Is a consulting firm's software design and implementation work for an insurance fund taxable data processing/software licensing, or nontaxable custom programming?

Plain-English summary

A consulting firm ("Company A") had two related agreements with the Texas Workers' Compensation Insurance Fund: a Data Processing Services Agreement (which everyone agreed was taxable) and a separate Professional Services Agreement for Design, Implementation and Consulting, which Company A argued was nontaxable because it was limited to analyzing the Fund's business functions and designing software solutions, not the actual sale, lease, or licensing of software.

The Comptroller's office first responded (June 22, 1992) that simply labeling work "consultation" or "design" doesn't automatically make it nontaxable — a charge for design or consulting is taxable if it's connected with the sale, lease, or rental of computer software or hardware, even if billed separately, because licensing software counts as a lease of that software. The office also flagged that the two contracts contained nearly identical provisions (one clause in the Design/Consulting agreement matched a data-processing clause almost word for word), so it directed that any nontaxable, segregated services be supported by separately stated billings.

After the taxpayer wrote back on June 29, 1992 with more detail — explaining that the "deliverables" from the consulting agreement would be "a product of our consultation and design efforts" — the Comptroller's office issued this August 28, 1992 follow-up letter narrowing the test to one key question: who ends up owning the rights to the resulting software? If Company A keeps the rights, it is licensing (renting) computer software to the Fund, which is taxable. If the Fund owns the rights, Company A is instead providing nontaxable computer programming services, and the associated design/consulting charges follow that same taxable-or-not-taxable treatment.

What this means for you

Software and IT consulting firms

If you provide system design, analysis, or "consulting" services that lead to custom software, the taxability of your fees doesn't hinge on how you label the engagement. Texas looks at who actually holds the ownership/rights to the software deliverable. Retaining the rights and letting the client use the software makes you a software licensor (taxable); transferring full ownership of the resulting software/programming work to the client makes the underlying services nontaxable custom programming.

Businesses with parallel data-processing and consulting contracts

If you split a single overall engagement into a "taxable" data processing agreement and a separate "nontaxable" design/consulting agreement, expect scrutiny if the two contracts contain overlapping or nearly identical clauses. The Comptroller's office in this letter required separately stated billing to support any claimed nontaxable, segregated portion of the work.

Accountants and tax professionals

This letter illustrates the Comptroller's general framework for software/consulting engagements: (1) contract labels ("consulting," "design") are not controlling; (2) a design/consulting charge tied to a software sale, lease, rental, or license is taxable as part of that transaction, even if separately stated; (3) licensing software is treated as a lease of software; and (4) the dispositive fact for otherwise-standalone design/consulting work is ownership of the resulting software rights.

Common questions

Q: Does calling a contract a "Professional Services Agreement for Design, Implementation and Consulting" keep it out of sales tax?
A: Not by itself. The Comptroller's office specifically stated that "the mere labeling of an activity as 'consultation' or 'design' does not readily make the activity such." The actual substance of the arrangement controls.

Q: What is the deciding factor in this letter?
A: Who retains the rights to the software that results from the engagement. If the consulting firm keeps those rights, it is licensing/renting software (taxable). If the client (the Fund) owns the rights, the firm is providing nontaxable computer programming services.

Q: Why did the Comptroller's office mention that clauses in the two agreements were nearly identical?
A: Because the Data Processing Services Agreement (fully taxable) and the Design/Consulting Agreement (claimed nontaxable) contained closely overlapping provisions describing data-processing-type activities. Given that overlap, the office required that any segregated nontaxable services be supported by separately stated billings to justify different tax treatment.

Q: Is a charge for design or consulting services ever taxable even if billed separately from the software?
A: Yes. Per this letter, a charge for consultation or design is taxable if it is connected with the sale, lease, or rental of computer software or hardware — it becomes part of the taxable sale/lease price "even though separately stated."

Q: Can other taxpayers rely on this specific letter?
A: No. Per Texas rules, a STAR letter can only support a detrimental-reliance claim for the taxpayer it was issued to, and this letter's conclusion turns on the requester's specific facts (who owns the resulting software). Businesses with similar consulting arrangements should confirm their own facts, particularly software ownership, with a tax professional or their own ruling request.

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9208421L

Original ruling text

August 28, 1992

Dear Mr. **:

Thank you for your letter of June 29, 1992, providing additional facts
regarding your firm's Professional Services Agreement for Design,
Implementation and Consulting.

You state:

These services consist of analyzing the business functions of the Fund, and
working with the Fund to design and implement software solutions for their
business applications. The deliverables from this agreement will be a product
of our consultation and design efforts. (Emphasis added.)

If the "deliverables" are computer software and the rights to the software are
retained by your firm, you are licensing or renting computer software. If the
rights to the computer software belongs to the Fund, your firm is providing
nontaxable computer programming services. The associated costs will be taxable
or not taxable depending on whether your firm is licensing taxable custom
computer software or providing nontaxable programming services.

This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change.

You may call toll free 1-800-252-5555, extension 3-4683 if you have any
questions or need more information. You may write to Tax Administration
Division, Comptroller of Public Accounts.

