Does an out-of-state company that only licenses 'canned' software to Utah customers to access its data services create Utah corporate franchise tax nexus?

Plain-English summary

An out-of-state company ran a "gateway" service that let its customers dial in over the phone network to search a range of third-party databases the company didn't own. To use the gateway, each customer signed a Service Agreement and, in many cases, was given a license to standard ("canned") software that let their computer connect to the gateway -- the company kept ownership of that software at all times. The company had no offices, property, or employees in Utah other than that licensed software, but it expected to add traveling salespeople whose only job would be soliciting orders (with no authority to close a sale) and it asked the Utah State Tax Commission whether any of this created Utah corporate franchise (income) tax nexus.

The Commission said yes, even before adding any salespeople. Two things did it: first, mainframe-level software licenses located in Utah counted as enough property presence to meet the constitutional "substantial nexus" test from Complete Auto Transit v. Brady; second, the Commission treated telecommunications-based, interactive services like this gateway as creating nexus simply by delivering the service into Utah through the local phone exchange. Public Law 86-272 -- the federal law that shields an out-of-state seller from state income tax if its only in-state activity is soliciting orders for tangible personal property -- did not apply, because licensing software and selling access to databases isn't a sale of tangible personal property.

Adding traveling salespeople wouldn't change the nexus answer (the company was already taxable), but it would matter for apportionment: if a salesperson's activity in Utah went beyond mere solicitation, the Utah portion of that employee's wages would have to be included in the payroll factor. The Commission also concluded the company was primarily a service business (not a seller of tangible personal property), that it should use Utah's standard three-factor apportionment formula, and that -- under the law as it stood in 1993 -- its service-fee revenue from customers didn't have to go in the Utah sales factor at all because the services were "provided from outside the state," leaving only the value of Utah-located software in the property factor.

What this means for you

Software, SaaS, and data-service companies with Utah customers but no offices there

This ruling is a useful early example of a theme that's stayed consistent since: merely licensing software to in-state customers, or delivering an interactive service over the phone/internet, can be enough property or activity to create nexus on its own -- separate from whether you have any employees or a lease in the state. Public Law 86-272's safe harbor doesn't reach services or licensed intangibles; it only protects solicitation of orders for tangible personal property.

Businesses weighing whether to add a traveling sales force

Here, adding salespeople who only solicited (never closed deals) didn't change whether the company owed Utah franchise tax -- it was already taxable from the software licenses and service delivery alone. But if sales activity crosses the line from pure solicitation into something more, the wages tied to that Utah activity get pulled into the state's payroll apportionment factor, which can raise the tax bill even without changing the underlying nexus conclusion.

Accountants and tax professionals

Two things to flag when using this ruling today: (1) it predates Utah's own remote-seller economic nexus statute (§ 59-12-107(2)(c), enacted post-Wayfair) and the Commission's holding here rests entirely on 1990s constitutional nexus case law (Complete Auto Transit, National Geographic Society, Quill), which has since been substantially reshaped, especially for sales tax; (2) the ruling's treatment of service-fee revenue as excluded from the Utah sales-factor numerator reflects the market/cost-of-performance sourcing rules in place in 1993 -- apportionment sourcing rules for services have since been revised in many states, including Utah, so don't assume this specific numerator treatment still applies without checking current law.

Common questions

Q: Does licensing software to customers in a state create income/franchise tax nexus there, even with no offices or employees?
A: Under this ruling, yes -- the Commission found that mainframe-level software licenses physically present in Utah, combined with delivering an interactive telecommunications-based service through the local phone exchange, were enough to meet the constitutional "substantial nexus" standard.

Q: Does Public Law 86-272 protect a company that only licenses software and sells database access?
A: No. P.L. 86-272 only shields solicitation of orders for sales of tangible personal property. Licensing software or leasing any other kind of property is not immune, and selling a service (database access) isn't covered at all.

Q: If traveling salespeople are added later but they only solicit orders, does that change the nexus outcome?
A: In this ruling, no -- the company was already taxable from its software and service-delivery presence alone. But if the salespeople's Utah activity exceeds solicitation, their Utah wages must be included in the state's payroll apportionment factor.

Q: Does this ruling apply to my company's software licensing or data-service business today?
A: Not automatically. It's a private letter ruling binding only on the Commission for the taxpayer and facts described, and it predates Utah's post-Wayfair economic nexus statute and decades of change in apportionment and sourcing rules. Consult a Utah tax professional and verify current law.

