Although Gross Receipts From Transferring Both Canned And Custom Computer Software Are Generally Subject To Nebraska Sales And Use Tax, An Exception May Apply For Custom Software


by Matt Ottemann and Nick Niemann

Ottemann, Matthew     Niemann, Nicholas
mottemann@mcgrathnorth.com
nniemann@mcgrathnorth.com
(402) 341-3070

R.R.S. Neb. § 77-2701.16
Nebraska Admin. Code Title 316, Ch. 1, Reg-1-088

INSIGHT

The gross income for coding, punching, or otherwise producing computer software is subject to Nebraska sales and use tax. However, an exception exists for custom software if a taxpayer meets the three factor test for hiring a “temporary employee” under Nebraska Revenue Ruling 1-02-1 (Feb. 11, 2002), http://www.revenue.ne.gov/legal/rulings/rr010201.html.

ANALYSIS

R.R.S. Neb. § 77-2701.16(9)(a) establishes that the “gross income received, including the charges for coding, punching, or otherwise producing any computer software and the charges of the tapes, disks, punch cards or other properties furnished by the seller” is subject to Nebraska sales and use tax. In Nebraska Admin. Code Title 316, Ch. 1, Reg-1-088, the Nebraska Department of Revenue (Department) provides more detail about the meaning of this statute. Reg-1-088 establishes the following points regarding the taxation of Nebraska software:

(1)  Software is subject to Nebraska sales and use tax regardless of the manner in which it is conveyed. See Reg-1-088.01.

(2)  Both canned and custom software are subject to Nebraska sales and use tax. Reg-1-088.01A establishes that the gross receipts from furnishing software “includes services provided by a consultant that results in a transfer of software from the consultant to the client.” This provision affirms that the transfer of custom software programs, written by a consultant or independent entity, is generally subject to Nebraska sales tax. This contradicts the tax treatment for custom software in many states, in which the transfer of custom software is exempt from sales and use tax.

(3)  Modifications to existing software are taxable. Reg-1-088.04 establishes that “software that alters existing software is considered separate from the existing software and is taxable.” In addition, Reg-1-088.05 declares that charges for agreements that require a company, without an additional charge or at a reduced price, to provide future changes or modifications to computer software are also taxable.

(4)  Charges for software training are taxable if paid to the software retailer, but not to an independent consultant. Reg-1-088.02 declares that charges for software training that are paid to the retailer of the software are subject to Nebraska sales and use tax. In contrast, training charges that are paid to any person other than the software retailer, such as an independent consultant, are exempt from Nebraska sales and use tax.

(5)  Charges for consultants who merely provide generalized computer advice are exempt from sales and use tax. Charges for consultants who do not provide any software or modify existing software are exempt from Nebraska sales and use tax.

Computer software does not include electronic data or mailing lists.

Reg-1-088.06 defines the term “computer software” to mean a “sequence of instructions which directs the computer to process either digital or analog data.” As the Department concedes, “computer software” does not include lists of electronic data, such as mailing lists. Computer software acts to process digital or analog data, so data itself is not considered “computer software.” In addition, Reg-1-088.06 establishes that charges for converting data into machine-usable form are not taxable as charges for “computer software.”

Sales and use tax on computer software that may be used in more than one state may be apportioned among states.

Reg-1-088.07 establishes that computer software that is delivered electronically and is concurrently available for use in more than one state may be purchased under a Certificate of Exemption for multiple points of use. See 8-2008 Certificate of Exemption. Purchasers utilizing a Certificate of Exemption for multiple points of use must remit Nebraska sales and use tax on the purchase of that software using a consistent and uniform method of apportionment. Reg-1-088.07 does not establish what constitutes a “consistent and uniform method of apportionment.”

Advisors should be aware that the Department’s ultimate acceptance of a taxpayer’s proposed “consistent and uniform method of apportionment” will likely be dependent upon the facts of the taxpayer’s situation. Advisors who propose that their clients apportion sales and use tax on computer software under Reg-1-088.07 should be able to substantiate their client’s proposed method of apportionment, to show that it is consistent and reasonable under the facts of their client’s economic situation.

