When a software company bundles its core product with optional add-on components and charges one non-itemized price, does the $1,600 local-option and $3,200 state single-article sales tax cap apply to each component, or to the whole bundle?

Subject

How the single article cap applies to bundled, non-itemized software licensing sales.

Plain-English summary

The Tennessee Department of Revenue ruled that a software company's bundled sales of core software plus optional add-on components, sold for a single non-itemized price, do not qualify for Tennessee's "single article cap" — meaning the entire sales price is taxed, not just the first $1,600 (local option tax) or the $1,600-$3,200 band (state single article tax).

Tennessee taxes the first $1,600 of a "single article" of tangible personal property at the local option rate, and the next $1,600-$3,200 band at an additional 2.75% state rate. A "single article" is something "regarded by common understanding as a separate unit" that can be sold independently — but items "sold in sets, lots, suites, etc., at a single price" don't count. Under Honeywell Information Systems v. King and Executone of Memphis, Inc. v. Garner, individual software products (core and optional components) would ordinarily qualify as separate "single articles" based on their own character. But Colemill Enterprises, Inc. v. Huddleston holds that if a seller doesn't itemize the price of each component, the Department has no way to verify each piece's price — so the cap doesn't apply and the whole lump sum is taxed.

This taxpayer's practice was exactly the Colemill pattern: it negotiates one price covering core software plus whatever optional components a customer selects, invoices a single line item ("licensed software") with no per-product breakdown, and keeps internal cost allocations only in its own billing system — never disclosed to the customer or itemized on the invoice or license appendix. Because the Department cannot verify a per-component price from the customer-facing documents, the cap doesn't apply to either the local option tax or the state single article tax (which uses the identical "single article" definition).

What this means for you

Software companies and other multi-component sellers

If you want your bundled products to each qualify for the $1,600 single-article cap, you must itemize the price of each component separately on the invoice (or an incorporated schedule/appendix) — not just track internal cost allocations that customers never see. A single non-itemized lump-sum price for a bundle forfeits the cap for the entire bundle, even if each component would qualify as its own single article if sold alone.

Accountants and tax professionals

This ruling walks through the full Honeywell/Executone/Colemill line on Tennessee's "single article" definition (Tenn. Code Ann. § 67-6-702(d)): character of the component controls whether it's capable of being a single article (Executone), but a seller's own invoicing practice controls whether the Department can actually apply the cap component-by-component (Colemill, Honeywell). Since the local option tax (§ 67-6-702) and the state single article tax (§ 67-6-202(a)) share the same "single article" definition, this itemization analysis applies to both simultaneously.

Common questions

Q: If each software component would independently qualify as a "single article," does bundling them change that?
A: Yes, if sold for one non-itemized price. Tenn. Code Ann. § 67-6-702(d) expressly says independent units "sold in sets, lots, suites, etc., at a single price shall not be considered a single article."

Q: How can a seller preserve the single article cap on each component of a bundle?
A: By separately itemizing the price for each component on the invoice or an incorporated document (like the license appendix), so the Department can verify what each individual item actually sold for.

Q: Does keeping an internal cost breakdown in billing records (not shown to the customer) count as itemization?
A: No. This ruling makes clear that internal-only records the customer never sees don't satisfy the itemization requirement — the price must be disclosed per component in the customer-facing sale documents.

Q: Does the single article cap analysis differ between the local option tax and the state single article tax?
A: No. Both taxes use the identical statutory definition of "single article," so the same itemization analysis determines the outcome for each.

Q: Does this ruling apply to my company's bundled product sales?
A: No. A Tennessee letter ruling binds the Department only for the specific taxpayer and facts addressed and cannot be relied on by others, though it's a clear illustration of the itemization requirement.

