Did remotely managed servers placed with Virginia customers create sales-tax duties for an out-of-state software company?

Subject

Virginia tax treatment of remotely managed customer servers and licensed software

Plain-English summary

Virginia said the transaction was not described clearly enough for one classification, so it analyzed the company as either a service provider or a lessor. The out-of-state company had no personnel entering Virginia, but retained ownership of servers shipped by common carrier to Virginia customers. Each server carried canned software licensed for recurring fees and managed remotely.

If the company was a service provider

The company would generally be the user or consumer of servers, software, and other tangible property used to provide its services in Virginia. Virginia tax would apply, with a credit only for tax correctly imposed by another state after title or possession first transferred there. Software delivered into Virginia on the server remained taxable tangible property under the ruling's analysis.

The ruling separately noted a statutory exception for qualifying Internet service providers, but the submitted facts did not establish that the servers enabled subscribers to access the covered Internet, email, information, and content package.

If the company leased or rented the property

Continuing ownership of customer servers in Virginia created a regular physical presence. Virginia concluded that this leasing presence from 2002 through 2006 was sufficient to require dealer registration and collection of sales or use tax on server and software charges.

Tax mistakenly paid to the company's home state on property actually leased in Virginia would not qualify for Virginia's other-state credit.

Labor charges

Separately stated installation labor could be exempt. Configuration and setup were not exempt. Because the company charged one lump sum for installation, configuration, and setup, the full combined charge was taxable.

What this means for you

• Owning servers placed with customers can create tax duties even without employees or agents entering the state.
• Contract classification matters: service-provider use and equipment leasing lead to different tax mechanics.
• Tax paid to another state receives credit only when that other state's tax was correctly imposed.
• Separate exempt installation from taxable setup or configuration charges.
• A website-server exclusion did not apply where the servers were not shown to create or maintain Internet websites.

Common questions

Did Virginia give one final classification?

No. It said the facts were unclear and explained the consequences of two likely scenarios.

Could the company avoid nexus because no people entered Virginia?

Not under the leasing scenario. Its continuously owned servers in Virginia created the presence relied on by the ruling.

Was the combined installation and setup fee exempt?

No. The lump sum included taxable configuration and setup, making the entire charge taxable.

Citations and references

• Va. Code §§ 58.1-602, 58.1-609.5(1) and (3), 58.1-609.6(2), 58.1-611, and 58.1-612(B)(5) and (C)(9).
• 23 VAC 10-210-4040(E), 10-210-450, and 10-210-840(A).
• Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
• Virginia Public Documents 00-18, 00-53, 01-29, 02-96, 04-89, 05-128, 86-186, 88-41, 94-351, and 04-86.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-169

Original ruling text

October 23, 2009

Re: Request for Ruling: Retail Sales and Use Tax

Dear *:

This is in response to your letter in which you request a ruling on the application of retail sales and use tax nexus in Virginia. I apologize for the delay in responding to your letter.

FACTS

A client (the "Company") began operations in 2002 and has an office located outside Virginia. All employees work at this office. There are no traveling sales persons, installers, service people, subcontractors, independent contractors, agents, affiliates, or similar individuals entering Virginia on behalf of the Company.

The Company creates and sells canned software, which the Company installs, configures and tests on computer servers at its office. Once operating correctly, servers with installed software are shipped to customers in Virginia via common carrier. Servers delivered into Virginia consist of the following: one server in 2002, two servers

in 2003, three servers in 2004, four servers in 2005, and five servers in 2006. The Company retains ownership of the servers, records the servers on its books as fixed assets, and depreciates the servers. The Company pays sales or use tax on the cost of these servers to the state where its office is located.

The software installed on these servers functions and receives software fixes, upgrades and patches through a link to a network with an Internet connection. The servers are generally outdated, fully depreciated, and removed from the Company's records after three years of use. Although customers are expected to return the servers for disposal, many servers are not returned and presumed junked by the customers.

In each instance, an annual license fee is charged for the use of the software installed on the servers depending upon the number of users. Payments for the license fee may be monthly, quarterly or annually. If the customer fails to make a required payment, the software is shut off through use of a remote software access key. The charge for the software license is generally 10 to 30 times the cost of the server. The Company also makes a one-time, separately stated charge for installation, configuration and setup of the software on the server.

RULING

The facts provided do not clearly show the true nature of the Company's transactions in Virginia. For instance, although the Company states that it sells a canned software product, the facts reveal that the Company Iicenses the software without passing title to the software to another person. Also, the Company treats itself as a user or consumer of the servers as it pays the sales tax on the cost price of such servers to its home state. Generally, a person engaged in personal or professional service transactions is the user or consumer of the tangible personal property used in the performance of such services. See Title 23 of the Virginia Administrative Code ("VAC") 10-210-4040 E and Va. Code § 58.1-609.5 1. However, no mention is made that the Company is engaged in any type of exempt personal or professional service transactions in Virginia, such as information services or data processing services, in which servers function as the medium to provide the services. In an attempt to respond to the issue presented, I will address the application of the tax using two likely scenarios.

