Does a computer software marketing aid built by an out-of-state vendor for a Texas manufacturer qualify for the 'developed from scratch' exemption, and is it taxable even though the master copy stays out of state?

Subject

Software "Developed From Scratch" — Why This Marketing-Aid Program Didn't Qualify For Exemption

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9309L1273C08

Plain-English Summary

The taxpayer is a Texas manufacturer whose salesmen canvas Texas and other states. It hired a California firm to produce a computer software marketing aid — the firm was paid to create the program, to make copies for salesmen to hand out to potential customers both in and outside Texas, and to make software modifications. The taxpayer sought a credit for taxes paid, making three separate arguments, and the Comptroller rejected all three.

First argument — "created from scratch." The taxpayer argued the creation of the master was nontaxable under Rule 3.308(b). The Comptroller explained that the software-creation exemption in Rule 3.308(b)(4) applies only to software created from scratch for the customer where the exclusive rights to the program are transferred to the customer. Here, the vendor appeared to be in the business of developing and selling these advertising aids generally, and — even though the software was heavily customized — "a framework and several copyrighted routines ('recipes')" were more likely than not used to build it, so it did not meet the "from scratch" requirement. The letter also noted that although the program's text and graphics were specific to the taxpayer, there was no evidence the vendor had transferred exclusive rights to the software: the taxpayer couldn't even make its own copies, and the vendor retained the legal right to market the developed software to others.

Second argument — "preliminary art." The taxpayer pointed to Rule 3.321, which exempts "preliminary art" for advertisers, and argued the initial creation of the program was preliminary art while the disk copies were "finished art." The Comptroller rejected this because the statute and rule "do not speak of software in the context of advertising agencies" — Rule 3.321 defines taxable items to include all tangible personal property and taxable services with no exemption for these items, and Texas Tax Code Section 151.009 specifically makes a computer program part of the definition of tangible personal property.

Third argument — the master stays in California. The taxpayer argued only the copies entering Texas should be taxed, not the software itself, since the master never left California. The Comptroller disagreed: the software and programming "enter Texas in every copy used in Texas," and retaining a master in California doesn't change the taxability of the development charges. The letter also noted travel/invoice charges showing the vendor made trips to Texas for development, training, or exhibiting the product, and warned that allowing firms to sell an untaxed master out of state while taxing only cheap copies "would not capture the essence of the transaction, which is the sale of a computer program."

The letter also addresses a prior letter ruling the taxpayer had referenced (dated August 16, 1990) — the author couldn't locate it but speculated it might resemble a letter on Fiche No. 1173B06 dealing with dividing a software license fee by the number of licensed applications. The Comptroller distinguished that scenario from this one, where a one-time development fee is paid and the customer can then buy as many copies as needed for a minimal copy charge, concluding the two situations are not similar and don't require equal treatment.

Finally, the letter notes a partial win for the taxpayer: Rule 3.346 (Use Tax) allows a credit for taxes paid on diskettes delivered from out of state and temporarily stored in Texas before being used solely outside Texas, citing Rule 3.346(c)(1)(B).

What This Means For You

If you commission custom software from an out-of-state vendor: Don't assume "custom" or "highly modified" automatically means "created from scratch" for exemption purposes. Per this letter, the Rule 3.308(b)(4) exemption requires both that the software be built from scratch and that exclusive rights to the program be transferred to you. If the vendor reuses its own frameworks or copyrighted routines, or retains the right to resell or license the software (even if it hasn't yet done so), the exemption can fail.

If you're in the advertising/marketing-aid business: This letter makes clear that the "preliminary art" exemption for advertising agencies under Rule 3.321 was not treated as extending to computer software — the ruling ties this back to Tax Code Section 151.009, which folds computer programs into the definition of tangible personal property.

If your vendor keeps a "master" copy out of state: Keeping the master in California (or any state) does not make software development charges nontaxable, according to this letter — Texas taxes the development charge because the software "enters Texas" through every copy actually used here.

If you pay for diskettes that pass through Texas but are used elsewhere: The letter confirms a use tax credit is available under Rule 3.346(c)(1)(B) for diskettes delivered from out of state and only temporarily stored in Texas before being used solely outside the state — worth tracking if your distribution routes goods through a Texas warehouse or sales office.

Q&A

Q: Does hiring an out-of-state vendor to build custom, business-specific software automatically make the charge exempt as software "created from scratch"?
A: No. Per the letter, the Rule 3.308(b)(4) exemption requires both that the software be created from scratch and that exclusive rights to the program be transferred to the customer. Here, the vendor used "a framework and several copyrighted routines ('recipes')" and there was no evidence exclusive rights were transferred, so the exemption did not apply even though the software's text and graphics were specific to the taxpayer.

