Was a jointly funded artificial-intelligence software-development agreement a taxable custom-software sale or nontaxable contract programming?

Plain-English summary

Five companies agreed to fund and develop a software knowledge-representation and reasoning system described as artificial intelligence. The designated developer acted as an independent contractor; project deliverables and intellectual-property rights were to vest jointly in the participants, and the agreement contemplated participant and end-user licensing and royalties.

The Comptroller said retained legal rights determined the core sales-tax result. If the developer retained any rights in the program, it sold custom software, taxable to the extent the technology was used in Texas unless another exemption such as resale applied. If the developer retained no legal title, it provided nontaxable computer-programming services.

The same distinction applied to the alternatives. Sole funding plus royalties to a rights-retaining developer remained taxable to the extent of Texas use. Sole or shared funding with total ownership transferred to the funders and no developer royalties was nontaxable contract programming.

In either case, Texas use tax applied to the cost of materials and identifiable fabrication labor incorporated into deliverables brought into Texas, unless the deliverables were first used outside Texas for more than one year. The Texas participant could credit tax legally imposed and paid to another state on those taxable materials and fabrication labor.

What this means for you

Software-development agreements should state exactly who retains title and other legal rights. Calling the work independent-contractor development did not decide taxability by itself, and nontaxable programming did not eliminate use tax on physical or fabricated deliverables brought into Texas.

Common questions

Did retained developer rights matter? Yes; they produced a custom-software sale. What if all ownership transferred to the funders? The letter treated that as nontaxable contract programming. Could deliverables still trigger use tax? Yes. Was credit allowed for another state's tax? Yes when legally imposed and paid on the taxable inputs described.

Citations and references

• 34 Tex. Admin. Code Rule 3.346(b)(1)(A) and (c)(5)
• Texas Comptroller Hearings Decision No. 14,735

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9112L1146C01

Original ruling text

December 6, 1991

Dear **:

This is in response to the questions originally addressed in ***,Property
and Sales Tax Principal for COMPANY A, letter of April 2, 1991. ** and
*, of your Information Technology Group, met with us in September to review
and discuss the RT Development and Marketing Agreement between the participants.
**** requested that I direct my response to your attention. I appreciate your
patience and apologize for any delay.

The facts as determined through our discussions with *** and *****
and through our review of the RT Development and Marketing agreement among the COMPANY B,
CORP M, COMPANY C, COMPANY A, and COMPANY D are as follows:

TI has entered into a "Development and Marketing" agreement with four other companies
("Participants"): B, M, C, and D. The purpose of the agreement is to develop a "new
software knowledge representation and reasoning technology" referred to as "RT". RT will
consist
of Representation of Corporate Knowledge Technology ("ROCK") and TIN Technology, to be
provided by CORP M. In simple terms this is for the development of an "artificial
intelligence" system.

B employees will provide the labor to develop this new technology, with the other four
members contributing a total of $3,670,000 towards the project. This technology will
be developed at B's location in *** , Pennsylvania.

Article 13.6 of this agreement reads:

No Partnership. This agreement does not constitute a partnership or joint venture among
the Participants. B, in its capacity as Developer, is acting hereunder as an independent
contractor providing services to the other Participants.

B's intention is to integrate the ROCK and TIN technology so that they are portable to a
wide variety of software and hardware environments for both application development and
delivery. The Phase 1 and Phase 2 Implementation Deliverables will be delivered to the
participants in the following environment:

• a DECstation (*at least a 1-2 MIP machine,)
• a UNIX System V Compatible Operating System (a multi-tasking operating system,)
• at least 8 Mb of main memory,
• greater than 100 Mb of virtual memory,
• AT & T C++ version 2.0 and
• DECnet and TCP/IP (networking capabilities).

All rights, title and interest, including but not limited to all Intellectual Property
Rights, with the exception of trademark rights, in all Deliverables developed under this
Agreement shall vest jointly in all Participants to this Agreement.

Participants will not be charged royalties for internal use of the RT technology. Royalties
paid by end-users licensed by a Participant are to be paid to the group with M entitled to
the first 5% and the Participants sharing equally in the remaining 95%. Each Participant may
license the Deliverables, Derivatives and source code to end-users. Royalties on sublicensing
are to be paid directly to the Participant by the end-user.

I have requested the questions in **'s letter followed by
my response.

1. Is the above transaction taxable?

Response:

Article 13.6 of the Development and Marketing agreement is clear that B, as the Developer
of this new software technology, is acting as an independent contractor providing services to
the other members, including A.

In this context, if B retains any legal rights to the program it creates, then it is making
a sale of custom software. To the extent this software technology is used in Texas it would be
taxable unless some other exemption applied (i.e., held for resale).

If B did not retain any legal title to the program(s) it creates for the Participants, it would
be providing nontaxable computer programming services.

In either case, Texas use tax would be due on the cost of materials and identifiable fabrication
labor incorporated into the "deliverables" that are brought into Texas for use by A or another
Participant, unless the "Deliverables" were first used out-of-state for a period of more than one
year. See subsections (b)(1)(A) and (c)(5) of the enclosed Rule 3.346, Use Tax. TI is entitled
to a credit against Texas tax for tax legally imposed by and paid to another state on taxable
materials and fabrication labor. I have also enclosed an edited copy of Hearings Decision
No. 14,735, which addresses a similar situation.

2. Would this transaction's status be different if:

a) A was the only party funding the project, but still liable for royalties (to B) if any use
was made of the results.

Response: No. Again, if the developer (B) retained title to the software, requiring that
royalties be paid to it by A, Texas sales tax would be due to the extent that the software was
used in Texas.

b) A was the only party funding the project, but total ownership of the work was transferred
to A, that is no royalty due, regardless of the use made by A of the result.

Response: If B held no title to the programs it created for A, then B would be providing
nontaxable contract programming services to A.

c) A was associated with other partners in the funding, and total ownership was transferred
to all parties funding the project upon completion, that is no royalty due to the developer or
between funding partners.

Response: If B did not retain title to the completed program, then it would be providing
non-taxable contract programming services.

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

If you have further questions or need more information, you may call 512/463-4600, or
1-800-252-5555 from outside Austin. You may write to Tax Administration Division.

Sincerely,

Tax Administration Division