Citations and references

Statutes, rules, and cases (1993-era analysis -- constitutional nexus doctrine and Utah's apportionment rules have changed substantially since, especially after Wayfair and Utah's own economic-nexus statute; verify current law before relying on this):

• Public Law 86-272 (limits state net income taxation of out-of-state sellers whose only in-state activity is soliciting orders for tangible personal property)
• Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) (four-part Commerce Clause test: substantial nexus, fair apportionment, no discrimination against interstate commerce, fair relation to services provided; the ruling's own text cites this case as decided in "1974," which appears to be an error -- the Supreme Court decided it in 1977)
• National Geographic Society v. California Board of Equalization, 430 U.S. 551, 556 (1977) (rejecting a "slightest presence" nexus standard)
• Quill Corp. v. North Dakota, 504 U.S. 298 (1992) (holding that title to "a few floppy diskettes" in a state might show minimal nexus but did not, on its own, meet the Commerce Clause's "substantial nexus" requirement in that sales-tax case; the Commission here treated Utah's telecommunications-industry facts as distinguishable)

Source

• Landing page: https://tax.utah.gov/commission/rulings/
• Original page: https://files.tax.utah.gov/tax/commission/ruling/93-002.htm

Original ruling text

Response March 19,
1993

Request

January 12, 1993

XXXXX

Dear XXXXX:

We are writing on
behalf of our client ("Taxpayer") to request a ruling (opinion) from
the State. We seek this ruling to determine the income and/or franchise tax
consequences under the facts outlined below. The Taxpayer is anticipating
operations in your state and needs to know whether they are subject to income
and franchise tax in the State.

Facts

The Taxpayer offers
its customers a service which provides access (referred to as a �gateway�) to
many third party databases. The Taxpayer does not own the databases but has
agreements with the owners of the various databases whereby the Taxpayer has
access to these databases and can provide that access to the Taxpayer's
customers (see attached exhibit).

To access the service,
the customer must enter into a Service Agreement (�Agreement�) with the
Taxpayer. The customer requests information by connecting to the Taxpayer's
gateway via the XXXXX public data network. the Taxpayer's gateway then routes
the customer's request to the appropriate database back through the XXXXX
public data network. Consequently, all the information is transmitted over the
telephone lines. As part of the Agreement, the customer may be provided with
software (via a software license agreement) to allow access to the Taxpayer's
gateway. The Taxpayer at all times retains ownership of the software. The
software licensed is standard (�canned�), thus is not customized for any
individual customer.

Service Fees - The
customer is billed monthly based on the number of information requests made and
for the time connected to the gateway. A minimum monthly fee is charged if the
actual usage charge is lower than $$$$$. The majority of customers do not incur
this minimum fee. The customer does not incur long distance charges since they
need only dial a local number or an 800 number, owned by XXXXX, to access the
XXXXX public data network. The charges for XXXXX network usage and the charges
for the information retrieved from the databases are allocated and billed
directly to the customer based on usage. Service fees generate significantly
greater revenue than any of the other fees. All other fees combined will only
represent a very small percent (from l%-5%) of total revenues.

Establishment Fee -
Each customer pays a one time fee of $$$$$ in order to establish the service.

Software License Fee -
For personal computer users, there is no fee. Mainframe licenses range up to
$$$$$. The Taxpayer expects to sell very few (maximum 1 to 2 each year in a
given state) mainframe licenses to customers. In addition mainframe users may
purchase a standard software maintenance agreement whereby the customer receives
software upgrades (if any) and telephone support. The upgrades are not shipped
from your state nor is the telephone support located within your state.

The Taxpayer is
located outside of your state and does not have any property, other than the
licensed software, or payroll in your state. The Taxpayer does not have any
leased property or leased telephone lines in the state.

The taxpayer does
expect to have a traveling sales force in the near future. The purpose of this
sales force would be to engage in the solicitation for sales. The sales people
would not have any authority to accept orders, only the home office out of
state would have this authority. For sales to personal computer users, the
sales person would complete the sale over the telephone from out of state. The
sales to main frame users would require on site visits to solicit for the sale.
In any event, the sales person would not exceed the authority permitted in
Public Law 86-272 relating to sales of tangible personal property.

