software price.

Companies buying licensed business software with customization or maintenance bundled in

Ask your vendor to break out charges for customization, testing, and training from the software license fee -- if those charges are lumped together, the whole bill can become taxable. The same applies to maintenance agreements: if support and updates are billed as one combined fee, expect to pay tax on the whole thing.

Accountants and tax professionals

The controlling authority is Tax Law § 1115(o) and TSB-M-93(3)S: services performed on software are exempt only when reasonably and separately stated. A maintenance agreement mixing a taxable element (prewritten updates) with a nontaxable element (support) is fully taxable as a unit unless the nontaxable piece is carved out on the invoice -- there's no partial exemption by default.

Common questions

Q: If a software module is later customized for my business, does that make the license fee exempt as "custom software"?
A: No. If the base module is the same across customers before customization, it's still prewritten software and the license fee is taxable, even after extensive customization.

Q: Are separately stated charges for software customization, testing, and training taxable?
A: No, as long as the charges are reasonable and actually itemized separately from the software license fee on the invoice.

Q: Is a software maintenance agreement that includes both updates and phone support taxable?
A: The whole fee is taxable if updates (taxable) and support (nontaxable) are billed as one combined charge. It's only the nontaxable portion that becomes exempt if it's broken out as its own reasonable, separately stated charge.

Q: Does this ruling apply to my software licensing agreement?
A: Not automatically. An Advisory Opinion binds the Department only for the taxpayer and facts it was issued to, and it can't be relied on by anyone else. It shows how the Department reasons through a mixed software/services contract, but your billing structure and contract terms may differ.

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/sales_ao_1998.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/sales/a98_20s.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-98(20)S
Sales Tax

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO.S970812A

On August 12, 1997, the Department of Taxation and Finance received a
Petition for Advisory Opinion from SAP America, Inc., 701 Lee Road, Wayne, PA
19087.
The issue raised by Petitioner, SAP America, Inc., is whether the licensing
of its software and related, separately stated charges for customization,
maintenance, support, updates and training services are subject to New York State
sales and compensating use taxes.
Petitioner submitted the following facts as the basis for this Advisory
Opinion and provided a sample of the software agreement in question.
Petitioner, a Delaware corporation headquartered in Wayne, Pennsylvania,
engages in the business of licensing computer software throughout the United
States. Petitioner’s software contains three main modules from which customers
may choose; the modules are virtually identical for every customer. The modules
assist customers in managing their accounting, human resources and logistics
functions. Within each of these main modules, customers may choose among various
applications according to their specific needs.
For example, within the
accounting module, customers can choose from the following applications: accounts
receivable, accounts payable, fixed assets, general ledgers and others. The
modules are inoperable for any specific customer's business needs until
customized as discussed below. Petitioner's pre-sale technical representatives
meet with potential customers to assist them in determining which of the modules
or applications will best suit each customer's particular business needs. The
pre-sale technical representatives typically spend several months with a
particular customer reviewing the customer’s operations and system requirements.
Based on this review, the pre-sale technical representatives develop a Systems
Requirements Analysis which the customer uses in deciding which modules or
applications to license and how the customer's chosen configuration should be
customized.
The software licensed by Petitioner resides on one or more designated
computers whose physical location is determined by the customer. The customer
will connect to each computer one or more application servers where Petitioner's
software will also reside. The customer will have a number of users attached to
the application server accessing the applications. For example, a particular
customer may have individuals from its production, sales, engineering,
purchasing, human resources and accounting departments use the software to
generate reports designed specifically for each department's use.
Each customer is responsible for the installation of the software it
chooses. The various departments within a customer's organization that use the
software may utilize different hardware platforms on which they run their
specific software applications. To accommodate the uniqueness of each customer,
the software licensed by Petitioner has the capability to run on a number of

