Is software licensed while it was only partly built taxable — the portion finished before the license as prewritten software, and the portion built afterward to the licensee's specs as custom software?

Plain-English summary

A financial-data-processing company licensed securities back-office software that its developer had only partly finished — about 60% complete when the license was signed. The company would be the beta site, and the remaining programming would be finished over about six months to the company's needs, then folded into the company's existing "Tradepro" system. The company asked whether the licensed software is subject to sales tax.

New York taxes prewritten (canned) computer software as tangible personal property, but does not tax custom software designed and developed to a specific purchaser's specifications. The Department split the software along the timeline of the license:

• The ~60% built before the license existed independently of this purchaser, so it is prewritten software (Tax Law § 1101(b)(14)) and its receipts are taxable under § 1105(a).
• The portion developed after the license, to the company's specifications, is custom software and is not taxable — provided it really was designed and developed to the company's specs.

The opinion added several practical rules. The affiliated-group custom-software exemption (§ 1115(a)(28)) did not apply to this license, but would apply to a later transfer of the software to a corporation or partnership in the company's affiliated group (except the prewritten portion, and not if the transfer is a tax-avoidance plan). Software maintenance charges are exempt under § 1115(o) — but if a maintenance agreement bundles taxable elements (prewritten upgrades) with nontaxable ones (training, consulting, troubleshooting), the whole charge is taxable unless the nontaxable part is reasonable and separately stated and billed. Finally, an upgrade to prewritten software is generally taxable, but an upgrade designed to a specific purchaser's specs is exempt custom software.

What this means for you

Software developers and licensors

Where software sits on the prewritten-versus-custom line drives its New York tax treatment, and the timing and specificity of development matter. Code that already exists (or is sold to someone other than the person it was built for) is prewritten and taxable; code designed and developed to a particular customer's specifications is custom and exempt. When a deal mixes both, expect the prewritten portion to be taxed.

Businesses licensing or buying business software

Do not assume a "custom" or heavily-configured system is entirely tax-free. Any prewritten core is taxable even if later tailored to you. For maintenance and upgrade contracts, insist that nontaxable services (training, consulting, support) be reasonable and separately stated — otherwise a single bundled maintenance charge is taxable in full because it includes prewritten upgrades.

Accountants and tax professionals

The controlling definitions are § 1101(b)(6) and (b)(14) (prewritten software is taxable tangible personal property) against the custom-software exclusion, with § 1115(o) exempting services performed on software and § 1115(a)(28) covering intra-affiliated-group custom-software transfers. The separately-stated requirement is decisive for bundled maintenance and modification charges.

Common questions

Q: Is the licensed software taxable?
A: Partly. The roughly 60% developed before the license is taxable prewritten software; the portion developed afterward to the company's specifications is exempt custom software.

Q: What makes software "custom" and exempt?
A: It must be designed and developed by the author to the specifications of the specific purchaser. Software that already exists, or that is sold to someone other than the person it was built for, is prewritten and taxable.

Q: Are software maintenance charges taxable?
A: Charges for maintenance are exempt under § 1115(o). But if a maintenance agreement bundles taxable prewritten upgrades with nontaxable services (training, consulting, troubleshooting), the entire charge is taxable unless the nontaxable elements are reasonable and separately stated and billed.

Q: Are upgrades taxable?
A: Generally yes — an upgrade to prewritten software is taxed as prewritten software. But an upgrade designed and developed to a specific purchaser's specifications is exempt as custom software.

Q: Does the affiliated-group exemption apply here?
A: Not to this license. It could apply to a later transfer of the software to a corporation or partnership in the company's affiliated group, but not to the prewritten portion and not if the transfer is a plan to avoid tax.

Q: Can another company rely on this opinion?
A: No. An advisory opinion binds the Department only as to the petitioner and the facts described. It illustrates the Department's reasoning, but your facts may differ.