Questions

(1) If the Taxpayer
does not have any traveling sales people in your state, are they subject to
income (franchise) tax based on the presence of licensed software in the state?

(2) Would the answer
to (1) above be different if they did have traveling sales people in your
state?

(3) If the Taxpayer is
subject to income (franchise) tax, are they considered a seller of tangible
personal property (sale of canned software) or a service business, since the
primary revenue is from the use of the database or maintenance agreements and
not the sale of the software?

(4) If the Taxpayer is
subject to income (franchise) tax, what apportionment methodology should be
used (i.e. three factor, single gross receipts factor, or another method).

(5) If the Taxpayer is
not subject to income (franchise) tax and does not have traveling sales people
in your state, is the presence of licensed software in your state sufficient
nexus to require the Taxpayer to qualify to do business in your state?

(6) Would the answer
to (5) above be different if they did have traveling sales people in your
state?

Discussion and
Analysis

The Due Process and
Commerce Clauses of the United States Constitution and Federal law (Public Law 86-272)
prevent states from subjecting a corporation to taxation unless the corporation
has sufficient nexus with that state. The Supreme Court enunciated the modern
Commerce Clause test for determining whether a state tax is unconstitutional in
Complete Auto Transit Inc. v. Brady. 430 U. S . 274 (1974). The Court held that a state tax will be
upheld against Commerce Clause scrutiny �when the tax is applied to an activity
with a substantial nexus with the taxing State, is fairly apportioned, does not
discriminate against interstate commerce, and is fairly related to the services
provided by the state.�

The court expressly
rejected a �'slightest presence' standard of constitutional nexus� again in National
Geographic Society v. California Board of Equalization, 430 U.S. 551, 556
(1977).

In Quill
Corporation v. North Dakota. No. 91-194, Supreme Court of the United
States, May 26, 1992, the Court upheld the �substantial nexus� standard for
licensed software in the state. Quill licensed a computer software program
to some of its customers in the state that enabled them to check Quill's
current inventories and prices and to place orders directly. The Court noted
�Quill's interests in the licensed software does not affect our analysis of the
due process issue and does not comprise the �substantial nexus� required by the
Commerce Clause.� The Court concluded that �title to �a few floppy diskettes�
present in a State might constitute some minimal nexus,� but " Quill's
licensing of software in this case does not meet the �substantial nexus�
requirement of the Commerce clause.�

Based on the above
cases, it is clear the Supreme Court has determined that substantial nexus is
required in order for the State to subject the corporation to an income tax
under the Commerce Clause. In Quill, the Court expressly stated that the
holding of title to licensed software in the State does not meet the
�substantial nexus� requirement of the Commerce Clause.

Therefore, to the
extent the doing business statutes attempt to impose an income (franchise) tax
on the taxpayer, we believe they are inapplicable as they relate to the
licensing of software by the taxpayer since they are in conflict with numerous
decisions by the Supreme Court.

Thank you for your
assistance with this matter. Please respond to the address below.

XXXXX

If you have any
questions please do not hesitate to call me directly at XXXXX.

Very truly yours,

XXXXX

TO: XXXXX, Director

FROM: XXXXX, Secretary

DATE:XXXXX

SUBJECT: Request for Ruling - No. 93-002DJ

Attached is a request
for information and/or ruling from XXXXX of XXXXX. Will you please review the request of XXXXX to determine the
income and/or franchise tax consequences of a taxpayer who is anticipating
operations in Utah and needs to know whether they are subject to income and
franchise tax in the state.

Please prepare the
response for signature by the Commission as per the guidelines established by
them.

Thank you.

XXXXX

Dear XXXXX:

Your request for an
advisory opinion regarding whether a taxpayer engaging in the providing of data
base services referred to as a �gateway� is subject to the Utah corporation
franchise tax was referred to the Auditing Division for their analysis.

The division staff has
recommended the following:

It is necessary at the
outset to distinguish between limitations imposed by Public Law 86-272 and the
constitutional limitations imposed.
Public Law 86-272 places limitations on the taxing power of the states
with regard to the sale of tangible personal property within the state. The leasing, renting, licensing or other
disposition of tangible personal property, intangible or any other type of
property is not immune from taxation by reason of P.O. 86-272. Therefore, the ownership of licensed
software in Utah would not qualify for exemption under P.L. 86-272 since such
ownership does not constitute the sale of tangible personal property.