Citations and references

Statutes and cases:

• Tenn. Code Ann. § 67-6-702(a)(1) (2007) (local option sales tax on first $1,600 of a single article)
• Tenn. Code Ann. § 67-6-702(d) (2007) (definition of "single article"; bundled sets/lots/suites excluded)
• Tenn. Code Ann. § 67-6-202(a) (2007) (state single article sales tax, $1,600-$3,200 band, same definition)
• Tenn. Code Ann. § 67-6-102(36)(B) (2007) (software as tangible personal property)
• 2007 Tenn. Pub. Acts, ch. 602 (definition of "prewritten computer software" effective January 1, 2008)
• Honeywell Information Systems v. King, 640 S.W.2d 553 (Tenn. 1982) (seller's own itemized invoicing controls single-article treatment)
• Executone of Memphis, Inc. v. Garner, 650 S.W.2d 734 (Tenn. 1983) (character of each component determines single-article status)
• Colemill Enterprises, Inc. v. Huddleston, 1996 Tenn. App. LEXIS 769 (Tenn. Ct. App. 1996) (single article cap forfeited when components aren't itemized)

Source

• Landing page: https://www.tn.gov/revenue/tax-resources/legal-resources/tax-rulings.html
• Original PDF: https://www.tn.gov/content/dam/tn/revenue/documents/rulings/sales/08-17.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 08-17

WARNING

Letter rulings are binding on the Department only with respect to the individual taxpayer
being addressed in the ruling. This presentation of the ruling in a redacted form is
informational only. Rulings are made in response to particular facts presented and are not
intended necessarily as statements of Department policy.

SUBJECT

How the single article cap for the local option sales tax and the state single article sales tax apply
to the sale and licensing of bundled software products.

SCOPE

This letter ruling is an interpretation and application of the tax law as it relates to a specific set of
existing facts furnished to the department by the taxpayer. The rulings herein are binding upon
the Department and are applicable only to the individual taxpayer being addressed.

This letter ruling may be revoked or modified by the Commissioner at any time.

Such revocation or modification shall be effective retroactively unless the following conditions
are met, in which case the revocation shall be prospective only:

(A) The taxpayer must not have misstated or omitted material facts involved in
the transaction;

(B) Facts that develop later must not be materially different from the facts upon
which the ruling was based;

(G) The applicable law must not have been changed or amended;

(D) The ruling must have been issued originally with respect to a prospective or
proposed transaction; and

(E) The taxpayer directly involved must have acted in good faith in relying upon
the ruling; and a retroactive revocation of the ruling must inure to the taxpayer's
detriment.

FACTS

[TAXPAYER], a Delaware corporation headquartered in [STATE-NOT TENNESSEE], is
engaged in the business of licensing computer software to businesses throughout the United
States. The Taxpayer also sells related software implementation services, optional software
maintenance contracts, training classes, hosting and other services. All products and services
sold by the Taxpayer are contracted for and invoiced separately from the sale of software.

The licensing of the Taxpayer’s software is contracted under an end-user license agreement (the
“License Agreement”). The Agreement grants the customer a perpetual license for the use of the
software. The License Agreement contains provisions that restrict the customer’s duplication
and use of the software, and prohibit the customer from licensing, sublicensing or transferring
the software to third parties, with the exception of affiliated entities. An appendix to the License
Agreement is executed for each software sale, and within the appendix the software that is
licensed by the customer is itemized in detail as to the specific software product.

There are two elements that factor into the determination of the price for the licensed software.
The first element consists of the actual software product or products. The second element
consists of the number of licenses granted for the product or products.

The software products are of two major types: core or basic software solutions and optional
components. The pricing of the core or basic solutions is affected by the number and type of
licensed users (professional, limited professional, employee, developer, etc.) These core
solutions can be thought of as the ‘Taxpayer’s primary software applications that provide
software solutions for general business processes. There are also numerous optional software
components that tailor the core or basic solutions(s) to the needs of a specific industry. Both the
core or basic software solutions and the optional components are software products that may be
sold independently of each other.