-2­
TSB-A-98(20)S
Sales Tax

different operating systems, such as UNIX, OS/2 and Microsoft Windows. This
flexibility enables various operating units within a customer's organization to
utilize the software to generate reports to meet their specific needs regardless
of the operating system or hardware platform used by each unit.
With the wide array of options available to customers, there is a need to
configure or modify the operation of the software to accommodate different
operating environments. Petitioner is not responsible, pursuant to Section 9.2
of the sample agreement, for “the modification or improvement of the Software to
fit the particular requirements of Licensee; or . . . for preparation or
conversion of data into the form required for use with the Software.” Either
Petitioner or an independent consultant or an independent consultant with the
assistance of Petitioner generally enters into a separate contract with the
customer for customization of the software. The time necessary to customize the
base software can range from six to eighteen months depending upon the complexity
and scope of the customization. Typically, the separately stated total charge
for customizing the software can range from two to three times the cost of
purchasing the software license. However, in some cases, the cost of
customization can be ten times the cost of the software license. The cost for
purchasing Petitioner's license of software is generally in excess of $1,000,000
per customer.
The activities involved in customizing the software are much more
complicated and lengthy than what would commonly be considered installation. One
of the more time consuming processes in the customization procedure is
establishing the new databases.
This is accomplished by evaluating the
customer's business processes and customizing Petitioner's software to
accommodate the new required processes. Another time consuming process is moving
the data from the old system to the new system. The migration of the data is
performed by a specialized program. The alternative would be to key the data
into the new system which would be cost prohibitive. The customization of the
software also involves either the elimination or simplification of existing
routines.
Often the customization requires that Petitioner re-engineer the
customer's business processes.
Again using the accounting function as an
illustration, the charts of accounts are always adjusted in the customization
process. Tables are adjusted, screens are customized and parameters are set up.
Another aspect of the customization involves creating interface logic which
allows the various modules to "talk" to one another.
After the software is customized, Petitioner performs extensive testing to
ensure that the customized software satisfies the customer's requirements set
forth in the Systems Requirements Analysis. The testing process normally lasts
several weeks. Petitioner’s charges for testing are stated separately from other
charges relating to purchase and customization of the software. In addition, the
customer's employees using the software will generally enroll in an extensive
training program, conducted by Petitioner or an independent consultant. The
training program consists of a multitude of application and system instructional
courses, with each course normally lasting from two to five days. As part of the
training courses, trainees receive extensive documentation dealing with the
operation of the specific software modules and applications purchased.
Petitioner separately states the charges for training from other charges relating
to purchase and customization of the software.

-3­
TSB-A-98(20)S
Sales Tax

Included as part of the license of software is a six-month maintenance
agreement. Upon expiration of this initial agreement, customers may purchase an
extended maintenance agreement. Pursuant to Section 7.4 of the agreement, the
fee for this extended maintenance agreement is paid annually in advance in an
amount calculated as a percentage of the net license fee for the software. To
date, all of Petitioner's customers have purchased this optional extended
maintenance agreement. As part of the agreement, the customers are entitled to
receive the following:

• new releases and updates of the software ("updates");
• "hot-line" telephone support provided by Petitioner; and
• on-line support of the software product.
  Both maintenance and updates are provided under one agreement. As noted
  above, maintenance is provided in the form of "hot line" telephone support and
  on-line support of the software licensed to customers.
  Updates for the software contain product modifications that modify and/or
  enhance the existing software.
  These product modifications may include new
  features or fixes for problems which were identified in the current or previous
  version of the software.
  As a result, customers are able to enhance the
  usefulness of the software product licensed from Petitioner through the purchase
  of an extended maintenance agreement.
  Furthermore, through these updates
  Petitioner is continually enhancing and modifying the software it licenses to its
  customers. Updates normally require integrated application of the customer's
  specific needs.
  The amount and complexity of modifications contained in
  Petitioner’s updates vary from one update to another. Based on the content of
  an update, varying degrees of consultation and/or modification are required for
  the proper installation and utilization of an update.
  As a result of
  Petitioner's research, development and a customer's feedback, updates are
  generated containing corrections to flaws in the existing system, enhancement for
  existing functionality and possibly new system functionality.
  The standard Software License Agreement ("Agreement") grants the customer
  a perpetual license for the use of the software. The Agreement contains
  provisions which restrict the customer's duplication and use of the software, and
  prohibit the customer from licensing, sublicensing, or transferring the software
  to third parties with the exception of affiliated entities.
  Further, the
  Agreement requires that upon termination of the license, the customer will
  irretrievably delete the software and documentation from its computer system.
  In addition, the customer is required to deliver to Petitioner, or at
  Petitioner's request delete, all copies of the software and documentation from
  any storage media.
  Finally, it is Petitioner's policy to replace damaged,
  malfunctioning or lost software at no cost to the customer.
  Applicable Law and Authority
  Section 1101(b) of the Tax Law provides, in part:
  When used in this article for the purposes of the taxes imposed by
  subdivisions (a), (b), (c) and(d) of section eleven hundred five and
  by section eleven hundred ten, the following terms shall mean:

