Is non-executable source code that a seller licenses to manufacturers, who must substantially re-engineer it before use, a 'completed computer program' subject to Texas sales tax?

Subject

Software/Computer Programs — Source Code Definition

Plain-English summary

A software company asked the Comptroller for a ruling on whether it had to charge Texas sales tax on its source code. The company (using "ABC" as a stand-in for its redacted name) sells non-executable source code -- what it called the "building blocks, or raw material" -- to manufacturers, not to end users. Those manufacturers must perform substantial engineering on the code before it can become an actual end-user product, and the code deliveries are customized for each customer. The company argued that under 34 Tex. Admin. Code Rule 3.308, its source code did not qualify as a "completed computer program" and should therefore be exempt from sales tax collection. It also asked whether, if that interpretation were correct, it would need to charge tax on maintenance or technical support tied to that code.

The Comptroller disagreed with the company's interpretation. Citing the definition of "computer program" that was added to the rule (explained via a 1987 Texas Register excerpt) to exclude contract programmers who modify or create programs for a customer, and citing a computer dictionary's definition of "source code" as the typed program instructions a programmer writes before compiling or interpreting into machine language, the Comptroller concluded that the company's source code is a completed computer program and therefore taxable, regardless of the additional engineering work customers must do to it afterward.

On the follow-up question about maintenance: the letter explains that maintenance, like other taxable items, can itself be purchased for resale. So if a customer buys the source code for resale, it can also buy maintenance for resale if it intends to resell that maintenance (on the modified program) to a third party. Otherwise, the seller must collect tax on maintenance charges related to source code it sold, unless the customer provides a valid resale or exemption certificate. As with other rulings of this era, the Comptroller notes the answer is based on the facts presented and could change if the facts are different.

What this means for you

Software and source-code sellers

If you license source code -- even non-executable code that customers must substantially rework before it becomes a finished product -- Texas treats that source code itself as a "completed computer program" for tax purposes. The fact that further engineering is required downstream, or that you sell only to manufacturers rather than end users, does not by itself make the sale exempt.

Businesses selling software maintenance or technical support

Maintenance and technical support tied to taxable source code are themselves taxable, unless your customer gives you a properly completed resale or exemption certificate. A customer that bought the source code for resale can also buy the related maintenance for resale, but only if it intends to resell that maintenance to a third party too.

Accountants and tax professionals

Note the ruling's reliance on a general-purpose computer dictionary definition of "source code," rather than a Tax Code or rule definition, to conclude the code is a "completed" program. Also note the historical context cited: the December 18, 1987 Texas Register excerpt on the "completed program" language in the rule, and the October 1, 1989 amendment to Tax Code § 151.0101(a) exempting the work product of contract programmers who modify or create programs for a customer -- a different fact pattern from selling source code outright.

Common questions

Q: Is source code that requires substantial customer re-engineering before use exempt from Texas sales tax?
A: No. This letter holds that such source code is still a "completed computer program" under the rule and is taxable, even though the purchaser must perform substantial engineering before it becomes an end-user product.

Q: Does it matter that the seller only licenses to manufacturers and never sells to retail or end users?
A: Not according to this ruling. The Comptroller's conclusion did not turn on who the ultimate buyer was, but on the definition of "source code" and "completed computer program."

Q: Is maintenance or technical support on that source code taxable?
A: Yes, generally. The seller must collect tax on maintenance charges unless the customer furnishes a valid resale or exemption certificate.

Q: Can a customer buy maintenance tax-free for resale?
A: Yes, but only if the customer bought the source code for resale and intends to resell the maintenance on the modified program to a third party as well.

Q: Could this answer change under different facts?
A: Yes -- the letter states the opinion is rendered based on the facts presented, and the opinion may change if there are additional or different facts.

Citations and references

Statutes and rules:

• 34 Tex. Admin. Code Rule 3.308 (computer programs; definition of "completed computer program")
• Tex. Tax Code § 151.0101(a), as amended effective October 1, 1989 (exemption for creation, maintenance, and repair of software not sold by the person performing that function)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9609L1435A10

Original ruling text

September 3, 1996

Dear *****:

Thank you for your recent letter. Your facts are
restated in part with response below.

We believe ABC is exempt from collecting Texas sales
tax on all purchases of our source code, but would like a definitive ruling
from your office. According to our interpretation of Rule 3.308, our software
does not qualify as "completed."

ABC's ISDN source code is non-executable software
source code that is used by the purchaser to build end-user software. In
essence, we supply the building blocks, or raw material for our customers. We
never sell retail or to end users. We only license our code to manufacturers,
who, in turn, must perform substantial engineering (changing the software) to
develop end-user products. ABC's software cannot be sold, licensed, or even
used without substantial engineering effort. Our source code deliveries are
customized for each customer.

If our interpretation is correct that our source code
is not a "completed computer program," do we have to charge sales tax for the
maintenance or technical support involved with some of these customers? We
have obtained a resale certificate from the only customer we have had in Texas
this year.

Response: The term "completed computer program" has an
interesting history. The following excerpt was taken from the December 18,
1987 issue of the Texas Register to explain its use.

The change is to the definition of computer program in
subsection (b)(1). The new definition defines a computer as a completed
program. This has the effect of excluding contract programmers who change or
modify existing programs of a customer, or create a new program for a customer,
from the requirement to collect sales tax on these activities.

Effective October 1, 1989, the Texas Legislature
amended Tax Code Section 151.0101(a) to provide an exemption for the creation
of computer software and for the maintenance, repair, etc. of software not sold
by the person performing that function. In other words, the amendment exempted
the work product of contract programmers, which was already exempt by rule
(above).

Ques's Computer & Internet Dictionary defines "Source
Code" as, "In a high-level programming language, the typed program instructions
that programmers write before the program is compiled or interpreted into
machine language instructions the computer can execute." Accordingly, the
ABC's ISDN source code you sell is a completed computer program.

I should point out that maintenance, like other taxable
items can be purchased for resale. The effect is that a customer that bought
your source code for resale could also buy the maintenance for resale if it
intended to resell the maintenance of the modified program to a third party.
Collect tax on charges for maintenance on source code you sold unless your
customer gives you a completed resale or exemption certificate.

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

You may call me toll free at 1-800-531-5441, ext. 3-4680. The direct line
is 512/463-4680. You may also write to Tax Policy, Comptroller of Public
Accounts. My Internet address is [email protected].

Sincerely,

Al Van Allen
Tax Policy Division

NOTE: Previous Accession Number 9609656L