Sales personnel strive to understand the customer’s business needs and then point the customer
to the Taxpayer’s core applications and industry specific optional components that when
purchased together will meet those needs. The customers have the ability to pick and choose
what optional components they will purchase. The sales invoice for a software sale contains a
single line that states that the invoice is for licensed software, without showing the names of the
product(s) (i.e., the core solutions or optional components) or the number of licensed users.
Each software product is not listed individually on the sales invoice, but the appendix that has
the details of the purchase is referenced on the invoice.

The price for all the software licensed, whether a core solution or optional component, is
negotiated as a single sale. This price appears as a single amount in the appendix and on the
invoice. However, the cost of each application or component is recorded in the company’s
billing records, reflecting the net value of the products after discounting from list prices and after
negotiated credit(s) for previous purchases. This allocation of the single negotiated sales price is
not provided to the customer, nor is it part of the appendix. It is instead part of the billing
system, and results in all software products that were sold in a single negotiation being totaled
and billed as one amount.

QUESTIONS

1. With regard to the facts presented herein, how is the single article cap for the local option
   sales tax applied to the licensing of the Taxpayer’s software products?

2. With regard to the facts presented herein, how is the state single article sales tax applied to the
   licensing of the Taxpayer’s software products?

RULINGS

1. The Taxpayer’s software products are not subject to the single article cap for purposes of the
   local option sales tax, and the entire sales price will be subject to the local option sales tax.

2. The Taxpayer’s software products are not subject to the single article cap for purposes of the
   state single article tax.

ANALYSIS

Under the Retailers’ Sales Tax Act, Tenn. Code Ann. § 67-6-101 (2007) et seq., the sale of
tangible personal property is generally subject to the Tennessee sales and use tax. Tenn. Code
Ann. § 67-6-702(a)(1) authorizes counties and incorporated cities to impose an additional tax on
the first $1,600 of the sale of any single article of tangible personal property (the “local option
sales tax”). Tenn. Code Ann. § 67-6-202(a) imposes an additional state tax at the rate of 2.75
percent on the amount over $1,600, but less than or equal to $3,200, on the sale or use of any
single article of tangible personal property (the “state single article sales tax”).

1. The single article cap and the local option sales tax

The Taxpayer’s software products are not subject to the single article cap for purposes of the
local option sales tax, and the entire sales price will be subject to the local option sales tax.

Tenn. Code Ann. § 67-6-702(a)(1) (2007) authorizes counties and incorporated cities to impose
the local option sales tax on the first $1,600 of the sale of any single article of tangible personal
property.’ Tenn. Code Ann. § 67-6-702(d) defines the term “single article” for purposes of the
local option sales tax as “that which is regarded by common understanding as a separate unit
exclusive of any accessories, extra parts, etc., and that which is capable of being sold as an
independent unit or as a common unit of measure, a regular billing or other obligation.”
Additionally, Tenn. Code Ann. § 67-6-702(d) provides that “[s]uch independent units sold in
sets, lots, suites, etc., at a single price shall not be considered a single article.”

The creation and transfer of computer software constitutes a taxable sale under Tennessee law,
thereby subjecting the sale of software to the local option sales tax. Tenn. Code Ann. § 67-6-
102(36)(B) (2007) defines the term “software” as tangible personal property for the purposes of
the Tennessee sales and use tax. Specifically, that section states that:

“Sale” also means such transfer of customized or packaged computer software,
which is defined to mean information and directions loaded into a computer
which dictate different functions to be performed by the computer, whether

' The $1,600 limit is referred to for purposes of this letter ruling as the “single article cap.”

contained on tapes, discs, cards, or other device or material. For such purpose,
computer software shall be considered tangible personal property.”

