When is custom software considered 'developed from scratch' and when has a developer transferred 'exclusive rights' to it, for purposes of the Texas custom-programming tax treatment discussed in an earlier ruling (fiche 9309L1273C08)?
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This page answers the general question as of 1996. Ezel answers yours, under current Texas tax law, with citations.
Plain-English summary
This 1996 Tax Policy memo answers a long list of audit questions about a software developer building a custom application (something like a general ledger system) for a customer. It builds on an earlier ruling, fiche 9309L1273C08, that used the terms "exclusive rights" and "developed from scratch" without fully defining them — this letter fills in those definitions.
Exclusive rights. "Rights" means the buyer has the "power of free action" — the ability to copy, change, and market the software without needing the seller's approval or paying more money. "Exclusive rights" means the developer has given up all of those rights and won't market the software itself. If the developer keeps any option to share the rights — even if never exercised — exclusive rights have not been transferred, and if rights are shared, the entire development charge becomes taxable, not just the portion actually exercised. There's a narrow carve-out for "common routines" (like a specific method of writing a file to disk) that a developer reserves purely so it isn't barred from reusing that small routine on future jobs; retaining only that kind of routine doesn't necessarily defeat exclusive-rights treatment. The memo also flags that a contract stating the buyer receives only "non-exclusive" rights of usage (rather than clearly stating the buyer may sell or license the software) points toward a taxable transaction.
"From scratch." This means the developer assessed the customer's needs and began coding a program, rather than modifying an existing program the developer has already sold or is holding for marketing. Using a purchased compiler's bundled example code, or third-party function libraries (like a rounding function), does not by itself disqualify a program from being "from scratch" — but if the real substance of the deal is modifying the compiler itself (especially if the developer also sold that compiler to the customer), it's taxable. Likewise, incorporating a developer's own pre-existing copyrighted programs into a "new" project for a customer is not "from scratch," and splitting the bill into a "new code" charge and a "pre-existing code" charge doesn't avoid tax on the pre-existing portion — though a genuinely stand-alone new program billed separately can qualify in its own right.
The memo also defines related terms cited in the earlier fiche: under Tax Code Section 151.0031, a "computer program" is a series of instructions coded for use by a computer system to process data and produce results; a "module" is a self-contained unit of a program (e.g., a checkbook module); "routines"/"subroutines" (also called "recipes" in the earlier fiche) are portions of a program set aside to perform a specific task usable by more than one part of the program, and cannot stand alone to generate recognizable output; "application" software performs a specific task (e.g., payroll); and an "integrated application" combines two or more software functions (e.g., accounts payable, payroll, accounts receivable, and general ledger together).
Finally, on ownership: absent a written contract, Tax Code Section 151.009 treats software as tangible personal property, so it is presumed taxable until the taxpayer documents that a transaction (like a clear transfer of exclusive rights) is not subject to tax.
What this means for you
Custom software developers and their customers
Whether a custom development contract is taxable can turn on contract language, not just on how "custom" the work feels. To support exempt treatment, contracts should clearly and unambiguously state that the developer transfers all rights (copy, modify, market, sell, license) to the buyer, without retaining any option to share or exercise rights beyond narrowly defined "common routines." Vague "non-exclusive" or "right of usage" language pushes the deal toward being taxable.
Auditors and businesses under audit for custom programming charges
If any rights are shared with the developer (beyond the common-routines carve-out), the whole development charge is taxable — not just the shared portion. Similarly, using bundled compiler example code or third-party function libraries doesn't automatically make a project taxable, but modifying the compiler itself, or modifying a program the developer already owns/markets, does.
Accountants and tax professionals
This letter is a useful reference for parsing "from scratch" vs. modification-of-existing-code fact patterns, and for spotting contract red flags (shared or non-exclusive rights clauses) that could convert an otherwise-exempt custom development charge into a fully taxable one.
Common questions
Q: What does "exclusive rights" mean for a custom software contract?
A: It means the buyer gets the full "power of free action" to copy, change, and market the software without needing the seller's approval or paying anything more, and the developer gives up all of those rights and will not market the software itself.
Q: If the developer keeps the option to share rights in the software, even without exercising it, does that defeat exclusive-rights treatment?