Sincerely,

Eddie Washington
Tax Administration Division

June 29, 1992

Mr. Eddie C. Washington
Tax Administration Division
Comptroller of Public Accounts
State of Texas
Austin, Texas 78774

Re: Comptroller's Opinion Regarding Sales Tax Applicability for Services
Provided by COMPANY A to the Texas Workers' Compensation Insurance Fund

Dear Mr. Washington,

Thank you for your letter of June 22, 1992 to Mr. ** of
** expressing your opinion regarding the applicability of sales tax
for services provided by ** ("COMPANY A") to the Texas Workers'
Compensation Insurance Fund (the "Fund). At your invitation, I am presenting
more facts to support our belief that the services provided by our Professional
Services Agreement for Design Implementation and Consulting are not taxable.

We understand from your letter that all services provided by our Data
Processing Services Agreement are taxable.

We understand that charges for consultation and design are taxable when the
charge is connected with the sale, lease or rental of computer software or
hardware, and that licensing computer software is considered a lease of the
software. We do not believe that services provided by our Professional Services
Agreement for Design! Implementation and Consulting are connected with the
sale, lease, rental or licensing of software. These services consist of
analyzing the business functions of the Fund, and working with the Fund to
design and implement software solutions for their business applications. The
deliverables from this agreement will be a product of our consultation and
design efforts.

The consultation and design that is connected with the delivery of the software
and that is subject to the sales tax is included in the Data Processing
Services Agreement.

Thank you for your further consideration of this important matter. I am looking
forward to your response. Please do not hesitate to contact me if you need more
information.

Sincerely,

Vice President - Operations

June 22, 1992

Dear Mr. **:

Thank you for your letter of April 22, 1992, concerning the taxability of
certain services provided by ** (COMPANY A).

The contracts reasonably segregate the nontaxable services from the taxable
data processing services. However, the mere labeling of an activity as
"consultation" or "design" does not readily make the activity such.

A charge for consultation or design services is taxable if the charge is
connected with the sale, lease, or rental of computer software or computer
hardware. The charge is part of the sales, lease of rental price even though
separately stated.

Licensing computer software is considered a lease of the software. A charge for
consulting connected with licensing or re-licensing computer software is
taxable. Paragraph 10, Article IV [10. COMPANY A agrees to re-license its SIGMA
System software to Insurer (for use on Insurer's in-house computers) within the
scope of the functions described in Appendix A. On notice of Insurer's
intention to re-license, COMPANY A shall have four (4) months to propose a
re-license plan, including, as necessary, making any data and program
conversions required because of differences between the COMPANY A hardware,
software and communications systems and those of Insurer. The prices, schedules
and limitations of use and resale of these services shall be provided to
Insurer under the same or better provisions that COMPANY A offers to other
large domestic U.S. insurers in its then normal course of business. COMPANY A
shall have a minimum of eighteen (18) months from the date that COMPANY A and
Insurer agree on the re-license plan to complete the re-license activity on
Insurer's in-house computers (such time will include offering Insurer a minimum
of four (4) months of parallel processing on both systems). During the entire
sequence of proposal, discussion, conversion, parallel testing, etc., Insurer
shall continue to use the data processing services of COMPANY A as generally
described in this Agreement.] of the Professional Services Agreement for
Design, Implementation and Consulting. Consulting pertaining to computer
software licensing or computer hardware sales, leases, or rentals must be
distinguished from consulting connected to data processing services,
programming, etc.

Paragraph 3, Article III [3. To use due care in processing work submitted by
Insurer or Insurer's agents. COMPANY A shall not be responsible for damages
from errors in the data provided to COMPANY A nor for any damages arising from
delays in COMPANY A's receipt of said data. COMPANY A shall only be responsible
for malfunctions of COMPANY A controlled computer systems and programs, or
errors of COMPANY A operators. In the event of any such error of malfunction
for which COMPANY A is responsible and for any breach of warranty under Article
XI, Paragraph 3, Insurer shall notify COMPANY A, in writing, and COMPANY A
shall have five (5) days from receipt of such notice to cure such error,
malfunction or breach of warranty by rerunning the job of recreating the data
or program files using machine readable data supplied by Insurer or Insurer's
agent.] of the Professional Services Agreement for Design, Implementation and
Consulting contains is identical to paragraph 2, Article III [2. To provide a
design and consulting for the information system of Insurer as generally
outlined in COMPANY A's response to Insurer's Request for Proposal (see
Appendix A); provided, however, that any recommendations made by COMPANY A as a
result of such consulting services shall not be implemented until approved and
authorized by Insurer in its sole discretion.] of the Data Processing Services
Agreement. Both provisions describe activities that fall within the definition
of data processing services.

Because of the close similarity between the contracts, the segregated
nontaxable services set out in the contracts must be supported by separately
stated billings.

This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change.

You may call 463-4683 if you have any questions or need more information. You
may write to Tax Administration Division, Comptroller of Public Accounts.

Sincerely,

Eddie Washington
Tax Administration Division