When a software company sells a development-tool product AND separately hires out consultants to help clients build their own applications with that tool, which charges are taxable — the tool itself, the consulting/training, or the applications the consultants help build?

Plain-English summary

A software company sold a development-tool product (SOFTWARE) that customers use to build their own applications (a general ledger, inventory system, flight tracker, etc.). Separately, the company also sold consulting services to help customers use the tool, and had a distinct classroom-training offering. The company asked the Comptroller to confirm that its consulting services were not taxable.

The Comptroller's answer drew several distinctions rather than a single yes/no:

• The sale of the SOFTWARE tool itself is taxable — it's software, full stop, regardless of the fact that it's used to build other software.
• Separately stated training charges are not taxable.
• Consulting charges to help a client build an application the client will exclusively own are not taxable, and neither are later modifications to that client-owned application — both fall under the custom-software exception in Tax Code § 151.3111.
• Charges to modify or support the SOFTWARE tool itself, however, are taxable.

The Comptroller reviewed the company's actual invoices and contracts and found nothing inconsistent with the facts presented.

What this means for you

Software companies that both sell a development tool and sell related consulting/training

Structure your billing to separate: (1) the sale/license of your tool (taxable), (2) training on how to use the tool (not taxable if separately stated), (3) consulting to help a client build an application it will own outright (not taxable, protected as custom software), and (4) support or modification work on your own tool (taxable). Bundling these together risks the whole charge being treated as taxable.

Clients hiring consultants to build custom applications with a vendor's development tool

If you end up owning all rights to the application built for you, the consulting charge for building it — and later modifying it — should not carry sales tax, separate from whatever you paid for the underlying development-tool license.

Accountants and tax professionals

This letter is a useful worked example of applying § 151.3111's custom-software exception in a real audit context (the Comptroller reviewed actual invoices and contracts, not just a hypothetical). The line it draws — tool sale and tool support/modification are taxable, client-owned custom-application work and training on the tool are not — is a template for similar SaaS/dev-tool fact patterns.

Common questions

Q: Is a software development tool itself taxable when sold to a customer?
A: Yes — the sale of the tool product is taxable regardless of what the customer uses it to build.

Q: Is training on how to use a development tool taxable?
A: No, according to this letter, as long as the training charges are separately stated from other charges.

Q: Is consulting to help a client build their own custom application taxable?
A: No — charges for helping a client develop an application the client will exclusively own, and later modifications to it, are not taxable under Tax Code § 151.3111.

Q: Is support or modification of the vendor's own software tool taxable?
A: Yes, per this letter — charges to modify or support the underlying development tool itself remain taxable.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.3111 (custom-software / modification exception)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/200007542L

Original ruling text

July 31, 2000

Dear **:

Thank you for your letter concerning the taxability of consulting services
performed by COMPANY A. Per my request of May 11, 2000, you submitted
contracts and invoices in connection with these services. Your have also
provided the following information in response to my previous letter:

1. The sale of your software product is not linked to your services. Customers
   can and do purchase your product and use the product without any consulting
   services. A common occurrence is a purchase by a customer, experienced with
   your product, who buys additional seats so that he can put more developers on a
   project. In such sales, there are often no services associated with the sale.

2) The same SOFTWARE product can be used to build any number of applications.
The customer may use the SOFTWARE product to build as many applications as the
customer wishes. Assistance from COMPANY A is not necessary in either the first
application produced or for any subsequent application.

3) The SOFTWARE product is essentially the same for all applications. The same
product without any change could be used to develop a flight tracking system, a
general ledger, personnel system, inventory management system and many others.
Customers will buy different versions of the product to match their data
processing environment. For example: one customer will use a Unix operating
system while another will use a NT operating system. These customers will buy
different versions of SOFTWARE, one designed to run on Unix and the other
designed to run on NT. These different versions are chosen at the time of sale
and each is delivered complete. By the same logic, customers will buy different
versions of the product to work with different database engines. For example:
one versions of the product will work with Oracle database and another version
of the product will work with the Sybase database engine. Once a customer has
selected the operating system option, database options, and other environment
related options, that customer can then use the one SOFTWARE product to build
all the different applications discussed here.

You are not aware of a case where COMPANY A has sold consulting to a customer
who did not own your product. Your consulting service is specific to your
product. However, there is not a one-to-one relationship between product sales
and consulting services. Some customers have used your product for many
projects over many years. These customers often hire your consulting services
many times over the years in connection with the same SOFTWARE product. So, on
a great number of your consulting engagements, the customer has already had the
product for a number of years and the consulting engagements are associated
with additional use of the product not additional product sales.

You have a distinct set of part numbers and descriptions that identify formal
classroom training as a service offering that is separate and distinct from
consulting services. Revenue resulting from classroom training is clearly
segregated from consulting revenue in your accounting records and in your
invoices to customers. However, consulting services sometimes serves the
purpose of providing extended or advanced training in the use of our product,
even if the service is not delivered in a classroom setting. It would be
incorrect to say that there is no training underlying invoices for consulting
services.

You have allowed customer's to market the software that they develop while
using SOFTWARE. You included an agreement with ** (COMPANY B).
** (COMPANY B) is the flight reservation company owned by AIRLINE
COMPANY. This agreement documents COMPANY B's right to sell applications
developed by COMPANY B using SOFTWARE. The agreement documents that COMPANY B
has the right to control pricing terms and conditions and is not required to
pay royalties. In addition, COMPANY B is not required to make up-front
payments to obtain the right to market the applications developed by COMPANY B.
COMPANY B is required to take measures to protect COMPANY A intellectual
property rights and trademark rights. Since the maintenance of the COMPANY B
developed applications, once sold to third parties, will require the use of the
SOFTWARE product, the agreement calls for involvement of COMPANY A in the
delivery of the SOFTWARE product to third parties as well as maintenance of the
SOFTWARE product.

The standard agreement is silent on the customers' rights to sell the developed
applications. Since customers have possession of the applications they develop,
they can market the applications without COMPANY A consent or involvement or
payment of royalties.

In summary, you state that COMPANY A sells a development tool (SOFTWARE) to
customers. The tool is used by customers to develop additional software
programs (applications). COMPANY A provides skilled development personnel
(consultants) for hire by customers. The consultants assist the customer to
develop applications for the customers use or sale. COMPANY A does not sell
application software. The consultants do not modify or maintain the development
tool. The consulting services provided by COMPANY A is for the creation and
maintenance of applications not sold by COMPANY A.

It is your belief that the consulting services described here are not taxable.

Response. The sale of the SOFTWARE Product is taxable. This product is
software used as a tool in the development of software. Separately stated
charges to train the clients in the use of the developmental aid software are
not taxable (Article 11 of COMPANY B agreement). Charges to assist the client
in using the tool to develop software where the client will obtain all and
exclusive rights to the software developed are not taxable. Subsequent
modifications of the software developed would also be nontaxable per Section
151.3111. However, charges to modify or support the software tool itself are
taxable (item 6 of master agreement and Articles 6.06 through 6.11 of COMPANY B
agreement).

A review of the invoices and contracts did not give any reason to doubt the
validity of the preliminary statements and responses accompanying the request.

This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change.

You may call me toll free at 1-800-531-5441, ext. 5-0613. The direct line is
512/475-0613. You may also write to Tax Policy Division, Comptroller of Public
Accounts.

Sincerely,

Kevin Koller
Tax Policy Division

cc: Mary Kasner, Supervisor, ** Audit Office
Gem Zhan, Auditor