When a financial institution outsources its whole computer and data processing operation, which of those services are exempt as 'outsourced' -- and what about work it used to do for its clients rather than for itself?

Plain-English summary

Connecticut taxes computer and data processing services, but Conn. Gen. Stat. § 12-412(74)(B) carves out an "outsourcing" exemption: if, on or after July 1, 1995, a provider takes over data processing operations that its customer formerly conducted for the customer's own use, those services are exempt — unless the provider and customer are related persons. The phrase "for its own use" is the whole game.

Here, the Company is a financial institution that also provides services to other financial institutions (its "Clients"). It used to run its own in-house data processing shop that served both its internal needs and the services it sold to Clients. After July 1, 1995 it handed the entire operation to an unrelated Outsourcing Company. DRS sorted the outsourced services by whether the Company had formerly performed them for itself or for its Clients:

• Exempt (own use): "LAN Management Services," "Corporate Enterprise System Processing Services," and "Systems Development Services" — internal systems the Company ran for itself. Also item processing of the Company's own items.
• Not exempt (Client use): item processing performed for Clients, and all "ATM Services" — these had been provided by the Company to its Clients, not for its own use, so the § 12-412(74)(B) exemption doesn't reach them.

For the non-exempt, Client-facing pieces, DRS pointed to a different mechanism: the Company can buy those services from the Outsourcing Company on a resale basis under § 12-410 (if it resells them without intervening use, or they become an integral, inseparable part of an enumerated service), and then charge its Clients sales tax on the resold services.

DRS also flagged two things that aren't exempt data processing at all and must be separated out and taxed: on-site repair or maintenance of computer hardware is fully taxable as a repair/maintenance service to tangible personal property (§ 12-407(2)(i)(DD)), and upgrades of prewritten ("canned") software delivered in tangible form are taxable as sales of tangible personal property. It's the parties' responsibility to break those charges out. (DRS addressed the same outsourcing exemption on different facts in Ruling No. 98-4, named here in prose, not linked.)

What this means for you

Businesses outsourcing their own data processing

The exemption rewards handing off work you used to do for yourself. Services the outsourcer takes over that you formerly ran for your own internal use can be exempt; services you had been reselling to your own customers don't qualify as "your own use," even inside the same outsourcing contract. Map each outsourced function to who it really served.

Providers and customers, watch the two carve-outs and the "related person" bar

Even within a genuinely outsourced operation, on-site hardware repair/maintenance (taxable under § 12-407(2)(i)(DD)) and tangible canned-software upgrades (taxable tangible personal property) are not exempt data processing — separate and tax them. And the exemption is off the table entirely if the provider and customer are related persons (§ 12-217m; for periods on or after January 1, 1998, the definition moved to 1997 Conn. Pub. Acts 295, § 1).

The resale path for client-facing services

If part of the outsourced work supports services you resell to your customers, you may be able to buy it for resale under § 12-410 instead of exempt — meaning you don't pay tax on the purchase, but you charge your customers tax on what you resell. This only works if you resell without making intervening use, or the service becomes an integral, inseparable component of an enumerated service you sell.

Common questions

Q: What is the "outsourcing" exemption?
A: Under § 12-412(74)(B), computer and data processing services are exempt when a provider, on or after July 1, 1995, takes over data processing operations the customer formerly conducted for its own use — provided the two aren't related persons.

Q: Why weren't the ATM and client item-processing services exempt?
A: Because the Company had performed them for its Clients, not for its own use. The exemption only reaches operations the customer formerly ran for itself, so client-facing services fall outside it.

Q: If those services aren't exempt, is the Company just stuck paying tax?
A: Not necessarily. It can buy them for resale under § 12-410 (if it resells them without intervening use or they become an integral part of an enumerated service it sells) and charge its Clients sales tax on the resold services.

Q: Is everything an outsourcer does exempt?
A: No. On-site hardware repair or maintenance is taxable as a repair service (§ 12-407(2)(i)(DD)), and upgrades of canned software delivered in tangible form are taxable as sales of tangible personal property. Those must be separately stated and taxed.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-412(74) / § 12-412(74)(B) (exemption for computer and data processing services a retailer takes over from a customer that formerly conducted them for its own use, on/after July 1, 1995; inapplicable between related persons)
• Conn. Gen. Stat. § 12-410 (purchases for resale)
• Conn. Gen. Stat. § 12-407(2)(i)(A) (computer and data processing services enumerated as taxable)
• Conn. Gen. Stat. § 12-407(2)(i)(DD) (repair or maintenance services to tangible personal property, fully taxable)
• Conn. Gen. Stat. § 12-217m (definition of "related person"), superseded for periods on/after January 1, 1998 by 1997 Conn. Pub. Acts 295, § 1

Related rulings:

• Ruling No. 98-4 (same § 12-412(74) outsourcing exemption applied to a procurement-process-management provider)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 98-1

Original ruling text

Ruling 98-1, Sales and Use Taxes / Computer and Data Processing Services / "Outsourcing" Exemption

FACTS:

A Connecticut company (the "Company") is a financial institution that serves as the financial institution for other financial institutions (the "Clients"). The Company had an on-site computer and data processing facility operated by its own employees which provided computer and data processing services for its internal functions and for supporting services the Company provided to its Clients. After July 1, 1995, the Company contracted with a computer and data processing service provider (the "Outsourcing Company") for the Outsourcing Company to take over the Company’s entire computer and data processing operations. The Company and the Outsourcing Company are not related parties within the meaning of Conn. Gen. Stat. §12-217m, nor are they related parties within the meaning of 1997 Conn. Pub. Acts 295, §1 (effective for periods commencing on or after January 1, 1998).