Q: Can a computer software marketing aid qualify as exempt "preliminary art" for an advertising agency under Rule 3.321?
A: No, according to this letter. Rule 3.321 defines taxable items to include all tangible personal property and taxable services and provides no exemption for these items, and Texas Tax Code Section 151.009 specifically includes a computer program within the definition of tangible personal property.

Q: If the master copy of software never leaves California, is the development charge exempt from Texas tax?
A: No. The letter states the software and programming "does enter Texas in every copy used in Texas," and that a master retained in California "will not alter the taxability of the software development charges."

Q: Is there any tax relief mentioned for diskettes that pass through Texas?
A: Yes. The letter states that Rule 3.346 concerning use tax will allow the taxpayer to receive credit for taxes paid on diskettes delivered from out of state and temporarily stored in Texas prior to use solely outside of Texas, citing Rule 3.346(c)(1)(B).

Q: Did the Comptroller find the taxpayer's cited prior letter ruling (from August 16, 1990) persuasive?
A: The author of this letter could not locate that referenced ruling but speculated it might be similar to a letter on Fiche No. 1173B06, involving dividing a software license fee by the number of licensed applications. The letter concludes that scenario (an ongoing license fee) is not similar to this taxpayer's situation (a one-time development fee followed by minimal per-copy charges), so equal treatment was not required.

Original ruling text

DATE: September 20, 1993

TO: GARY MOERBE, MANAGER, ** AUDIT OFFICE

FROM: KEVIN KOLLER, TAX ADMINISTRATION DIVISION

SUBJECT: TAXPAYER - TAXPAYER NO. **

TAXPAYER is a manufacturer located in **, Texas. The company has
salesmen that canvas Texas and other states. TAXPAYER has engaged a California
firm to produce a computer software marketing aid. The firm has paid for
creation of the aid, copies for salesmen to distribute to potential customers
both in and outside of Texas, and software modifications.

TAXPAYER is requesting a credit for taxes paid on the basis of the following
arguments;

• The creation of the master is nontaxable per Rule 3.308(b).

• In the alternative, the taxpayer points out that Rule 3.321 concerning
  advertisers exempts preliminary art. The taxpayer believes that the initial
  creation of the program would qualify as preliminary art.

• The taxpayer further believes that the master software copy is not taxable
  as it physically remains in California.

Dealing with the first contention, the Comptroller has held that the exemption
for software creation [Rule 3.308(b) (4)] applies to software created from
scratch for the customer where the exclusive rights to the program are
transferred to the customer. COMPANY appears to be in the business of
developing and selling these computer program advertising aids. The software
may be modified greatly for each customer, however, a framework and several
copyrighted routines ("recipes") are more likely then not employed to produce
the software. This does not meet our from scratch requirement. Secondly,
although the program is TAXPAYER specific in that the text and graphics are not
usable by other firms, there is no evidence that the exclusive right to the
software program is transferred to TAXPAYER. The fact that the software has not
been used by the vendor as the basis for software sold to other customers does
not negate the fact that they have legal rights to do so. TAXPAYER admittably
cannot make copies, even for their own use, much less for the marketing of
similar software to others. It appears that the right to market developed
software rests with the vendor.

In their second contention, the taxpayer discusses the possibility of calling
the development of the program (software) "preliminary art" and the disk copies
"finished art". The statute and rule do not speak of software in the context of
advertising agencies. Rule 3.321 defines taxable items as including all
tangible personal property and taxable services and includes no exemptions for
these items. Texas Tax Code Section 151.009 specifically states that a computer
program will be included in the definition of tangible personal property.

The third contention is that the software does not enter Texas, only the copies
do. Therefore only copies entering Texas should be taxed. The software and
programming does enter Texas in every copy used in Texas. The fact that a
master is retained in California will not alter the taxability of the software
development charges. The narrative and invoice travel charges indicate that the
vendor has made trips to Texas in the development, training, or exhibiting of
the product. To allow software firms to sell a nontaxed master copy to be
retained at their out-of-state location and tax copies at drastically reduced
amounts would not capture the essence of the transaction, which is the sale of
a computer program.

I have not been able to locate the referenced letter ruling dated August 16,
1990, however, can only speculate that it is similar to the letter contained on
Fiche no. 1173B06. This letter states that when a software licensing agreement
allows "x" applications the customer may divide the license fee by "x" and
multiply by the program copies used in Texas. In the case at hand, a one time
development fee is paid. The customer can then buy one or as many copies are
needed and only pay a minimal copy charge. These cases are not similar and do
not require equal treatment.

Rule 3.346 concerning use tax will allow TAXPAYER to receive credit for taxes
paid on diskettes delivered from out of state and temporarily stored in Texas
prior to use solely outside of Texas. See Rule 3.346 (c) (1) (B).

NOTE: Previous Accession Number 9309110L