When a Texas company buys software hosted on an out-of-state server, with modification services performed partly in Texas and partly out of state, how is the license price and modification labor taxed based on where the licenses are used?

Plain-English summary

Company A, based in Texas, planned to buy a software package from an out-of-state vendor. The software would be installed on the vendor's servers in Colorado and would need modification before Company A could use it. The vendor's modification work would happen both in Texas (about 25% of the total modification effort) and in Colorado (the rest), though all invoices would go to Company A in Texas. The license agreement covers about 10,000 total licenses, of which 1,000 (10%) would be used in Texas; separately, only 110 of those licenses would be used by the vendor's own programmers to perform the modifications, and of those 110, about 26 (roughly 24%) would be used by programmers working in Texas.

Company A asked the Comptroller to confirm its own read: that it wouldn't owe sales tax on the software purchase or modifications, but WOULD owe use tax measured by the 10% Texas-user share, on a tax base of the software price plus all modification services. The Comptroller's answer partially agreed but added important nuance, breaking the transaction into three pieces:

1. The software license itself: Since the software is delivered to Company A from a point outside Texas (Colorado), it's subject to Texas use tax, not sales tax. But that use tax is only owed on the license charges attributable to the Texas-used licenses (the 10% share) — Company A "uses" the software in Texas each time it's accessed from a Texas terminal, even though the software physically resides on a Colorado server.
2. Modifications performed OUTSIDE Texas: Company A owes use tax on its cost of these out-of-state modifications, but again only to the extent the modified software will be used in Texas (the same 10% Texas-use share) — consistent with Tax Code § 151.330(f), which exempts services used both in and outside Texas to the extent they're used outside Texas.
3. Modifications performed IN Texas: Here the answer flips — Company A owes tax on the entire charge for modification work the vendor performs in Texas, including the portion attributable to licenses that will ultimately be used outside Texas. That's because labor to repair, remodel, restore, or maintain tangible property became fully taxable in Texas effective October 2, 1984 when the labor itself happens in Texas, regardless of where the finished work will later be used.

The letter also confirms Texas, as a member of the multistate tax compact, allows a credit against Texas use tax for legally-imposed sales or use tax already paid to another state (or its subdivision) on the same property — even if that other state isn't itself a compact member. Finally, as a contrast case: if the software had instead been delivered to Company A from a point inside Texas, full Texas sales tax would apply, and simply moving the software out of state afterward wouldn't undo that tax.

What this means for you

Companies buying and modifying software across state lines

Where the software is delivered from, where it's used, and where the modification LABOR physically happens are three separate sourcing questions that can each produce a different tax result. Modification work done in Texas is fully taxable regardless of end-use location, while modification work done outside Texas (and the underlying software license itself, if delivered from outside Texas) is only taxed to the extent of actual Texas use. Track license-use percentages carefully — they're doing real work in this apportionment.

Accountants and tax professionals

This letter is a useful multi-part illustration of Texas software/service sourcing: use tax on out-of-state-delivered software (apportioned by Texas-use share), the § 151.330(f) out-of-state-use exemption for services, the where-the-labor-happens rule for taxable repair/remodel/restore/maintenance labor (fully taxable if performed in Texas regardless of end use), and the multistate compact credit for tax already paid elsewhere.

Common questions

Q: Is a software license bought from an out-of-state vendor and hosted on an out-of-state server subject to Texas tax?
A: Yes, but only use tax (not sales tax) on the portion of licenses actually used in Texas, per this letter.

Q: Are modification services performed outside Texas on software Company A will use taxed the same way as modifications performed in Texas?
A: No — per this letter, out-of-state modification labor is taxed only to the extent the resulting software is used in Texas, while modification labor performed IN Texas is fully taxable regardless of where the software will ultimately be used.

Q: Can Company A get credit for tax already paid to another state on the same software?
A: Yes, per this letter — Texas, as a multistate compact member, allows a credit against Texas use tax for legally-imposed sales/use tax already paid to another state (even a non-compact state) on the same property.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.330(f) (services used both within and outside Texas are exempt to the extent used outside Texas)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9809833L

Original ruling text

September 22, 1998

Dear Mr. **:

Thank you for your recent email which is restated in part with response below.

The details of the transaction are as follows:

1. Our client, Company A, is located in **, Texas.

2. Company A is considering purchasing a software package from an out of state
   vendor.

3. The software will be installed on Company A's servers in Colorado.

4. After the software is installed in Colorado, it will have to be modified
   before Company A will be able to use it.

5. The modification services will be performed by the vendor.

6. The modification services will be performed in Texas and Colorado.

7. The services in Texas will constitute approximately 25% of the total
   modifications that will be performed in order for the program to be used by
   Company A.

8. Although the modification services will be performed in Texas and in
   Colorado, all invoices will be sent to Company A in **, Texas for
   payment.

9. The license agreement between the vendor and Company A grants Company A
   approximately 10,000 licenses, 1,000 of which will be in Texas. These licenses
   enable users at terminal units to access the server in Colorado for purposes of
   using the software.

10. During the modification process, before the software can be utilized by
    Company A, only 110 licenses will be used by the programmers to effect
    modifications. Of these 110 licenses, approximately 26 will be used by the
    vendor's programmers in Texas.

Based on our discussion yesterday, it is my understanding that Company A will
not be liable for sales tax on the purchase of the software or its
modification, but it would be liable for use tax on the use of the software
used in Texas as measured by the Texas users over all users, or 10%. Is this
correct?

It is also our understanding that the tax base in this situation would be the
price of the software plus all modification services. Is this correct?

Response: The software purchase is subject to use tax rather than sales tax if
the software is delivered to Company A by the vendor from a point outside
Texas. Given that situation, tax will be due on the charge for licenses used
in Texas even if the software resides on server in Colorado. Company A uses
the software in Texas when it brings up the software on a computer in Texas.

Company A will owe tax on its cost of modifications performed by the vendor
outside of Texas on software for use in Texas.

Company A will also owe tax on the charges for modifications performed by the
vendor in Texas including the charges for modifications attributable to the
licenses used outside Texas. According to Tax Code Section 151.330(f):

(f) Services performed for use both within and outside this state are exempt to
the extent the services are for use outside this state and made taxable on or
after September 1, 1987.

Charges for labor to repair, remodel, restore, and maintain tangible property
became taxable effective October 2, 1984.

As a member of the multi-state compact, Texas will allow as a credit against
Texas use tax due any combined amounts of legally imposed sales or use taxes
paid on the same property to another state or any subdivision of another state.
Credit will be allowed even though the other state may not be a member of the
multi-state compact.

Company A will owe Texas sales tax on purchases of software delivered to it
from a point inside Texas. The fact that Company A may subsequently transfer
the software outside Texas will not serve to exempt the transaction.

This opinion is rendered based on the facts presented. If there are 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. The email address is .

Sincerely,

Al Van Allen
Tax Policy Division