When did a software business's natural gas and electricity qualify for Texas's manufacturing exemption, and could an audit reject its predominant-use study?

Plain-English summary

Computer software was tangible personal property, but contract programming was a service when the client retained ownership rights to the program.

Natural gas and electricity directly used to create, develop, modify, or update the software producer's own product for sale, lease, or license could qualify as manufacturing use. Utilities for customer-owned software work, contract programming, time-sharing, support systems not directly used in production, and other nonproduction uses were not exempt.

Host systems and their components qualified only when directly used in manufacturing software for market. Climate-control utility use could qualify only in the required manufacturing area when temperature or humidity directly affected the product or equipment, supported by documentation such as manufacturer requirements.

For a mixed-use meter, more than 50% of each utility measured by each meter had to be exempt use. The taxpayer bore the burden of clear and convincing proof. A utility company's acceptance did not make the study final: an audit could review the study's completeness, classifications, and accuracy and accept or reject it based on validity.

Common questions

Was contract programming manufacturing? No.

Was software time-sharing exempt manufacturing use? No; the letter called it taxable data processing.

What percentage of a mixed-use meter had to be exempt? More than 50%, separately for each meter and utility.

Could an audit reject the study later? Yes.

Citations and references

• 34 Tex. Admin. Code Rule 3.295 (Natural Gas and Electricity)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9001L0974E07

Original ruling text

COMPTROLLER OF PUBLIC ACCOUNTS
STATE OF TEXAS
AUSTIN, 78774

January 12, 1990

Dear *:

Thank you for your letter regarding sales tax exemption on natu-
ral gas and electricity used in a software business.

You explained that the development of software involves the line-
by-line creation of software code which is then tested for errors
and compliance to specifications. In many cases, software is
modified, sold, licensed, leased, and rented. In a small number
of facilities, the main use of electricity is the operation of the
central processing unit (CPU), disk drives, printers, and other
support equipment and related systems.

Your specific questions are outlined below with response:

1. Is computer software considered tangible personal property?

Response: Yes. However, contract programming is a service and not
the sale of tangible personal property. Contract programming is
when the client, not the programmer, retains ownership rights
to the program.

2. Is the use of electricity and gas in the "manufacturing"
   (creating, processing, modifying, updating) of computer software
   and its related activities subject to the sales tax exemption on
   utilities?

Response: Natural gas and electricity (utilities) directly used
in manufacturing software to market and sell, lease, or license
are exempt. The utilities used for support equipment, related
systems (assuming that related systems is not direct use in manu-
facturing) and for any other nonproduction uses are not exempt.

A software manufacturer who modifies and updates his own software
to market and sell is manufacturing. The utilities directly used
in manufacturing are exempt. Utilities used to make corrections
or modifications to the customer's software are not exempt.

Utilities directly used in contract programming would not qualify
as exempt use.

3. Is the use of a host computer system with local and remote
   computer terminals, printers, disk drives, and other "necessary
   and essential" support equipment (such as required climate control)
   exempt?

Response: The utilities for the host computer system or for any
of its components are exempt if the system or any of its compo-
nents are directly used in manufacturing software to market.
If not directly used, the utilities would not be exempt.

Utilities for climate control in a manufacturing area are consid-
ered exempt if temperature and humidity have a direct effect on
the item being manufactured or on the manufacturing equipment
(i.e., to prevent equipment malfunctions). The exempt use of air
conditioning and heating would be limited to the manufacturing
area where climate control is required. Uses outside the manufac-
turing area or in the manufacturing area where climate control is
not require are not exempt. Documentation must be maintained to
substantiate the effect on the item being manufactured. Documen-
tation such as the equipment manufacturer's requirements, not
suggestions, for temperature and humidity control must be main-
tained when claiming exempt use because of the equipment.

4. If in your opinion the development of computer software is
   exempt and the Comptroller has not written a formal opinion on
   the subject, what steps do you recommend the taxpayer perform to
   ensure that the Comptroller would not reverse a claimed exemption
   during an audit?

Response: The creating, development, modifying, and updating of
software may or may not be manufacturing tangible personal proper-
ty for sale. If the computer company creates, develops, and
produces software to market, the computer company is manufacturing
tangible personal property for sale. If the computer company is
performing contract programming, the computer company is providing
a service and not manufacturing. See responses to questions 1 and
2 above.

The burden of proof is on the taxpayer to establish through clear
and convincing evidence that the utility usage is exempt. This
means that the taxpayer must establish that he is manufacturing
software for sale and must establish that the predominant use of
utility is for exempt use when both exempt and nonexempt uses are
measured by a single meter. Over 50% of a utility must be for
exempt use to claim tax exemption. Each meter and each utility
must qualify for exemption on its own.

I am enclosing Rule 3.295 regarding the exemption for natural gas
and electricity. The rule outlines the requirement for a study to
determine predominant use, the engineer's certification, and the
procedure for claiming tax exemption.

The claim for sales tax exemption on utilities is subject to
review in the event of an audit the same as any other claim for
sales tax exemption. The study prepared to determine predominant
use will be reviewed to determine that the study is complete as
required and is a valid reflection of the utility uses. The study
will be accepted or rejected based on the validity of the study.
Because we will be verifying that items are properly categorized
as exempt and nonexempt use, I would suggest that the taxpayer
(person claiming the exemption) write and explain what his busi-
ness activities are, explain the various procedures used in manu-
facturing software, and what and how the equipment is used in the
actual manufacturing of the software to determine the various uses
that would be considered exempt and nonexempt.

5. Would the utilities used for computer time-sharing be
   considered exempt?

Response: No. Time-sharing is a taxable data processing service,
not manufacturing tangible personal property for sale.

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

If you have any questions or need additional information, you may
call me at 463-4666 or the toll-free number 1-800-252-5555, exten-
sion 3-4666. You may write to Tax Correspondence, Comptroller of
Public Accounts.

Sincerely,
Jo Ann Dieck
Tax Correspondence