Were bundled software-maintenance charges taxable when updates were delivered by modem or installed from a disk the employee retained?

Plain-English summary

A prewritten-software retailer sold flat-fee maintenance packages combining upgrades, error corrections, and consultation. Its contracts required customers to have modems so updates normally could be transmitted remotely.

The internal memorandum said remote maintenance was nontaxable because no tangible property passed to the customer. In rare modem failures or emergencies, an employee brought a floppy disk to the customer's premises, operated the customer's computer to copy the update, then removed and retained the disk. Counsel treated that work as reprogramming or reconditioning the existing computer system, not fabricating new tangible property, and recommended granting the retailer's petition.

An April 28 confirmation letter separately stated that a prewritten program transferred by modem from the seller's business to or through the purchaser's computer was not taxable. The source does not show the Board's final action on the recommended redetermination.

Citations and references

• California Revenue and Taxation Code sections 6006(a), 6006(b), and 6006(g) (as cited)
• California Sales and Use Tax Regulations 1502(f)(1)(C)-(D), 1525, 1526(b), and 1546 (as cited)

Source

• Annotated Legal Opinions collection: https://cdtfa.ca.gov/taxes-and-fees/annotations-menu.htm
• Annotation page: https://cdtfa.ca.gov/lawguides/vol2/suta/120-0000-all.html
• Original supporting opinion: https://cdtfa.ca.gov/lawguides/annotations/120-0560-225.pdf

Original ruling text

State of California

Board of Equalization
Legal Division

Memorandum
:

Mr. Donald J. Hennessy
Assistant Chief Counsel
Appeals Review Section

From :

Gary J. Jugum
Assistant Chief Counsel

Subject:

S--- B--- S---, Inc.
Account No. SR -- XX-XXXXXX-010

To

120.0560.225
Date:

March 23, 1995

The petition for redetermination of tax of the referenced taxpayer was heard in Culver City on November 30, 1994. Pursuant to the direction of the Board, Glenn Bystrom and I met with Mr. E--- R---, principal officer of the corporation, in Culver City on March 21, 1995. Taxpayer is a retailer of prewritten computer programs and reports and pays sales tax with respect to the sale of such programs. Taxpayer enters into software maintenance contracts with its customers (1) to furnish upgrades to the programs as they are developed and become ready for distribution, (2) to furnish error corrections when faults are located in the program, and (3) to provide consultation services. This is the standard package of goods and services normally “bundled” together in software maintenance contracts. Taxpayer charges a flat fee for the service, on a monthly or semi-annual basis. This is customary pricing mechanism used with software maintenance contracts. That is, there is no specific fee charged for specific services rendered--the charge is a flat amount. At issue in the audit was the taxability of charges made with respect to the software maintenance contract. Software upgrades, if sold alone, are clearly subject to tax. They are nothing more than prewritten computer programs. Error correction, if sold alone, would be nontaxable, because error correction qualifies as repair or reconditioning under our Regulation 1546. Consultation services, if sold alone, are likewise nontaxable. When the three items discussed are sold as a single package, we have assessed tax on the entire contract price. See Regulation 1502(f)(1)(C). Taxpayer’s contracts with its customers specified that taxpayer would perform its software maintenance services, including transmission of program updates, by remote telecommunications means. In fact, taxpayer would not contract with the customer unless the customer had a modem in order to receive software maintenance by telephone. Taxpayer understood, and it has been the continuing interpretation of this agency, that tax would not apply to charges for software maintenance contracts, where the contract is performed by remote telecommunications means.