A: Yes. If the developer has the option to share the rights, "exclusive rights" have not been granted, and if rights are actually shared, the entire development charge becomes taxable, not just the shared portion.
Q: Does using a compiler's example code or third-party function libraries stop a program from being "developed from scratch"?
A: Not by itself. Using such example code, or a function like a rounding routine, does not disqualify the developer from creating a "from scratch" program — but if the actual substance of the deal is modifying the compiler (especially where the developer also sold that compiler to the customer), it becomes taxable.
Q: Can a developer avoid tax by separately billing for "new" code versus incorporated pre-existing code?
A: No — presuming pre-existing routines are incorporated into an application, tax cannot be avoided by separately billing for new versus pre-existing code. However, if the new code is a genuinely stand-alone computer program, it can qualify in its own right.
Q: Who owns the rights to custom software if there's no written contract and the author isn't an employee?
A: Tax Code Section 151.009 defines software as tangible personal property, so it is taxable until the taxpayer clearly documents that the transaction is not subject to tax. In the absence of a written contract clearly transferring exclusive rights, the transaction may simply be taxed.
Q: What is a "common routine" and does retaining rights to one ruin exclusive-rights treatment?
A: A common routine is something like a specific method of writing a file to disk — a small piece a developer retains mainly so it isn't barred from using that routine on future contracts. The memo says it would be "unreasonably harsh" to say exclusive rights weren't transferred just because this narrow routine was retained, as long as the buyer can still market the software intact.
Citations and references
- Tax Code Section 151.0031 (definition of "computer program")
- Tax Code Section 151.009 (software as tangible personal property)
- References an earlier Comptroller ruling, fiche 9309L1273C08, whose terms "exclusive rights," "from scratch," and "recipes" this letter defines and applies (that earlier fiche is not itself reproduced here)
Source
- STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
- Opinion: https://star.comptroller.texas.gov/view/9606L1416A03
Original ruling text
DATE: June 7, 1996
TO: Jill Rogers, Manager, *** Audit Office
FROM: Kevin Koller, Tax Policy
SUBJECT: ** TP# **
Fact Situation: A software developer is developing an
application for ****. The application is specific purpose somewhat
like a general ledger system as opposed to an accounting system that may
consist of sub-systems like general ledger, accounts receivable, accounts
payable, job order costing, etc. Exclusive rights to the software belong to
the taxpayer except for common routines that may be defined at any time during
the life of the contract. No common routines have been defined at this time.
The developer sold the compiler (**) to be
used to the taxpayer. Also the developer used example code (programs,
routines, sub-routines, modules, recipes, etc.) that accompanies *** as
a starting place for portions of the application.
Questions:
- What does "exclusive rights" mean as used in fiche 9309L1273C08?
Response. "Rights" means that the buyer has the "power
of free action". Specifically, they would receive the right to copy, change,
market, etc. the software without obtaining approval or paying any additional
sums to the seller. "Exclusive Rights" means that the seller/developer has
given up all of their aforementioned rights to the software sold and will not
market the software developed. Blacks Law Dictionary defines "exclusive right"
as "..one which only the grantee thereof can exercise, and from which all
others are prohibited or shut out." If the rights are transferred back to the
developer, the original transaction will not qualify.
- Given the above facts, has "exclusive rights" to the software been
transferred to the taxpayer as contemplated in fiche 9309L1273C08 even when
the developer has the option of sharing the rights to the software?
Response. If the developer has the option to share the rights, the
"exclusive rights" have not been granted.
- Does sharing the rights make all or part of the development charges taxable?
Response. All of the development charges would become taxable, not just the
portion on which rights were actually exercised on.
- What impact, if any, does postponing definition of "common routines" have?
Response. If the vendor could exercise a right to the
software itself or application within the software, the exclusive rights have
not been transferred even if the vendor has not exercised any options to date.
