When a company hires a team to implement and customize a new ERP system, which parts of the project — configuration, custom coding, training, support — are subject to Tennessee sales tax?

Plain-English summary

A Tennessee company hired an outside team to replace its old ERP system with a new cloud-based ERP/CRM platform. The work was split across three statements of work (SOWs) and billed by time and materials. The big question was which parts of that implementation project are subject to Tennessee sales tax.

The Department's answer: only the custom software development is taxable. In Tennessee, computer software is broadly taxed — and that includes custom software and any customized modification or enhancement of software. So when the project team wrote new code or used developer tools to build functions the platform didn't already have (custom flows, plug-ins, JavaScript, web-service calls), that customization was a taxable modification of software. The unit testing of that custom code is taxed along with it, because it's a necessary part of delivering the code.

Everything else in the project was not taxable: the discovery/planning ("Blueprint") work, data migration, configuration of the system's existing features (turning on built-in capabilities, not writing code), user-acceptance training, and go-live support — none of these are enumerated taxable services. The installation wasn't charged for, since the company's own IT team installed the software.

Two structural points mattered:

• The custom work was severable. Normally, lumping configuration in with custom development can make the whole bundle taxable. But here the customization was optional (confirmed by contract addendums), separately tracked and billable, and the parties had set out to avoid customization where possible — so the Department treated it as a severable piece. Taxing the customization therefore did not make the rest of SOW 1 taxable. (SOW 2 had no customization at all, so nothing in it was taxable.)
• No out-of-state allocation. The company wanted to allocate part of the tax to its roughly 15% of users located outside Tennessee. That allocation rule applies only to remotely accessed software that stays on the seller's server. Here the company had downloaded and installed the software on its own servers, so it couldn't allocate any of the customization tax out of state.

What this means for you

Companies running ERP or software-implementation projects

The taxable sliver is custom code (and its testing). Configuration of existing features, planning, data migration, training, and support are generally not taxable in Tennessee. How your statement of work is structured — whether the custom development is optional, separately tracked, and severable — can keep a taxable component from making the entire engagement taxable.

IT consultants and system integrators

Bill custom development as a distinct, severable, separately tracked line item if it's truly optional. The Department leaned heavily on the contract addendums calling the customization optional and on the detailed line-item tracking. If custom development is woven in as an inseparable part of a single software sale, the configuration can be pulled into tax with it.

Buyers of cloud/SaaS software with users in multiple states

The in-state/out-of-state allocation only works for software that stays on the seller's servers and is accessed remotely. If you download and install the software on your own servers, you can't allocate the tax based on where your users sit.

Accountants and tax professionals

Software (including custom and modified software) is taxable under § 67-6-231(a) and § 67-6-102(18); configuration is not an enumerated service (compare prior Ruling 11-29). Severability follows Penske Truck Leasing v. Huddleston and the intent-of-the-parties test, against the bundling default in § 67-6-102(87)(A)(vi). The allocation question turns on the remotely-accessed-software rule in § 67-6-231(b).

Common questions

Q: Is ERP implementation taxable in Tennessee?
A: Mostly not. The only taxable part is custom software development — writing new code or modifying the software — plus the testing of that custom code. Configuration of existing features, planning, data migration, training, and support are not taxable.

Q: What's the difference between "configuration" and "customization" here?
A: Configuration means using the software's existing functionality — flipping built-in settings and building tables within the delivered application — and is not taxable. Customization means developing new code or using developer tools to add functions the software didn't have, which is a taxable modification of software.

Q: Does one taxable item make the whole project taxable?
A: Not if the taxable part is severable. Here the custom development was optional, separately tracked and billable, and not essential to the rest of the work, so the Department analyzed it separately and the rest of the contract stayed non-taxable. If it had been an inseparable part of one software sale, the bundle could have been fully taxed.

Q: Can I allocate the tax to my out-of-state users?
A: Only for remotely accessed software that stays on the seller's server. If you download and install the software on your own servers, no out-of-state allocation is allowed.