Mr. Donald J. Hennessy

-2-

March 23, 1995
120.0560.225

In a number of instances, rather than transmitting the upgrades by telephone, taxpayer’s employees took a floppy disk to the place of business of the customer, inserted the disk in a disk drive, and copied the program into the memory of the customer’s computer by operating the computer. Taxpayer’s employees then removed the disk, and returned with the disk to taxpayer’s place of business. The computer update was “delivered” in this manner only in circumstances where taxpayer was unable to access the customer’s computer by remote means. This would occur when the customer’s modem was not operating for some reason, or when, as during the Southern California earthquake, taxpayer was unable to reach the customer by telephone. It is our opinion that taxpayer’s charges to its customers in the circumstances described are not subject to sales tax. The charges are subject to tax only if the transactions are retail sales by title transfer (Rev. & Tax. Code § 6006(a)), or retail sales by processing of customerfurnished tangible personal property (§ 6006(b)), or retail sales by lease of ex-tax property (§ 6006(g)). There is no title transfer transaction, and there is no lease transaction. The question is whether the activities performed by taxpayer’s employees at the customer’s place of business constituted “the producing, fabricating, processing, printing, or imprinting of tangible personal property for a consideration for customers who furnish either directly or indirectly the materials in the producing, fabricating, processing, printing, or imprinting.” Regulation 1526 provides in paragraph (b) as follows: “Producing, fabricating, and processing include any operation which results in the creation or production of tangible personal property or which is a step in a process or series of operations resulting in the creation or production of tangible personal property. The terms do not include operations which do not result in the creation or production of tangible personal property or which do not constitute a step in a process or series of operations resulting in the creation or production of tangible personal property, but which constitute merely the repair or reconditioning of tangible personal property to refit it for the use for which it was originally produced.” It is our view that the reprogramming activity conducted by taxpayer at the customer’s place of business is a kind of reconditioning of the customer’s computer system--tangible personal property--which does not constitute a step in the process of the creation or production of tangible personal property. If the customer has a computer system which is programmable, tax would have been paid with respect to the acquisition of the system. Section 6006(b) is designed to insure that all fabrication charges incurred in the production of a completed article are included in the measure of tax, whether the raw materials are furnished by the retailer or by the retailer’s customer. It is a prophylactic rule which has no basis for application in circumstances of the type under consideration. It is our opinion that reprogramming a

Mr. Donald J. Hennessy

-3-

March 23, 1995
120.0560.225

programmable piece of equipment does not constitute fabrication or processing of the equipment. If taxpayer’s employee were to sit at the customer’s keyboard and reprogram the computer by keying in the changes to the extant program, this would no more constitute a fabrication of tangible personal property than would the circumstance of my paying someone to change my television set from Channel 3 to Channel 10. Likewise, it would be our position that charges made for reprogramming a programmable cash register to reflect a change in the sales tax rate would be nontaxable. It would be immaterial to our analysis that the reprogramming effect might be facilitated and expedited by use of a transfer media, such as a floppy disk. The tangible personal property--the equipment itself--might well be in a different “state”, but it would not be a new or different property. Indeed, the best example might be an on-off switch. We do not think that turning electronic equipment from off to on (or vice-versa) constitutes taxable fabrication of customer-furnished property within the meaning of that concept as it is employed in section 6006(b) or in Regulation 1525. There, it is our conclusion charges made for reprogramming programmable equipment are charges for the performance of the service, not for the sale of tangible personal property, and are not subject to sales tax. Our recommendation is that taxpayer’s petition for redetermination be granted. GJJ:sr cc:

Mr. Glenn A. Bystrom - MIC:43
Sales and Use Tax Attorneys

120.0560.225

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION

JOHAN KLEHS
First District, Hayward

LEGAL DIVISION - MIC 82
450 N STREET, SACRAMENTO, CALIFORNIA
(P.O. BOX 942879, SACRAMENTO, CALIFORNIA 94279-0001)

DEAN ANDAL
Second District, Stockton

Telephone No.: (916) 445-3723
Fax No: (916) 323-3387

ERNEST J. DRONENBURG, JR.
Third District, San Diego
BRAD SHERMAN
Fourth District, Los Angeles
KATHLEEN CONNELL
Controller, Sacramento

April 28, 1995

BURTON W. OLIVER
Executive Director

Mr. E--- R--S--- B--- S---, Inc.
XXXX --- -----, CA XXXXX
Re:

S--- B--S---, Inc.
SR -- XX-XXXXXX-010

Dear Mr. R---:
This is to confirm our advice to you on March 21, 1995 that the sale of a prewritten computer program is not subject to sales tax if the program is transferred by remote telecommunications, i.e. by modem, from the seller's place of business, to or through the purchaser's computer. See our Regulation 1502, "Computers, Programs, and Data Processing," subdivision (f)(1)(D). Very truly yours,

Gary J. Jugum
Assistant Chief Counsel
GJJ:sr
Sent by facsimile transmission to (714) 761-5455