However, when the only right retained is "common routines" such as the method
that a file is written to disk, and is primarily in force to ensure that the
developer would not be barred from using the routine while performing future
contracts, it would appear to be unreasonably harsh to say exclusive rights
have not been transferred. It appears that the taxpayer would still be able to
market the software intact and even reproduce the routine for internal use
without attempting to license/copyright or sell the common routine. But I must
question Section 7.4 of the contract that states that the taxpayer receives
"non-exclusive" rights and does not clearly state that buyer may sell or
license the software. This leads me to believe that the program is taxable and
that the buyer receives only a right of usage that extends to copies and free
distribution.
- Can "exclusive rights" be shared?
Response. If the sale is to a partnership in which
both the developer and the taxpayer has a legal interest, the purchaser (the
partnership) would enjoy exclusive rights and the benefit would still be shared
by the entities making up the legal partnership. In the case at hand, the
"exclusive rights" cannot be shared.
- Presuming pre-existing routines are incorporated into an application, can
tax be avoided by separately billing for new code and pre-existing code?
Response. No. However, if the new code is a stand alone computer program,
it could qualify in its own right.
- What does from scratch mean as used in fiche 1273C08?
Response. It means that the developer assessed the
needs of his customer and began coding a program. The developer is not
modifying an existing program that they have sold or are holding for marketing.
- Has the developer in the instant case met the "from
scratch" requirement of fiche 9309L1273C08 since "pre-existing code" (as is or
modified) that accompanied the compiler was used? Does the fact that the
developer sold the compiler used influence this answer?
Response. The use by the developer of example code
that accompanies the compiler will not disqualify the developer from creating
"from scratch" programs. If the actual essence of the transaction is the
modification of the compiler in order to perform various work, it will be
taxable if the developer sold the compiler to the customer.
- Are third party, function libraries considered
"pre-existing code" or tools? Does their use make an otherwise exempt
agreement to create an application taxable?
Response. As long as the essence is actually a
function (i.e., rounding function) and not a program that is being modified for
the specific use of the client, the use would not disqualify the client from
producing "from scratch" software. However, I can imagine that this may have
an effect on whether the developer can actually sell exclusive rights to the
software.
- Is the "from scratch" requirement of fiche
9309L1273C08 met when developers use pre-developed code from a personal library
for tasks ranging from simple to complex? Must "pre-existing code" stand alone
or can it depend on other code to use it?
Response. The conception that "from scratch" means
beginning with a "blank sheet of paper" is probably never a reality unless the
developer has never before created a program or received any training in
programming. Programmers will have favorite routines, subroutines, macros, and
programming conventions that they will use when presented with similar needs
and challenges. The auditor should attempt to discern whether the essence of
the transaction is the creation of a "from scratch" program or the modification
of an existing program for sale. A creator of banking software may have
several of their programs copyrighted for sale. They may be called upon to
develop related software for a customer and may incorporate related copyrighted
software. This is not considered developed from scratch and also, more than
likely, would not transfer the exclusive rights to their software to their
customer.
- Please give an examples of the following terms:
Program, Module, Routine, Sub-routine, Recipe (see 9309L1273C08), Application,
Integrated Application.
Response. Section 151.0031 of the Tax Code defines
computer program as "..a series of instructions that are coded for acceptance
or use by a computer system to process data and provide results and
information.." A module is a unit or section of a program that can function on
its own. For example; accounting software may include a checkbook module.
Routines and subroutines are used interchangeably. They are a portion of a
program that performs a specific function or task that is set aside so that
more than one section of the program can use it. For example, writing a file
to a disk may be a subroutine. "Recipes" was used by the TR. requester in
fiche 9309L1273C08 to describe routines or subroutines. The requester stated
that the "recipes" must work within the framework of a program and could not
stand alone and generate recognizable output (page 6 of 7). Application
software is a program that performs specific tasks such as payroll. An
integrated application is a program that combines two or more software
functions (i.e.; accounts payable, payroll, accounts receivable and general
ledger).
- (Added by phone conversation.) In the absence of a
written contract, who owns the rights to the software if the author is not an
employee?
Response. Section 151.009 of the Tax Code states that
software is "tangible personal property." As such, it is taxable until the
taxpayer clearly shows and presents documentation that the transaction is not
subject to tax. As a result, transactions may be taxed in the absence of a
written contract clearly transferring exclusive rights to a customer.
NOTE: Previous Accession Number 9606325L
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