Q: Can I rely on this ruling?
A: Not directly. A Tennessee letter ruling binds the Department only as to the taxpayer and exact facts it addressed and cannot be relied on by anyone else. Contract structure drives the result here. Tennessee sales tax is state-administered, so there's no separate self-collected city tax.

Citations and references

Statutes:
- Tenn. Code Ann. § 67-6-102(18) (broad definition of "computer software")
- Tenn. Code Ann. § 67-6-231(a) (computer software, including custom software and modifications, is taxable)
- Tenn. Code Ann. § 67-6-231(b) (in-state/out-of-state allocation for remotely accessed software)
- Tenn. Code Ann. § 67-6-205(c)(4) (repair of computer software is taxable) and § 67-6-205(c)(6) (installation of computer software is taxable)
- Tenn. Code Ann. § 67-6-102(97)(A) (prewritten software is tangible personal property)
- Tenn. Code Ann. § 67-6-102(87)(A)(vi) ("sales price"; bundled transactions)

Cases and rulings:
- Penske Truck Leasing Co. v. Huddleston, 795 S.W.2d 669 (Tenn. 1990) (severable, divisible contract provisions analyzed separately)
- Creasy Systems Consultants, Inc. v. Olsen, 716 S.W.2d 35 (Tenn. 1986) (custom software is a taxable sale)
- Ryder Truck Rental, Inc. v. Huddleston, 1994 WL 420911 (Tenn. Ct. App. Aug. 12, 1994) (only enumerated services are taxed)
- Tenn. Dep't of Revenue Letter Ruling 11-29 (configuration vs. customization) and Letter Ruling 14-10 (true object / bundling)

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/23-10.pdf

Original ruling text

Letter rulings are binding on the Department only with respect to the individual taxpayer being
addressed in the ruling. This ruling is based on the particular facts and circumstances
presented and is an interpretation of the law at a specific point in time. The law may have
changed since this ruling was issued, possibly rendering it obsolete. The presentation of this
ruling in a redacted form is provided solely for informational purposes and is not intended as
a statement of Departmental policy. Taxpayers should consult with a tax professional before
relying on any aspect of this ruling.

The application of Tennessee sales and use tax to customized software developed in an enterprise
level software system.

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;

(C)

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.

[REDACTED] (the “Taxpayer”) is a contractor headquartered in [REDACTED], Tennessee serving
[REDACTED] customers throughout middle Tennessee and the surrounding states. The Taxpayer
provides [SERVICES].
The Taxpayer engaged [REDACTED] (the “Project Team”) to migrate the Taxpayer’s previous enterprise
resource planning (“ERP”) system to [REDACTED] (the “New System”). The New System is a cloud-based

software-as-a-service ERP and customer relationship management system. The Taxpayer purchased
the New System licenses directly from the third-party publisher, and the Taxpayer’s internal IT team
downloaded and installed the software. Approximately 15% of the licenses were for the Taxpayer’s
employees that access the software from outside of Tennessee.
The Project Team was engaged to implement the New System across [REDACTED – THE TAXPAYER’S
BUSINESS]. High level goals of the engagement included the implementation of the New System;
adoption of a “best practices” approach for business processes; and avoidance of customizations or
non-standard processes unless necessitated by the business lines. A key project objective was to
implement the New System with a focus on using the New System’s out-of-the-box capabilities. The
project was spread across three statements of work. The engagement was based on time and
materials for professional fees.
Statement of Work #1 (“SOW 1”) contained four distinct phases:
Blueprint Phase
In the Blueprint Phase, the Project Team provided consulting resources to host discovery workshops
to break down the high-level phases of the project. Following the discovery process, the Project Team
provided a set of documentation that clarified business and application process flows, integration
points, and relationships of data. The documents were live and updated throughout the course of the
project. During this phase, the Project Team also identified requirements needed to support each
business process in addition to configuring applications to support prototyping and testing. Data
migration from the Taxpayer’s legacy system was included in this phase as well. This included data
mapping between the Taxpayer’s legacy system and the New System and import (or manual entry) of
an initial sampling of legacy data.
One result of these workshops was the foundation for writing “user stories.” The user stories formed
the deliverables and requirements against which the Project Team configured the application and
developed it as needed. After the workshops, user stories were created and refined, then imported
back into the product backlog.
Build and Validate Phase
This phase consisted of configuration, technical design, and development. Applications were
configured to support prototyping and testing. The Project Team applied security and began initial
testing of roles. Troubleshooting support was provided along with training. The Project Team
continued to refine user stories in the backlogs to drive the development work. In this phase, the
Project Team worked with the Taxpayer to design how the system would be configured and
customized to support the user stories included in the backlog. Process flows and prototypes were
used to document the design. The Project Team performed testing to determine whether user stories,
business process flows, and roles were successfully implemented and functioning as expected.
Various functions were customized and tested by the Project Team to provide functionality that was
not already available in the New System. According to SOW 1, customization is considered anything
requiring code or the use of developer tools. This customization includes JavaScript, custom flows,
plug-ins, web service calls, etc. The customized functions include finance and supply chain

