How were separately contracted software modifications, upgrades, and maintenance receipts sourced under former Texas franchise tax?

Plain-English summary

Software modifications and maintenance followed service location; upgrades followed payor location unless bundled without separate charges.

Separately contracted modifications were services sourced where performed. Separate future-upgrade receipts followed payor location, while maintenance followed performance location.

In one combined contract with reasonable separate upgrade and maintenance charges, each kept its own sourcing rule. Without separate charges, the whole agreement became a service contract; internal book allocations did not change that result, and all receipts were Texas receipts because all services occurred in Texas.

What this means for you

Software companies

Contract structure and separately stated charges controlled whether upgrade and service receipts were split.

Common questions

Q: Were separately contracted modifications part of the software sale?
A: No; they were services.

Q: Could an internal allocation replace separately stated contract charges?
A: No.

Citations and references

• Comptroller Hearing No. 27,833, discussed and limited to its own facts in the letter

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9608956L

Original ruling text

August 9, 1996

Dear ***:

In your letter of April 30, you requested clarification of two issues involving
revenues related to computer software.

I have restated each of the issues you presented followed by my response:

1. Sourcing of software modification revenues for purposes of computing the
   capital and surplus portion of the franchise tax.

Response

In my letter of December 28, 1995, I indicated that the software modification
agreements entered into at the same time that the inventory software program
was licensed to the customer were not made in connection with the "sale" of the
program because the program and modification are under separate contracts. I
have reviewed the additional information you submitted and consulted with our
tax policy director and sales tax policy personnel. We do not agree with your
contention that the agreements should be treated as one. Therefore, as I
indicated in my December 28 letter, receipts for modification of the software
should be apportioned based on where the modifications are performed because
the modification is the performance of a service.

You should note that software modification charges which are contracted for
separately from the "sale" of software are not considered made in connection
with the "sale" of the program for sales tax purposes. Therefore, the agency
position on this issue is consistent for sales and franchise tax purposes. In
particular, the facts and conclusions of Hearing No. 27,833 are applicable only
to that case and do not support your contention that the separate agreements
should be treated as one agreement.

2. Sourcing of software maintenance fees and upgrade revenues for purposes of
   computing the capital and surplus portion of the franchise tax.

Response

If your client (Taxpayer) enters into separate agreements for the future sale
of upgrades and maintenance, receipts from the upgrade agreement would be
apportioned based on the location of payor and the charge for maintenance would
be apportioned based on where the service is performed.

On the other hand, if Taxpayer enters into one agreement for the future sale of
upgrades and maintenance services, the apportionment will be as follows:

If reasonable amounts for upgrades and maintenance services are stated
separately in the contract, the charge for upgrades should be apportioned based
on the location of payor rule while the charge for maintenance should be
apportioned to Texas because the services are performed in Texas.

If Taxpayer does not separately state charges for upgrades and maintenance, the
agreement will be considered an agreement for the performance of services even
if taxpayer is able to show a reasonable internal allocation using its books
and records. Receipts from the agreement should be apportioned to Texas
because all services are performed in Texas.

This response is based on the facts presented and current law. If there are
different or additional facts, the response may change.

If you have any questions, contact Tax Policy Division. You may call toll free
1-800-531-5441, or our regular number is 512/463-4600. My extension is 3-4662.
You may write me at Tax Policy Division, Comptroller of Public Accounts.

Sincerely,

Bob Jeffcoat
Tax Policy Division