Service Provider

If the Company is a service provider in Virginia, then it is generally liable for the tax on all servers, software and any other tangible personal property used in Virginia for its provision of services. In such instances, a tax credit against the Virginia retail sales and use tax would be available for the tax paid to another state on the servers if title or possession to the servers first transfers in the Company's state and is correctly subject to taxation in such other state. For example, if the tax rate in the Company's state is 6% on the cost price of the server, then no retail sales and use tax is due Virginia. On the other hand, if the other state's combined sales tax rate is 4%, then the Company would owe Virginia the difference of 1% ( i.e. , 5% - 4%). [For further information on the credit, see Va. Code § 58.1-611 and Title 23 VAC 10-210-450.] As for the software, the Company would remain liable for the tax on the software because it is delivered into Virginia on hardware media ( i.e. , the server). Other non-taxed tangible personal property used in Virginia in connection with the provision of services would also be taxable.

An exception to the above rule would be for servers and software owned or leased by an Internet service provider to enable users to access proprietary and other content, information electronic mail, and the Internet as part of a package of services sold to end-user subscribers. See the exemption applicable to certain Internet services providers in Va. Code §§ 58.1-609.6 2 and 58.1-602. For further clarification, see Public Documents (P.D) 00-18 (3/17/00), 01-29 (3/29/01), and 04-89 (8/31/04).

Lessor or renter

If the Company is engaged in transactions for the lease or rental of tangible personal property in Virginia and does not use the servers, software and other tangible personal property in the provision of exempt information services, then it is engaged as a dealer in Virginia pursuant to Va. Code § 58.1-612 B 5. Under these circumstances, an examination of the Company's activities in Virginia is required to determine whether the Company has sufficient activity in Virginia pursuant to Va Code § 58.1-612 C 9 to require it to register for use tax collection duties. The facts presented suggest that the Company satisfies the criteria of Virginia Code § 58.1-612 C 9 which provides the following:

Owns tangible personal property that is rented or leased to a consumer in this Commonwealth, or offers tangible personal property, on approval, to consumers in this Commonwealth.

Furthermore, the Department's long-standing policy imposes sales or use tax collection duties upon any in-state or out-of-state person who leases or rents tangible personal property in Virginia. For instance, Title 23 VAC 10-210-840 A provides the following:

Any person engaged in business of leasing or renting tangible personal property to others is required to register as a dealer and collect and pay the tax on gross proceeds. A lessor of tangible personal property whose place of business is outside this state and who leases or rents tangible personal property to Virginia customers is required to register as a dealer and to collect and pay the tax on the gross proceeds.

Thus, when the Company engages in the rental or lease of servers with licensed prewritten software to Virginia customers, it maintains a continuous physical presence in Virginia that regularly and intentionally makes use of the Virginia marketplace. Such presence is much more than a few floppy diskettes that the U.S. Supreme Court ruled in Quill Corp. v. North Dakota , 504 U.S. 298 (1992) as constituting only the slightest physical presence that lacked the substantial nexus required by the Commerce Clause. The software and server fees are also not incidental, nor of immaterial value. Moreover, the Company's physical and economic presence on an ongoing basis in Virginia is not a de minimis presence in Virginia but a significant one. For these reasons, I find that the Company's leasing presence in Virginia from 2002 through 2006 is sufficient to require registration for the collection of the sales or use tax on the server and software charges imposed on Virginia customers.

The Company's payment of use tax to the home state on the servers would appear to be unjustified because the property is leased or rented in Virginia. In such instances, no credit against the Virginia use tax due would be allowed for the sales or use tax erroneously paid to the home state. See Title 23 VAC 10-210-450 A.

Other Applications of the Tax

Nexus Exclusion for Website Servers

In P.D. 00-53 (4/14/00), the Department held that no nexus existed for an out-of- state seller whose only presence in Virginia was the use of a computer server to create or maintain a site on the Internet. The Department also considered a similar situation in P.D. 05-128 (8/2/05). These rulings conform to the Department's interpretation of the Internet Tax Freedom Act enacted by Congress. In the instant case, however, no mention is made of using the servers in Virginia to create or maintain a website on the Internet. Rather, the facts presented suggest, that the Company's servers are used for other purposes. Accordingly, I fired no basis for applying the server exclusion set out in P.D. 00-53 to the Company's servers.

Installation, Configuration and Setup Labor

A separately stated charge for installation labor is exempt pursuant to Va. Code § 58.1-609.5 3. Installation labor is "labor rendered after the product is complete in order to install it for the customer." See P.D. 86-186 (9/18/86). There is, however, no statutory exemption for configuration or setup labor. Rather, as set out in P. D. 02-96 (6/25/02), configuration labor is treated as a taxable element of the sales transaction. Furthermore, in P.D. 88-41 (3/18/88), setup fees in connection with taxable accommodations were held taxable. In the instant case, a lump-sum charge is made for an exempt installation service and taxable services (configuration and setup). Accordingly, the lump-sum charge is taxable in full. Such treatment is consistent with prior rulings. See P.D. 94-351 (11/22/94) and P.D. 04-86 (8/30/04).

CONCLUSION

This response is based on the facts provided as summarized above. Any change in facts or the introduction of new facts may lead to a different result. T

The Code of Virginia section, regulations and public documents cited are available on-line at www.tax.virgiriia.gov in the Tax Policy Library section of the Department's web site. If you have any questions about this ruling, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-1368429751.R