Under the local option sales tax, a single article is taxed at the local rate only with respect to the
first $1,600 of the sales price. However, if the item being sold does not meet the definition of a
“single article,” the entire sales price will be subject to taxation at the local rate. Therefore, it is
necessary to determine under what circumstances packaged, prewritten or “canned” computer
software products are “regarded by common understanding as a separate unit exclusive of any
accessories, extra parts, etc., and that which is capable of being sold as an independent unit.””
Tenn. Code Ann. § 67-6-702(d). A standard package software product developed for sale to the
general public, i.e., not customized or custom created software, is commonly understood as a
separate unit, and the single article cap will apply to the sale of packaged software. Similarly,
the Department also considers a license agreement that contemplates the transfer of rights to use
certain standard packaged software products to be a single article for purposes of the local option
sales tax and the state single article sales tax, provided that the agreement separately itemizes the
consideration to be paid for each separate software package and license. See Honeywell
Information Systems v. King, 640 S.W.2d 553 (Tenn. 1982) (taxpayer must treat sale of
components as individual sales and not as packaged sale for each component to be considered a
single article).

In Honeywell Information Systems, Inc., 640 S.W.2d at 553, the taxpayer plaintiff leased
computer components. The taxpayer’s method of marketing, invoicing and record-keeping
clearly demonstrated that it did not lease the component units of its computer systems as one
single entity. Rather, it invoiced its customer for each of the components, each bearing its own
serial number, and a specific monthly rental being charged for each component. The Tennessee
Supreme Court held that since the taxpayer did not treat these components as “a single article of
personal property” for purposes of its own leasing, invoicing and collections, the Commissioner
for the Department of Revenue was likewise justified in treating them separately.

In Executone of Memphis, Inc. V. Garner, 650 S.W.2d 734 (Tenn. 1983), the Tennessee Supreme
Court clarified that it is the character of each component, not how a taxpayer treats each
component, that determines its status as a single article. The court dismissed the plaintiff’s
argument that the plugs, the switching systems, and the telephone units in a digital telephone

• As of January 1, 2008, pursuant to Acts 2007 Public Chapter 602 the definition of “tangible personal property” will
  include “prewritten computer software.”

As of January 1, 2008, pursuant to Acts 2007 Public Chapter 602 “prewritten computer software” will be defined
as: computer software, including prewritten upgrades, which is not designed and developed by the author or other
creator to the specifications of a specific purchaser. The combining of two or more “prewritten computer software”
programs or prewritten portions thereof does not cause the combination to be other than “prewritten computer
software.” “Prewritten computer software" 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 the purchaser. Where a person
modifies or enhances computer software of which the person is not the author or creator, the person shall be deemed
to be the author or creator only of such person’s modifications or enhancements. “Prewritten computer software” or
a prewritten 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 “prewritten computer software;”
provided, however, that where there is a reasonable, separately stated charge or an invoice or other statement of the
price given to the purchaser for such modification or enhancement, such modification or enhancement shall not
constitute “prewritten computer software.”

switching system were components of a single article because no single component is sufficient
on its own. The Court held that:

In applying the considerations set out in Rule 6 to the present case, it requires no
distortion to conclude that the plugs, the switching systems, and the telephone
units, as they are described here, are “commonly understood” to be separate units.
The Plaintiff admits that these articles have unit prices, that they can be put
together to meet various office needs, and that if the occasion arose they could be
sold separately to one who needs a system alteration. To conclude that only the
system itself constitutes a single unit completely ignores the separate physical
character of each component part, both in the design of the system and in the
ultimate benefit to the customer.

Executone of Memphis, 650 S.W. 2d at 737 (emphasis added). Thus, it is character of each
component, not how a taxpayer treats each component, that determines its status as a single
article.