The Commerce Clause
under the Complete Auto Transit test does require that a taxpayer have a
substantial nexus with the state before the state may impose its tax. It is this test to which the U.S. Supreme
Court referred in Quill Corporation v. North Dakota when it stated that
�title to a few floppy diskettes present in the State...does not meet the
�substantial nexus� requirement of the Commerce Clause�. However, the Quill case was a sales tax case
which was reliant on previous sales tax case law including the XXXXX case. There are major differences in nexus
determinations between corporate tax and sales tax. The telecommunications industry is a unique industry which is
extremely interactive in nature.
Therefore, �a substantial nexus� could be found to exist in this
industry through delivery into the state of the service through the local
exchange.

The questions you
posed in your letter are restated with a corresponding answer below:

(1) If the taxpayer does not have any traveling
sales people in your state, are they subject to income (franchise) tax based on
the presence of licensed software in the state?

Yes. A mainframe license in the amounts discussed
in your letter would constitute sufficient property to the �substantial nexus�
test in our view. In addition, the
unique and interactive nature of the telecommunications industry and the
taxpayer�s use of the local exchanges would be sufficient to create nexus for
the company.

Further, it appears
that the activity that would potentially generate the majority of Utah tax
liability, if any, is the service fees charged to the Utah customer for access
to the �gateway� databases. Public Law
86-272 does not exempt the company from taxation on these service fees either
since they are not a sales of tangible personal property. However, the Utah statute does not presently
require the inclusion of these fees in the Utah sales numerator since the
services are provided from outside the state.
Therefore, at this point in time, the Utah law would only require
inclusion of the minimal amounts of tangible property in the property numerator
and nothing in the sales numerator which would not appear to create much of a
tax burden for the present.

2) Would the answer to (1) above be different
if they did have traveling sales people in your state?

No. The company would still be subject to tax
and required to include the property in the Utah property numerator. However, if the activities of the traveling
sales people exceeded �solicitation�, such activities would create nexus
standing alone and the Utah portion of the employee�s wages would be includable
in the Utah wage numerator.

(3) If the taxpayer is subject to income
(franchise tax, are they considered a seller of tangible personal property
(sales of canned software) or a service business, since the primary revenue is from
the use of the database or maintenance agreements and not the sale of the
software?

The taxpayer appears
to be primarily engaged in a service business.
The use of the database or maintenance agreements are services. To the extent the taxpayer sells, rents or
leases its canned software, it would also be engaged in the sale, renting or
leasing of tangible personal property.

(4) If the Taxpayer is subject to income
(franchise) tax, what apportionment methodology should be used? (i.e. three factor, single gross receipts
factor, or another method).

The XXXXX three-factor
formula is the law in Utah. As stated
above, under current statutes and rules, Utah would not include the fees from
the services provided in the Utah sales numerator. Utah would require the inclusion of any tangible property (canned
software) owned by the taxpayer which is physically located in this state.

(5) If the Taxpayer is not subject to income
(franchise) tax and does not have traveling sales people in your state, is the
presence of licensed software in your state sufficient nexus to require the
Taxpayer to qualify to do business in your state?

This question appears
to be inapplicable since we have stated that the taxpayer is subject to income
(franchise) tax based on the facts presented.
However, the Utah corporation franchise tax law does not include any
provisions requiring a corporation to qualify in this state although a
nonqualified corporation which is doing business in the state is required to
file a tax return and pay taxes. The
taxpayer should inquire of the Utah Department of Commerce if it has additional
questions regarding qualification requirements in Utah.

(6) Would the answer to (5) above be different
if they did have traveling sales people in your state?

No.

Based upon the facts
presented in your letter, we are in agreement with the Auditing Division�s
recommendations. Obviously, if there
are deviations from these facts, this opinion may be negated.

If you do not agree with
this determination, you may file an appeal before the Commission in a formal
hearing. Any adverse ruling would also
be appealable to the Utah Supreme Court.
A notice of appeal rights and a copy of the Utah Taxpayer Bill of Rights
are attached.

In contacting with the
Tax Commission, if special accommodations are needed in accordance with the
Americans with Disabilities Act, please call (801) 530-6920, (801) 530-6077 or
TDD (801) 530-6269 allowing three working days notice.

For the Commission,

Joe B. Pacheco,

Commissioner