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customization and customer engagement customization. The customized functions are specifically
identified in SOW 1.
The time incurred for customization is tracked separately from the configuration services. There is
sufficient line-item detail regarding rates, hours, and personnel on every invoice to delineate which
lines relate to custom code development and which do not. Because of how detailed the
customization is tracked, if needed, the Project Team can state the invoices separating the
customization into a separate billing. As mentioned above, one of the high-level goals of implementing
the New System was to avoid customization unless absolutely necessary to support additional
features requested by a business line. The additional features are not necessary for the completion
of the project, but instead are incidental add-ons requested by the Taxpayer. The exact time required
to develop the custom code may vary from the hours defined in SOW 1. If the hours required are more
than specified in SOW 1, the Project Team and the Taxpayer will discuss options including the Taxpayer
developing certain customizations, purchasing third-party solutions, or adding more hours to the
budget. The Project Team issued addendums to the related SOWs confirming that the customizations
were optional.
Validate and Deploy Phase
In the Validate and Deploy Phase, the Project Team facilitated and coached the Taxpayer’s employees
through User Acceptance Testing (“UAT”). They also supported the Taxpayer in the system for go-live
readiness.
Operate Phase
During the Operate Phase, the Project Team provided eight weeks of functional support during the
go-live period. Resources included the consultants utilized during the Build and Validate Phase.
Deliverables in this phase included items such as a project plan/schedules, issue logs, project status
reports, user stories, product backlogs, training plans, functional requirements documents, and
functional design documents, and comprehensive user manuals.
Statement of Work #2 (“SOW 2”) is for an implementation, i.e., configuration of a Field Service
Computerized Maintenance Management System (“CMMS”) for a business unit which outsources
facility maintenance for commercial customers. SOW 2 was structured similar to SOW 1, however,
there was no customization provided to the Taxpayer.
Statement of Work #3 (“SOW 3”) is for the modification of licensed software related to timekeeping,
manpower planning and construction financial forecasting. The software modifications are owned by
the Project Team and the Taxpayer’s rights to use the software customizations are the same as rights
with respect to licensed software. The Taxpayer submits that SOW 3 is subject to sales tax in
Tennessee.
Master Service Agreement
The Master Service Agreement (“MSA”) provides that the client may terminate the MSA or a SOW at its
convenience with written notice, and termination of a SOW does not result in termination of the MSA.
Additionally, the client is solely responsible for the evaluation, selection, purchase, licensing,

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installation, implementation, compatibility, use and performance of and results obtained from any
third-party products unless otherwise expressly agreed upon.

1.

What elements of SOW 1 are subject to Tennessee sales and use tax?
Ruling: The costs incurred to provide customization are subject to Tennessee sales and use
tax.

2.

What elements of SOW 2 are subject to Tennessee sales and use tax?
Ruling: Costs incurred under SOW 2 are not subject to Tennessee sales and use tax.

3.

May the Taxpayer allocate a percentage of the taxable elements of SOW 1 to the Taxpayer’s
out-of-state employees?
Ruling: No. The Taxpayer downloads the software to its servers.