-4­
TSB-A-98(20)S
Sales Tax

*

*

*

(4) Retail sale. (i) A sale of tangible personal property to any
person for any purpose, other than (A) for resale as such or as a
physical component part of tangible personal property . . .
(5) Sale, selling or purchase. Any transfer of title or possession
or both, exchange or barter, rental, lease or license to use or
consume, conditional or otherwise, in any manner or by any means
whatsoever for a consideration, or any agreement therefore . . .
(6) Tangible personal property. Corporeal personal property of any
nature. . . . Such term shall also include pre-written computer
software, whether sold as part of a package, as a separate
component, or otherwise, and regardless of the medium by means of
which such software is conveyed to a purchaser.
*

*

*

(14) Pre-written computer software. Computer software (including
pre-written upgrades thereof) which is not software designed and
developed by the author or other creator to the specifications of a
specific purchaser.
The combining of two or more pre-written
computer software programs or pre-written portions thereof does not
cause the combination to be other than pre-written computer
software. Pre-written software also includes software designed and
developed by the author or other creator to the specifications of a
specific purchaser when it is sold to a person other than such
purchaser. Where a person modifies or enhances computer software of
which such person is not the author or creator, such person shall be
deemed to be the author or creator only of such person's
modifications or enhancements.
Pre-written software or a
pre-written portion thereof that is modified or enhanced to any
degree, where such modification or enhancement is designed and
developed to the specifications of a specific purchaser, remains
pre-written software; provided, however, that where there is a
reasonable, separately stated charge or an invoice or other
statement of the price given to the purchaser for such modification
or enhancement, such modification or enhancement shall not
constitute pre-written computer software.
Section 1105 of the Tax Law imposes sales tax on “[t]he receipts from every
retail sale of tangible personal property, except as otherwise provided in this
article.”
Section 1105(c) of the Tax Law imposes tax on the receipts from every sale,
except for resale, of certain enumerated services.
Section 1110 of the Tax Law imposes a use tax “for the use within this
state . . . of any tangible personal property purchased at retail.”

-5­
TSB-A-98(20)S
Sales Tax

Section 1115(o) of the Tax Law provides:
Services otherwise taxable under subdivision (c) of section eleven
hundred five or under section eleven hundred ten shall be exempt from tax
under this article where performed on computer software of any nature;
provided, however, that where such services are provided to a customer in
conjunction with the sale of tangible personal property any charge for
such services shall be exempt only when such charge is reasonable and
separately stated on an invoice or other statement of the price given to
the purchaser.
Technical Services Bureau Memorandum, TSB-M-93(3)S, March 1, 1993,
pertaining to the taxability of computer software and certain related services
provides, in part:
Effective September 1, 1991, State and local sales and
compensating use taxes are imposed on the sale or use of prewritten
computer software and certain related services.
The effect of this change in the Tax Law is to broaden the
types of computer software that are subject to sales and use taxes
. . . . certain software previously considered "custom" may now be
considered prewritten computer software and subject to such taxes .
. . . The only software that is exempt from sales and use taxes
under the new law is software designed and developed to the
specifications of a specific purchaser. (Emphasis added)
Prewritten computer software is any computer software that is
not designed and developed by the author or other creator to the
specifications of a specific purchaser.
*

*

*

Prewritten software is subject to tax whether sold as part of
a package or separately. Software created by combining two or more
prewritten programs or portions of a prewritten program is still
prewritten software subject to tax. The medium by which the software
is transferred to the purchaser has no effect on the software’s
taxability. Thus, prewritten software is taxable whether sold, for
example, on a disk, tape or by electronic transmission over
telephone lines.
Prewritten software, even though modified or enhanced to the
specifications of a specific purchaser, remains prewritten software
subject to tax. (Emphasis added)
However, if a charge for the
custom modification or enhancement is reasonable and separately
stated on the invoice or billing statement, then the separately
stated charge for the custom modification or enhancement is not
subject to tax.

-6­
TSB-A-98(20)S
Sales Tax

Example 1.

A software developer creates an accounting
system using prewritten software modules
for general ledger, accounts receivable,
accounts
payable,
payroll,
inventory
management, etc.
The developer may also
sell the modules separately or bundled in
other packages.
Even though the modules
may
be
modified
to
the
specific
requirements of the client’s business, the
sale of the modules is subject to sales or
use tax as prewritten software.
An
additional charge for modification or
"custom" programming by the developer would
not be subject to sales or use tax if the
developer’s charge for the modification is
reasonable and is separately stated on the
billing statement.
*

*

*

Sale of Software Upgrades
Generally, the sale of a revision or upgrade of prewritten
software is subject to tax as the sale of prewritten software. If,
however, the software upgrade is designed and developed to the
specifications of a specific purchaser, its sale to that specific
purchaser would be exempt as custom software.
*