Citations and references

Statutes:

• Tax Law § 1105(a) (tax on retail sales of tangible personal property)
• Tax Law § 1101(b)(6) (tangible personal property includes prewritten computer software)
• Tax Law § 1101(b)(14) (definition of prewritten computer software; custom modifications)
• Tax Law § 1115(a)(28) (exemption for custom software transferred within an affiliated group)
• Tax Law § 1115(o) (exemption for services performed on computer software; separate-statement rule)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/sales_ao_1993.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/sales/a93_15s.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-93 (15)S
Sales Tax
February 26, 1993

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. S920610A

On June 10, 1992 a Petition for Advisory Opinion was received from Nomura Automation
Management, Inc., 2 World Financial Center, Building B, New York, NY 10281-1198.
The issue raised by Petitioner, Nomura Automation Management, Inc., is whether the
computer software which has been licensed non-exclusively for use by Petitioner is subject to the
imposition of sales tax.
Petitioner is in the business of providing customized financial data processing services
through the use of its "Tradepro" computer system. "Tradepro" is a back office system which handles
numerous functions related to the processing of customer and firm trades. These functions include
recording transactions and maintaining trade positions and account balances. In addition, "Tradepro"
supports the firms' regulatory and compliance reporting requirements to various external agencies
such as the Securities and Exchange Commission, the New York Stock Exchange and the Internal
Revenue Service.
Petitioner is currently in the process of obtaining a nonexclusive license from George
Davidsohn & Son, Inc., hereinafter "Davidsohn", a corporation organized and existing under the laws
of the State of New York and having its principal place of business in New York. The license is for
Petitioner to utilize software which Davidsohn is in the process of developing and which will be
marketed under the names Autocage and Autobank Pledge (hereinafter collectively called "the
software") when it is developed. Petitioner has agreed to be a beta test site for the software, once
fully developed, as its initial user.
The software was approximately 60% complete upon execution of the licensing agreement.
At that time, and until it is fully developed the software is not of any utility. Davidsohn will
complete the programming of the software within approximately six months of the execution date
of the agreement, after which time Petitioner will initiate an acceptance test of the software. It is
only after this process that the software will be fully developed, and be able to be used for its
intended purpose. Once fully developed, Davidsohn will market the completed software to other
companies.
Petitioner will incorporate the software upon completion in its already existing "Tradepro"
system. It will utilize the software in an effort to further computerize its securities settlement process.
The system will add the following automated functionality to the security settlement processes
currently utilized by Petitioner: 1) The software will allow for multi-company processing. 2)
Updates to the system database are to be made on a real-time basis; and 3) Many of the current
manual processes will be automated, and additional functionality for collateral financing will be
added.

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Petitioner has also retained the right to license the software (once fully developed) to other
companies, but only as a part of the basic securities back office software package which Petitioner
currently uses. Davidsohn will be entitled to a fee from Petitioner for any license of software entered
into pursuant to the Davidsohn agreement.
Section 1105 of the Tax Law states, in part:
Imposition of sales tax ...... there is hereby imposed and there shall be
paid a tax of four percent upon:
(a) The receipts from every retail sale of tangible personal property,
except as otherwise provided in this article.
Section 1101 of the Tax Law states, in part;
Definitions. - ­
(b) When used in this article for the purposes of the taxes imposed
by subdivisions (a), (b, (c) and (d) of section eleven hundred five and
by section eleven hundred ten, the following terms shall mean:
(6) Tangible personal property. Corporeal personal property of any
nature . ... Such term shall also include pre-written computer
software, whether sold as part of a package, as a separate component,
or otherwise, and regardless of the medium by means of which such
software is conveyed to a purchaser.
(14) Pre-written computer software. Computer software
(including pre-written upgrades thereof) which is not software
designed and developed by the author or other creator to the
specifications of a specific purchaser. The combining of two or more
pre-written computer software programs or pre-written portions
thereof does not cause the combination to be other than pre-written
computer software. Pre-written software also includes software
designed and developed by the author or other creator to the
specifications of a specific purchaser when it is sold to a person other
than such purchaser. Where a person modifies or enhances computer
software of which such person is not the author or creator, such
person shall be deemed to be the author or creator only of such
person's modifications or enhancements. Pre-written software or a
pre-written portion thereof that is modified or enhanced to any
degree, where such modification or enhancement is designed and
developed to the specifications of a specific purchaser, remains pre­
written software; provided, however, that where there is a reasonable,
separately stated charge or an invoice or other statement of the price