Charges for computer software that is produced by a taxpayer’s temporary employees are not subject to Nebraska sales and use taxes if the taxpayer’s agreement with its temporary employees passes a three factor test.

In Revenue Ruling 1-02-1, the Department confirmed that charges for furnishing software by an independent consultant are subject to Nebraska sales and use tax, but that charges for software produced by a taxpayer’s own employees (whether permanent or temporary employees) are not subject to sales and use tax. In the latter case, no transfer of the software has occurred. The Department further noted that the distinction between purchasing software and hiring temporary employees has been confused by common business practices in the software industry, where companies often pay for computer software based on time and materials rather than a fixed amount. This time and materials billing method does not distinguish between taxable sales of computer software and nontaxable temporary employee services.

Consequently, the Department issued Revenue Ruling 1-02-1 to provide guidance on the factors that may be used to distinguish between the taxable purchase of software from a consultant and the exempt hiring of a temporary employee. The Department stated that if a taxpayer receives personal services, including the services of a temporary employee that result in the providing or producing of computer software, those charges are subject to Nebraska sales and use tax unless the taxpayer and the service provider have an agreement that meets the following three factors:

(1)  The transaction is only to obtain services of a competent, temporary employee who will be under the control of the company with respect to the manner of performance and working conditions.

(2)  Neither the provider nor the temporary employee will have any liability for the failure of the software to perform.

(3)  Any software produced belongs to the company, which has full rights to control the future use of any and all copies of the software.
Unless the contract between the taxpayer and service provider expressly includes all three provisions, then the charges for the personal services are deemed to be charges for providing computer software, and gross receipts from that transaction are subject to Nebraska sales and use tax.

Example:    Widget Company, a manufacturer, wants to have a custom software program written that will control its specialized manufacturing operations. Widget Co. and a software provider enter into a time and materials agreement, in which Widget Co. will pay the software provider based on the time and materials expended to create the software program. The agreement between Widget Co. and the software provider expressly states that any software produced belongs to Widget Co., and that Widget Co. has full rights and control regarding future use of any and all copies of the software. However, the agreement does not expressly state that the software provider has no liability for the failure of the software to perform. Because the agreement does not contain an express disclaimer of liability for the software provider, as required under Revenue Ruling 1-02-1, the Department will likely rule that these charges are for providing computer software. Consequently, gross receipts from the transaction will likely be subject to Nebraska sales and use tax.

Practitioners should advise their clients of the uncertainty of satisfying the three factor test.

In our experience, there is confusion regarding whether common provisions in contracts for the creation of software programs fulfill the three factors of Revenue Ruling 1-02-1. This confusion results, at least in part, from the Department’s lack of formal guidance to help companies interpret the meaning of the three factor test. For example, the Department has not defined what types of working arrangements place a temporary employee “under the control of the company as to the manner of performance in the working conditions.” In addition, the Department has not clarified when a software provider or temporary employee will have liability for the failure of the software to perform. For example, can the Department’s liability test only be met if the customer agrees to pay the temporary employee at the normal time and materials rates until the software is actually functional, rather than requiring the temporary employee to work without additional compensation after some maximum charge?

Because of this uncertainty, advisors may not be able to state with certainty whether the provision of services under a specific software contract will definitely be exempt under Revenue Ruling 1-02-1. Advisors who have clients that either purchase or create custom software programs would be well advised to inform their clients of the potential uncertainty in the law in this area. Advisors should consider recommending to such clients that they clarify, within the agreement between a software provider and customer, who will bear ultimate responsibility for the payment of any Nebraska sales or use tax that may be assessed on their transaction.

These materials are published solely as reference materials for use by attorneys and other tax professionals.  They do not constitute an opinion or written advice concerning federal or state tax issues and are not written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable tax laws.

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