However, in Colemill Enterprises, Inc. v. Huddleston, 1996 Tenn. App. LEXIS 769
(Tenn.Ct.App. 1996), rev’d on other grounds, 967 S.W.2d 753 (Tenn. 1998), the Tennessee
Court of Appeals held that the single article cap did not apply to a rebuilt airplane, because the
plaintiff did not itemize the individual components and services separately on the invoice, with
the result being that the Commissioner of Revenue had no means to determine the price of each
individual component. The Colemill plaintiff rebuilt airplanes using numerous components, and
claimed that the single article cap applied to the sale of the entire rebuilt airplane even though a
portion of the sales price included charges for installation services (to which the single article
cap does not apply). The Tennessee Court of Appeals rejected this argument, noting that the
plaintiff charged one fee for an entire rebuilt airplane. Because the plaintiff did not itemize the
individual components and services separately on the invoice, the Commissioner of Revenue had
no means to determine the price of each individual component. The court agreed with the
Commissioner that assessing tax on the full sales price was the only way the Commissioner
could ensure that the full amount of the installation services were taxed, and that the aircraft
parts were properly taxed as well. The single article cap therefore did not apply to the rebuilt
airplane, and the entire sales price was subject to the local option sales tax.

Under the Honeywell and Executone analysis, the software solutions are properly characterized
as single articles. However, under Colemill, the sale of these items for one lump-sum price
causes the sale to no longer be subject to the single article cap. Furthermore, consistent with the
Colemill analysis, Tenn. Code Ann. § 67-6-702(d) provides that “[s]uch independent units sold
in sets, lots, suites, etc., at a single price shall not be considered a single article.”

Unlike the plaintiff in Honeywell Information Systems, Inc., the Taxpayer does in fact treat the
sale of a software package as the sale of a single item. Rather, the Taxpayer treats the sale in the
same manner as the plaintiff in Colemill. Specifically, the Taxpayer bundles the components
together and negotiates a single sales price with a customer; the consideration paid to license
each separate software package is not listed separately on the invoice or the appendix. The
Taxpayer charges one non-itemized price for the sale of the core or basic software solutions and

the optional components. Although the Taxpayer keeps a list of the cost of each application or
component in its billing records, it merely reflects the net value of each of the products after
discounts and credits for a customer’s previous purchases applied to the total sales price. As in
Colemill, the Commissioner has no means to determine at what price the Taxpayer actually sells
the core or basic software solutions and the optional components.

As illustrated in the Colemill decision and in Tenn. Code Ann. § 67-6-702(d), if a dealer does not
allocate or determine a sales price corresponding to each single article, the single article cap will
generally not apply, and the full sales price is subject to the local option sales tax. Because the
Taxpayer’s sale of the core or basic software solutions and the optional components cannot be
broken down, the sale will not be treated as the sale of single articles. Accordingly, the single
article cap will not apply, and the total sales price of the software packages will be subject to the
local option sales tax. As such, the entire price of the sale is subject to local sales tax. Note that
if the Taxpayer itemized the prices for the core or basic software solutions and the optional
components on its customers’ invoices, each component of the sale would be considered a single
article.

In summary, the Taxpayer’s software products are not subject to the single article cap for
purposes of the local option sales tax, and the entire sales price will be subject to the local option

sales tax.

2. The state single article sales tax

The Taxpayer’s software products are not subject to the single article cap for purposes of the
state single article tax.

Tenn. Code Ann. § 67-6-202(a) (2007) imposes an additional tax at the rate of 2.75 percent on
the amount over $1,600, but less than or equal to $3,200, on the sale or use of any “single
article” of personal property as defined in Tenn. Code Ann. § 67-6-702(d) (the “state single
article sales tax”). For purposes of the state single article sales tax, the analysis set forth above
applies because Tenn. Code Ann. § 67-6-202(a) uses the same definition of “single article” as the
local option sales tax. As discussed above, the software products are not subject to the single
article cap for purposes of the state single article tax under Tenn. Code Ann. § 67-6-202(a).
Because the single article cap does not apply, the software would therefore not be subject to the
additional state single article sales tax.

Tony Greer
Tax Counsel

APPROVED: Reagan Farr
Commissioner of Revenue

DATE: 2/29/08