In Tennessee, computer software is broadly defined under TENN. CODE ANN. § 67-6-102(18) (2022) as a
set of coded instructions designed to cause a computer to perform a task, and it is subject to sales
and use tax.1 Additionally, custom computer software and the customized modification or
enhancement of computer software are considered taxable sales of computer software. 2
Tennessee also imposes sales tax on certain, enumerated services. The sales tax does not apply to all
services; rather, it only applies to services specifically enumerated by the statute. 3 TENN. CODE
ANN. § 67-6-205(c)(4) (2022) imposes sales tax on the service of repairing computer software. Similarly,
TENN. CODE ANN. § 67-6-205(c)(6) imposes sales tax on the service of installing computer software.
Many transactions involve more than the sale of a single item or service. When a transaction involves
items or services that are all independently subject to sales tax, the entire transaction is subject to
sales tax, regardless of how the invoice is itemized. Similarly, if all the items or services are
independently either not subject to sales tax or are exempt, the entire transaction is not subject to
sales tax, regardless of how the invoice is itemized. Whenever two or more items are sold for a single

Retail sales of tangible personal property in Tennessee are subject to sales and use tax under the Retailer’s Sales Tax Act,
codified at TENN. CODE ANN. § 67-6-101 (2022) et seq. “Retail sale” is defined as “any sale, lease, or rental for any purpose other
than for resale, sublease, or subrent.” TENN. CODE ANN. § 67-6-102(84) (2022). The term “sale” is defined under the Tennessee
sales and use tax laws in pertinent part as “any transfer of title or possession, or both . . . of tangible personal property for a
consideration . . .” “Tangible personal property” is defined in pertinent part as “personal property that can be seen, weighed,
measured, felt, or touched,” and specifically includes prewritten computer software. TENN. CODE ANN. § 67-6-102(97)(A).
1

The sale of computer software, including prewritten and custom computer software, is subject to Tennessee sales and use tax
regardless of whether it is created on the premises of the customer or otherwise provided. TENN. CODE ANN. § 67-6-231(a) (2022);
see also Creasy Sys. Consultants, Inc. v. Olsen, 716 S.W. 2d 35, 36 (Tenn. 1986).
2

3

Ryder Truck Rental, Inc. v. Huddleston, 1994 WL 420911 (Tenn. Ct. App. Aug. 12, 1994).

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sales price and at least one of the items is subject to sales tax, the entire sales price is subject to the
sales tax.4
However, under the Tennessee Supreme Court Case Penske Truck Leasing Co. v. Huddleston, provisions
within a contract that are separate and divisible must be analyzed separately for taxability. 5 If a
contractual agreement provides for the sale of certain elements that are taxable and other items or
services that are non-taxable in isolation, and that contract is found to be severable, and operate
independently, according to the intention of the parties, then the taxability of the items or services
will be analyzed separately.6 The intention of the parties is determined by: the fair construction of the
terms and provisions of the contract; the subject matter to which the contract has reference; the
circumstances of the particular transaction giving rise to the question; and by the construction placed
on the agreement by the parties in carrying out its terms.”7
The Department has reviewed the MSA and SOWs 1, 2, and 3, and has found them to be separate and
distinct; the Department does not view the SOWs as being substantively controlled by the MSA for tax
purposes. Therefore, each SOW may be analyzed independently. Additionally, the purchase of the
New System from a separate vendor, which the Taxpayer installed itself on its own servers, is a
separate transaction from the SOWs analyzed in this ruling.
1. Elements of SOW 1 are subject to sales and use tax as computer software.
The costs incurred for providing custom functions in the New System are subject to sales and use tax
as computer software. The other elements of SOW 1 are not subject to sales and use tax.
Blueprint Phase
We first look to see if individual elements of SOW 1 are subject to sales and use tax. The Blueprint
Phase of SOW 1 does not contain any enumerated taxable services. The installation of the computer
software was conducted by the Taxpayer’s internal IT team; therefore, there are no charges for
installation. The Blueprint Phase does not involve the repairing, modification, or enhancement of
computer software. Rather, the Blueprint Phase predominantly comprises project planning and data
migration services, which are not enumerated services subject to sales and use tax.
Build and Validate Phase
The Build and Validate phase comprises two main components: configuration and customization.
Configuration involves using the existing functionality within the software to meet the requirements