*

*

Customer Support and Related Services
. . . charges for customer (user) support or for information
services provided by a vendor to a customer, either in person or by
some type of telecommunications arrangement (e.g., telephone, modem,
facsimile machine, etc.), in the nature of training, consulting,
instructing or other diagnostic or troubleshooting services related
to prewritten software are exempt from sales and use taxes where the
charges are reasonable and separately stated. . . .
*

*

*

Software Maintenance Agreements
If a software maintenance agreement provides for the sale of
both taxable elements (e.g., prewritten software upgrades) and
nontaxable elements (e.g., training, consulting, diagnostic and
troubleshooting support, etc.), the charge for the entire
maintenance agreement is subject to tax unless the charge for the
nontaxable elements is reasonable and separately stated in the
maintenance agreement and separately billed on the invoice or other
document of sale given to the purchaser . . . .

-7­
TSB-A-98(20)S
Sales Tax

Opinion
Petitioner develops and markets software and related services.
Petitioner’s customers are able to choose from certain pre-written modules and
applications in such areas as human resources, financial accounting and
production planning, in order to create systems tailored to their own
requirements. The modules are virtually identical for every customer; they are
sold separately by Petitioner and each customer is responsible for the
installation of the software it chooses.
These modules are sold under an
agreement, separate and apart from Petitioner's customization services. Even
though the modules may later be modified to the specific requirements of the
customer’s business, the modules constitute pre-written software since they are
not designed and developed to the specifications of a specific customer.
Accordingly, the receipts from the licensing fees Petitioner charges its
customers for the use of its software and for pre-written updates to the software
are sales of tangible personal property in the form of pre-written software that
are subject to the taxes imposed by Sections 1105 and 1110 of the Tax Law (see
Software Dynamics, Inc., Adv Op Comm T&F, July 23, 1997, TSB-A-97(45)S;
TSB-M-93(3)S, supra).
To accommodate different operating environments, each customer generally
enters into a separate contract for customization of the software. The customer
may choose either Petitioner, or an independent consultant, or both an
independent consultant with the assistance of Petitioner to customize the base
software.
Customization, in this regard, consists of configuring and/or
modifying Petitioner’s software to meet the computer application needs and
information processing requirements of the customer. Customization also may
include re-engineering the customer’s business processes. Such re-engineering
appears to be in the nature of consulting, which is not an enumerated tax
service. Customization is followed by testing of the software to ensure that the
customer’s requirements are fulfilled, and by extensive training of the
customer’s employees in the use of the software. Petitioner separately states
the charges for testing and training from other charges relating to the purchase
and customization of the software. Petitioner’s separately stated charges to
customize the modules and the updates it licenses to its customers, designed and
developed to the specifications of a specific customer, as well as charges for
business processes re-engineering, testing and/or training, are not subject to
tax provided these charges are reasonable and continue to be separately stated
in a fee statement given to customers (see Astrogamma Inc., Adv Op Comm T&F, June
22, 1992, TSB-A-92(50)S; State Tax Resources Group, Adv Op Comm T&F, July 11,
1996, TSB-A-96(44)S). However, any charge for interface logic which allows the
modules to talk to each other may be subject to tax, since the modules are
virtually identical and presumably the interface logic software for such
virtually identical modules would itself likely be pre-written, and therefore
taxable.
The sample software agreement provided by Petitioner includes a six-month
warranty by which Petitioner warrants that the software will substantially
conform to functional specifications. Petitioner’s customers may also purchase
an extended maintenance agreement that includes software updates and new
releases, correction of defects and both on-line and telephone maintenance
support. Pursuant to Section 7.4 of the agreement, the maintenance fee is paid

-8­
TSB-A-98(20)S
Sales Tax

annually in advance in an amount calculated as a percentage of the net license
fee for the software.
Since the software maintenance agreement offered by
Petitioner provides for the sale of both taxable elements (e.g., pre-written
software upgrades and new releases, to the extent that the new releases are pre­
written) and nontaxable elements (e.g., diagnostic and troubleshooting support),
the receipt from the charge for the entire maintenance agreement is subject to
tax (see Garpac Corporation, Adv Op Comm T&F, February 6, 1992, TSB-A-92(8)S;
Moore Business Forms, Inc., Adv Op Comm T&F, February 15, 1995, TSB-A-95(6)S;
ALLTEL Financial Information Services, Inc., Adv Op Comm T&F, May 2, 1996,
TSB-A-96(27)S). If Petitioner were to state the charges for such taxable and
non-taxable elements separately, and the charges were reasonable, Petitioner
would be required to collect tax only on the taxable elements.

DATED: March 24, 1998

NOTE:

/s/
John W. Bartlett
Deputy Director
Technical Services Bureau

The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.