For a software company that labels its programmers' department 'Research and Development,' does the computer equipment those programmers use to write mass-market software for sale qualify for the Texas manufacturing exemption?

Plain-English summary

A software company divides its development process into three departments: marketing (gathers customer feedback and produces a feature list for the next version), research and development (programs the actual end-product software to those specifications — no separate prototypes or throwaway test code), and production (duplicates the finished program onto CDs). Because equipment purchases were coded by department, and the company knew that R&D equipment in a traditional manufacturing environment usually isn't exempt, it asked the Comptroller whether its programmers' work — housed in a department internally labeled "Research and Development" — is really manufacturing, and whether that equipment qualifies for the manufacturing exemption despite the department's name.

The Comptroller's answer: yes, the equipment qualifies, and the internal department label doesn't control. Effective October 1, 1997, Tax Code § 151.318 was amended specifically to say that "the manufacturing of computer software begins with the design and writing of the code or program for the software and includes the testing or demonstration of the software." A separate 1997 change also limited the general manufacturing exemption to property directly used in the process that itself causes a chemical or physical change in the product (or an intermediate/preliminary product that becomes part of it).

Applying both changes here: computers used to actually design and write the code that will be sold to customers qualify for exemption — regardless of whether the company happens to call that department "Research and Development." What matters is the actual function (writing the sold end-product's code), not the accounting label. Two important limits:

• Divergent use is still taxable. If the same computer is also used for non-exempt purposes (email, accounting, etc.), tax is due on the fair market rental value of that divergent use, and the company should keep detailed computer logs documenting exempt use.
• Custom, exclusive-rights software is different. Creating software for a specific customer where the exclusive rights to the program transfer to that customer is NOT manufacturing — it's a nontaxable service, and equipment used to perform that custom work does not qualify for the manufacturing exemption.

What this means for you

Software companies

Don't assume your equipment loses the manufacturing exemption just because your accounting/organizational chart labels the programming group "Research and Development." What matters is whether the equipment is actually used to design and write code for software that will be sold to customers generally — that's exempt manufacturing use under the post-1997 statutory language, even inside an "R&D" cost center. But track and document any non-exempt (divergent) use of the same machines, and remember that building custom, exclusive-rights software for one customer is a different, nonexempt service category.

Accountants and tax professionals

Tax Code § 151.318's 1997 amendment specifically defining "manufacturing of computer software" (design/coding through testing/demonstration) is the key hook here — it overrides a purely departmental/labeling analysis. Watch for the custom-software carve-out when a client's business mixes off-the-shelf products with bespoke, rights-transferred development work.

Common questions

Q: Does labeling a department "Research and Development" cause software-writing equipment to lose the manufacturing exemption?
A: No, per this letter — what matters is the equipment's actual use (designing/writing code for software sold to customers), not the department name.

Q: Is equipment used for email or accounting on the same computer exempt too?
A: No — tax is due on the fair market rental value of that divergent, non-exempt use, and the letter recommends keeping detailed logs.

Q: Does the exemption cover custom software built for one customer?
A: No, per this letter — creating software for a specific customer with exclusive rights transferred to that customer is a nontaxable service, not manufacturing, and the equipment used isn't exempt.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.318 (amended eff. 10/01/1997: defines computer software manufacturing as beginning with code design/writing through testing/demonstration; also limits the exemption to property directly causing a chemical/physical change in the product)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9811955L

Original ruling text

November 2, 1998

Dear Ms. **:

Thank you for your recent letter which is restated in part with response below.

We have a client who manufactures computer software. We are aware that they

qualify for the manufacturing exemption but would like to get some

clarification as to what is manufacturing and what isn't.

The details relating to our client's business are as follows:

Our client divides their development of software into three departments:

marketing, research and development, and production. The marketing department

obtains information from clients, prospective clients, etc. and produces a list

of features to be included in the latest software version. This list of

features is provided to the research and development department who creates the

software with the added features. The research and development department

programs the software only to the specifications provided by the marketing

lists. No prototypes or test software is programmed that may never be sold to

customers. They are programming what will be the end products and will be sold

to customers. After the program is complete, the production department

duplicates the software onto CD.

Purchases of computers and equipment that will be used by the marketing

department are coded to the marketing account. Purchases of computers and

equipment that will be used by the research and development department are

coded to the research and development account. Finally, computer and equipment

purchases that will be used in the production department are coded to the

production account.

Our questions stem from the way that our client categorizes the development

process. When our client developed their accounting system and

departmentalization, the programmers who created the software were logically

part of the "research and development" department, as opposed to marketing or

production. We realize that equipment used in research and development in a

traditional manufacturing environment is not exempt. Is programming, as

described above, research and development or manufacturing? Will the computer

programming equipment, classified as "research and development" qualify for the

manufacturing exemption? What type of proof will the state require to show that

these purchases of programming equipment which are classified as "research and

development" are exempt?

Response: Effective October 1, 1997, Tax Code 151.318 was amended to add the

following provision "the manufacturing of computer software begins with the

design and writing of the code or program for the software and includes the

testing or demonstration of the software."

Another modification to Tax Code 151.318 limits the exemption for tangible

personal property used in the manufacturing process to property used directly

in the process and that makes or causes a chemical or physical change in the

product being manufactured for sale or in an intermediate or preliminary

product that becomes a part of the product manufactured for sale.

Accordingly, computers used to actually design and write the code will qualify

for exemption. However, the tax would be due on the fair market rental value of

any divergent use (e.g., use of computer or printer for emails, accounting,

etc.). The fact that a computer used to write software for sale was located in

the "Research and Development" Department will not cause the loss of the

exemption. The client should keep detailed computer logs to document exempt

use.

I should also point out that manufacturing does not include the creation of

software for a specific customer where the exclusive rights to the program are

transferred to the customer. That is a non-taxable service and equipment used

to perform it is not exempt from sales tax.

This opinion is rendered based on the facts presented. If there are additional

or different facts, the opinion may change.

You may call me toll free at 1-800-531-5441, ext. 3-4680. The direct line is

512/463-4680. You may also write to Tax Policy, Comptroller of Public

Accounts. The email address is .

Sincerely,

Al Van Allen

Tax Policy Division