Part 1 of the Appendix C to the October 30,2013 Streamlined Sales Tax Agreement defines a “bundled transaction” in pertinent
part as “the retail sale of two or more products, except real property and services to real property, where (1) the products are
otherwise distinct and identifiable, and (2) the products are sold for one non-itemized price.” See also 2 JEROME HELLERSTEIN ET AL.,
STATE TAXATION: SALES AND USE, PERSONAL INCOME, AND DEATH AND GIFT TAXES AND INTERGOVERNMENTAL IMMUNITIES ¶ 19A.04[2][a][iv], at
19A-14 (3d ed. 1998) (defining a “bundled transaction” as “a transaction in which two or more items that are potentially subject
to different tax treatment are sold for one undifferentiated price”).
4

5

795 S.W.2d 669 (Tenn. 1990).

6

Id.

7

Id.at 671.

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set by the user, which is not an enumerated taxable service.8 Accordingly, the costs incurred by the
configuration process are not subject to sales and use tax.
In contrast to the configuration services provided by the Project Team, customization of the New
System involves developing software code, either by writing new code or using developer tools, to
provide functionality that is not otherwise available in the New System. The customization at issue in
this ruling, then, is considered the modification of computer software, which is subject to sales and
use tax. Customization also involves unit testing the custom code to ensure functionality. This testing
is essential to ensuring that the custom code works as designed. Because the unit testing is a
necessary part of the sale of the customization, the costs of unit testing the custom code will be
considered a part of the sales price of the custom code. Accordingly, the costs incurred for developing
and testing the custom code are subject to sales and use tax.
Validate and Deploy Phase
The Validate and Deploy phase does not include any items that are subject to sales and use tax. During
the Validate and Deploy phase, the Project Team coaches the Taxpayer’s employees through User
Acceptance Training and provides remote support in the system for go-live readiness. The training
and support services are not enumerated taxable services.
Operate Phase
The Operate Phase does not include any items that are subject to sales and use tax. During the
Operate Phase, the Project Team provides on-site and remote functional support to the Taxpayer
during the go-live period, along with project plans and schedules, issue logs, project status reports,
user stories, product backlogs, training plans, functional requirement documents, functional design
documents, and comprehensive user manuals. The functional support provided by the Taxpayer is
part of the implementation of the software and is thus not taxable. The manuals, plans, reports,
documents, and manuals are all incidental to the provision of that functional support.
The element that is taxable in SOW 1 is the customization component of the build and validate phase.
The relevant question then, is whether the taxable customization component is severable from the
rest of the contract, or does its taxability subject the rest of SOW 1 to sales and use tax.
Generally, if a statement of work includes both software configuration services and custom software
development services (or any other service that involves the creation, fabrication, installation,
upgrade, or repair of software), then the software configuration services would be subject to taxation
as part of the sale of software.9 However, the Tennessee Supreme Court in Penske Truck Leasing Co. v.
Huddleston provides a rule more applicable to the specific provisions of SOW 1.10 In Penske, there was
a single contract that governed a transaction involving long-term truck leases and fuel sales
agreements.11 The taxpayer in that case claimed that the provisions governing each type of agreement
See Tenn. Dept. Rev. Ltr. Rul. 11-29 (June 23, 2011) (configuration involves the act of setting pre-defined software toggles or
switches or building tables that give direction within the standard delivered application software, it does not involve developing,
modifying, or creating software code.).
8

9

See Tenn. Dept. Ltr. Rul. 11-29 (June 23, 2011).

10

795 S.W. 2d 669 (Tenn. 1990)

11

Id.at 670.