The contract between the Company and the Outsourcing Company provides that the Outsourcing Company will perform the following services. (The Company has conceded that all of these services are computer and data processing services, and this Ruling does not specifically address that issue.)

"LAN Management Services," which are hardware and software support services for the facility and management of the internal local area network (LAN) system used by the Company;

"Corporate Enterprise System Processing Services," which includes PC applications and maintenance of the computer system with respect to the Company’s internal reporting systems;

"Systems Development Services," which is the group of activities performed by the Outsourcing Company regarding the development, implementation, and maintenance of the outsourced and updated information management systems;

"Item Processing Services," which include activities such as inputting, verifying, sorting, balancing and reporting of data from checks and other items for both the Company and its Clients; and

"Automated Teller Machine (ATM) Services," which include providing ATM network access, processing and ATM card management services to the Company’s Clients, and providing sales support to assist the Company in marketing the services to its Clients, installing ATM machines at Client financial institutions, and training of Client financial institution personnel as necessary.

ISSUES:

Whether the computer and data processing services provided by the Outsourcing Company to the Company are exempt from sales and use taxes under Conn. Gen. Stat. §12-412(74), when provided for the Company’s own internal use; and

Whether the computer and data processing services provided by the Outsourcing Company to the Company are exempt from sales and use taxes under Conn. Gen. Stat. §12-412(74), when the services were previously provided by the Company to its Clients and are for the use of the Clients.

DISCUSSION:

Conn. Gen. Stat. §12-412(74)(B) provides the following exemption from sales and use taxes:

Sales of computer and data processing services rendered to a customer by a retailer which, on or after July 1, 1995, acquired the data processing operations from the customer, provided such customer formerly conducted such data processing operations for its own use. . . . The provisions in this subparagraph shall not apply if the retailer is a related person, as defined in section 12-217m, with respect to the customer or the customer is a related person, as defined therein, with respect to the retailer. [Effective for periods commencing on or after January 1, 1998, the definition of "related person" is in 1997 Conn. Pub. Acts 295, §1.]

Under the contract between the Company and the Outsourcing Company, the Outsourcing Company took over all of the computer and data processing operations formerly provided in-house by the Company, after July 1, 1995. The statute provides specifically that to be exempt, the services performed by an outsourcing company must be those that the service recipient formerly conducted "for its own use."

It appears that the "LAN Management Services," consisting of hardware and software support services and management of the internal local area network system used by the Company, are computer and data processing services provided for the Company’s own internal use. Accordingly, they are exempt under the provisions of Conn. Gen. Stat. §12-412(74)(B). "Hardware and software support" typically consist of computer consulting by telephone, electronically or in person, computer programming and other computer and data processing services. Note, however, that if "hardware support" consists of any on-site repair or maintenance of computer hardware, these services are not computer and data processing services, and are fully taxable under Conn. Gen. Stat. §12-407(2)(i)(DD) as repair or maintenance services to tangible personal property. If the "software support" includes any upgrades of prewritten ("canned") computer software, and the upgraded software is provided to the Company in a tangible form, this portion of the software support is not a computer and data processing service, and is fully taxable as the sale of tangible personal property. It is the responsibility of the Outsourcing Company and the Company to properly separate charges for sales of tangible personal property or services other than computer and data processing services, and to pay the appropriate sales and use taxes on such charges.

It appears that the "Corporate Enterprise System Processing Services" and the "Systems Development Services" are computer and data processing operations formerly conducted by the Company for its own internal use. Accordingly, they are exempt under Conn. Gen. Stat. §12-412(74)(B) when provided to the Company by the Outsourcing Company.

To the extent that the "Item Processing Services" are performed with respect to the Company’s own items, they are exempt when provided by the Outsourcing Company. Because of the requirement in Conn. Gen. Stat. §12-412(74)(B) that services be those that the service recipient formerly conducted "for its own use," the item processing formerly done by the Company for its Clients is not exempt under this section. However, the Company may purchase computer and data processing services from the Outsourcing Company on a resale basis under the provisions of §12-410, if it will resell the services without making any intervening use of them or if the services will become an integral, inseparable component part of a service enumerated in §12-407(2)(i). Sales and use taxes should be charged by the Company to its Clients on the charges for these services.

With respect to the "Automated Teller Machine (ATM) Services," as noted above, under the requirements of Conn. Gen. Stat. §12-412(74)(B), only those operations formerly conducted by the Company "for its own use" are exempt when provided by the Outsourcing Company. Apparently, the ATM services were all provided previously by the Company to its Clients, and were not performed by the Company for itself; therefore, none of the ATM services are exempt under Conn. Gen. Stat. §12-412(74). However, if the Outsourcing Company is providing taxable services to the Company that the Company will resell to the Clients, the Company may purchase these services on a resale basis under the provisions of §12-410, if it will resell the services without making any intervening use of them or if the services will become an integral, inseparable component part of a service enumerated in §12-407(2)(i). Sales and use taxes should be charged by the Company to its Clients on the charges for these services.

RULING:

The computer and data processing services provided by the Outsourcing Company to the Company are exempt from sales and use taxes under Conn. Gen. Stat. §12-412(74), when provided for the Company’s internal use.

The computer and data processing services provided by the Outsourcing Company to the Company are not exempt from sales and use taxes under Conn. Gen. Stat. §12-412(74), when the services were previously provided by the Company to its Clients and are for the use of the Clients. The Company may purchase the services from the Outsourcing Company on a resale basis under the provisions of §12-410, if it will resell the services without making any intervening use of them or if the services will become an integral, inseparable component part of a service enumerated in §12-407(2)(i). Sales and use taxes should be charged by the Company to its Clients on the charges for these services.

LEGAL DIVISION

February 6, 1998