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Sales Tax
February 26, 1993
given to the purchaser for such modification or enhancement, such
modification or enhancement shall not constitute pre-written
computer software.
Section 1115 of the Tax Law states, in part
Exemptions from sales and use taxes. -- (a) Receipts from the
following shall be exempt from the tax on retail sales imposed under
subdivision (a) of section eleven hundred five and the compensating
use tax imposed under section eleven hundred ten:
(28) Computer software designed and developed by the
author or creator to the specifications of a specific purchaser which
is transferred directly or indirectly to a corporation which is a member
of an affiliated group of corporations within the meaning of
subparagraph six of paragraph (b) of subdivision seventeen of section
two hundred eight of this chapter except for clauses (ii) and (iii) of
such subparagraph that includes such purchaser, or to partnership in
which such purchaser and other members of such affiliated group
have at least a fifty percent capital or profits interest (but only if the
transfer is not in pursuance of a plan having as its principal purpose
the avoidance or evasion of tax under this article), but in no case
including computer software which is pre-written, as defined in
paragraph six of subdivision (b) of section eleven hundred one of this
article and available to be sold to customers in the ordinary course of
the seller's business.
(o) Services otherwise taxable under subdivision (c) of section
eleven hundred five or under section eleven hundred ten shall be
exempt from the tax under this article where performed on computer
software of any nature; provided, however, that where such services
are provided to a customer in conjunction with the sale of tangible
personal property any charge or such services shall be exempt only
when such charge is reasonable and separately stated on an invoice or
other statement of the price given to the purchaser.
In the instant matter, the software developed by Davidsohn was approximately 60% complete
at the time of execution of the licensing agreement between Petitioner and Davidsohn.
Section 1101(b)(14) of the Tax Law defines prewritten computer software, in part, to be
"computer software (including pre-written upgrades thereof) which is not software designed and
developed by the author or other creator to the specifications of a specific purchaser." Accordingly,
the portion of the software (approximately 60%) which had been developed by Davidsohn prior to
the licensing agreement between Petitioner and Davidsohn is considered to be prewritten software
and the receipts attributable to the sale of the prewritten software are subject to the tax imposed
under Section l105(a) of the Tax Law.

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Sales Tax
February 26, 1993
The receipts attributable to the sale of the portion of software which Davidsohn developed
subsequent to the licensing agreement between Petitioner and Davidsohn will not be subject to the
tax imposed under Section 1105(a) provided that such portion of the software was designed and
developed to Petitioner's specifications.
The exemption from sales tax provided under Section 1115(a)(28) of the Tax Law will not
apply to the instant transaction. The exemption will apply to any subsequent transaction where
Petitioner transfers the software licensed from Davidsohn to a corporation that is a member of an
affiliated group of corporations which includes Petitioner or to a partnership in which Petitioner and
other members of such an affiliated group have at least a 50 percent capital or profits interest.
However, the exemption will not apply to any receipts attributable to the prewritten portion of the
software as discussed above, nor if the sale or transfer of the software is part of a plan to avoid or
evade the tax.
Receipts from charges for the maintenance of the software will be exempt from sales tax
under the provisions of Section 1115(0) of the Tax Law. However, it is noted that where a software
maintenance agreement provides for the sale of both taxable elements (prewritten software upgrades)
and nontaxable elements (training, consulting, diagnostic and trouble shooting support, etc.) the
charge for the entire maintenance agreement will be subject to tax unless the charge for the
nontaxable elements is reasonable and separately stated in the maintenance agreement and separately
billed on the invoice or other document of sale given to the purchaser.
Generally, the sale of a revision or upgrade of prewritten software is subject to tax as the sale
of prewritten software. If, however, the software upgrade is designed and developed to the
specifications of a specific purchaser its sale to the specific purchaser will be exempt as a sale of
custom software.

DATED: February 26, 1993

/s/
PAUL B. COBURN
Deputy Director
Taxpayer Services Division

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.