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were severable, and that the truck leases should be taxed separately from the fuel sales, which would
have been exempt for the taxpayer, while the Commissioner argued that the fuel costs should be
included in the rental price of the equipment and the total price should be subject to sales and use
tax.12 The court found that an agreement can be either an entire contract or a severable contract
according to the intention of the parties; severable provisions would be subject to sales tax
separately.13 The court determined the intention of the parties by: the fair construction of the terms
and provisions of the contract; the subject matter to which the contract has reference; the
circumstances of the particular transaction giving rise to the question; and by the construction placed
on the agreement by the parties in carrying out its terms.”14
Here, we apply the court’s same basic criteria to determine if the software customization component
of SOW 1 is severable. First and foremost, the Project Team issued addendums to SOW 1 confirming
that the customization components were optional. As an optional item, the rest of SOW 1 is not
dependent on the sale of the customization component. In other words, if the customization
component was stricken from the contract, the contract would remain in effect, and the other services
in the contract continue to be meaningful services without the customization component. As such,
the parties intended for the customization component to be severable.
Next, SOW 1 states that a key project objective is to implement the New System with a focus on using
the New System’s out-of-the-box capabilities. This shows that at the outset, the parties intended to
avoid software customization. Again, this supports that the software customization was intended to
be severable.
Additionally, in SOW 1, the section on custom development provides that if the hours required to
develop the customizations are more than anticipated, the Project Team and the Taxpayer will discuss
options including the Taxpayer developing certain customizations on its own, purchasing third-party
solutions, or adding more hours to the budget. This provision further shows that the customization
provision is not a necessary part of the contract because it allows for other parties to perform the
customizations. Indeed, the rest of SOW 1 could be implemented without the customization provision.
It should be noted that although the facts state that the customization is necessary to support
additional features requested by a business line, the additional features themselves are not
necessary, and therefore, the customization is not necessary for the rest of the contract to be
performed.
Another factor supporting the severability of the customization provision is that the time incurred for
customization is tracked separately from the configuration services. There is sufficient line-item detail
regarding rates, hours, and personnel on every invoice to delineate which lines relate to custom code
development and which do not. Because of how detailed the customization is tracked, if needed, the
Project Team can restate the invoices separating the customization into a separate billing. This
detailed tracking and ability to bill separately for the customization component provides yet additional
support that the parties intended for the customization component to be severable.

12

Id. (the Commissioner relied on the holding in Magnavox Consumer Electronics v. King, 707 S.W. 2d 504 (Tenn. 1986).

13

Id.

14

Id.at 671.

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Considering the above factors, it is apparent that the parties intended for the customization provision
in SOW 1 to be severable from the rest of the contract. Accordingly, the taxability of the software
customization is analyzed separately from the rest of SOW 1. Thus, even though the charges for the
custom functions are subject to sales and use tax, the rest of the services provided for in SOW 1 are
not subject to sales and use tax.
2. SOW 2 contains no elements subject to sales and use tax.
SOW 2 provides the same implementation and configuration services found in SOW 1, but SOW 2 does
not contain any provisions for customizing functions. Accordingly, the services provided under SOW
2 are not subject to Tennessee sales and use tax.
3. The Taxpayer may not allocate a percentage of the taxable elements to the Taxpayer’s
out-of-state employees.
The Taxpayer suggests it may allocate a percentage of the taxable customization elements from SOW
1 to the location of the Taxpayer’s out-of-state employees pursuant to TENN. CODE ANN. § 67-6-231(b)
(2022), which provides that:
[i]f the sales price or purchase price of the software relates to users located in this
state and outside this state as indicated by a residential street or business address,
the dealer or customer may allocate to this state a percentage of the sales price or
purchase price that equals the percentage of users in this state.
The provisions of TENN. CODE ANN. § 67-6-231(b) apply to remotely accessed software that remains on
the server of the seller and is accessed and used by the employees of the purchaser. That is not the
nature of the transaction at issue in this ruling. The Taxpayer downloads the New System before its
employees use it. When the Project Team does the implementation work for the Taxpayer, the
software is already in the Taxpayer’s possession. Accordingly, the Taxpayer may not allocate a
percentage of the taxable customization elements in SOW 1.

APPROVED:

David Gerregano
Commissioner of Revenue

DATE:

November 17, 2023

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