My company licenses software to dealers who resell services to customers, and we also do business in states with no income tax -- do we qualify for Virginia's BPOL software exclusion and the out-of-state gross receipts deduction?

Plain-English summary

A company that develops software for connected-home products -- interactive security, video monitoring, automation, energy management -- had a definite place of business in a Virginia county and filed its BPOL tax returns as a "business service" provider. It claimed two things: an exclusion for the portion of its gross receipts attributable to designing, developing, or creating computer software (based on the payroll of employees it deemed part of the software-development process), and a deduction for receipts attributable to business conducted outside Virginia. The county's audit denied the software exclusion entirely and allowed the out-of-state deduction only for states where the company actually paid a genuine income tax, producing BPOL assessments for 2017-2020.

On the software exclusion, Virginia law lets localities exclude BPOL gross receipts attributable to designing, developing, or creating computer software for lease, sale, or license, but only for activity actually performed at the taxpayer's local place of business. The company pointed to registered software copyrights and its contracts with "dealers" who resold services built on its software to their own customers. But when the Department actually read those contracts, it found they defined and charged for a bundle of services -- wireless data transmission, hosting, remote access, remote control, notifications, alarm forwarding to a central station -- with software as a component that made those services possible, not the thing being sold. Because tax deductions and exclusions are construed narrowly against the taxpayer, and the contracts were fundamentally about delivering services rather than selling, leasing, or licensing software, the Department found the company didn't qualify as a software developer/licensor for exclusion purposes, regardless of holding software copyrights.

On the out-of-state deduction, Virginia lets a BPOL taxpayer deduct gross receipts attributable to business in another state or country only if the taxpayer is liable there for an income tax or a tax based on income (and generally must have filed a return there even in a no-liability year). The company had filed returns and paid tax in Ohio, Texas, and Washington, but the Department found none of those three qualify: Ohio's Commercial Activity Tax and Washington's B&O Tax are both based on gross receipts (not net income), and Texas's Margin Tax is a franchise tax the Texas legislature itself declared, by statute, is "not an income tax" -- confirmed by a Texas appellate court. Because all three are gross-receipts-style taxes states use instead of (not equivalent to) a corporate income tax, receipts attributed to those states didn't qualify for the deduction. The company also claimed it paid withholding tax in several foreign countries, but provided no proof those were income-based taxes, so the Department couldn't rule on that piece either. Because the county's ordinance question (whether the county's own local rule was broader than the state statute) wasn't something the Department would interpret, the assessments were upheld across the board.

What this means for you

Software companies whose customers actually receive a bundle of managed services, not a standalone license

Holding a copyright or patent on your software, and contractually retaining title to it, doesn't automatically make your dealer/reseller fees "software licensing" revenue for BPOL exclusion purposes. Look at what your contracts actually promise and charge for -- if they define and bill for services (hosting, monitoring, support, data access) rather than a software license fee, the exclusion is unlikely to apply even if software is essential to delivering those services.

Multi-state businesses claiming Virginia's BPOL out-of-state deduction based on taxes paid to gross-receipts states

Not every business tax you pay to another state counts as an "income tax" for this deduction. Broad-based gross receipts taxes that some states use instead of a corporate income tax -- Ohio's Commercial Activity Tax, Washington's B&O Tax, and Texas's Margin Tax are all specifically identified here as NOT qualifying -- won't support the deduction even though you filed a return and paid real money there.

Businesses relying on foreign withholding tax to support the out-of-state deduction

You need actual documentation that the foreign tax is an income tax or based on income; simply asserting you paid withholding tax in a list of countries isn't enough for the Department to grant the deduction.

Common questions

Q: We license software to partners who use it to serve their own customers -- does that automatically qualify for Virginia's BPOL computer-software exclusion?
A: Not necessarily. The Department looks at what your actual contracts say is being sold. If they define a bundle of services (hosting, monitoring, data access, notifications, etc.) with software as a component rather than a stand-alone license, that's service revenue, not software-licensing revenue, for exclusion purposes.

Q: Does paying Ohio's Commercial Activity Tax, Washington's B&O Tax, or the Texas Margin Tax qualify me for Virginia's BPOL out-of-state deduction?
A: No. All three are gross-receipts-based taxes that function as a substitute for a corporate income tax in those states, not an income tax or income-based tax themselves, so receipts attributed to those states don't qualify for Virginia's deduction under Va. Code § 58.1-3732 B 2.

Q: I paid a foreign withholding tax -- can I deduct the related gross receipts under the out-of-state deduction?
A: Only if you can document that the withholding tax is an income tax or a tax based on income in that country. Without that proof, the Department won't grant the deduction.

Q: My county's own local BPOL ordinance seems broader than the state statute -- can I rely on the local ordinance instead?
A: The Department generally won't interpret local ordinance provisions and will decide only whether you qualify under the state statute (Va. Code § 58.1-3732 B 2) itself.

Citations and references

• Va. Code § 58.1-3703.1 (Department decides BPOL tax appeals; local assessment deemed prima facie correct)
• Va. Code § 58.1-3703 B (localities may exclude BPOL gross receipts from computer software design/development/creation performed at a local place of business)
• Va. Code § 58.1-3732 B 2 (deduction for gross receipts attributable to business in another state/country with an income or income-based tax)
• 23 VAC 10-500-80 A 2 (must file an income or income-like return in the other jurisdiction, even absent actual liability, to claim the deduction)
• 23 VAC 10-500-632 (the Department will not interpret local ordinance provisions)
• Howell's Motor Freight, Inc. v. Virginia Department of Taxation, Cir. Ct. City of Roanoke, Law No. 82-0846 (10/27/1983) (deductions and credits are strictly construed against the taxpayer)
• Ohio Rev. Code § 5751.02(A) and § 5751.01 (Ohio Commercial Activity Tax is a gross-receipts tax, not based on net income)
• Tex. Tax Code Ann. § 171.001(a); Act of May 2, 2006, ch. 1, § 21, 2006 Tex. Gen. Laws 1, 38 (Texas Margin/franchise tax is, by its own enacting legislation, "not an income tax")
• Graphic Packaging Corp. v. Hegar, 471 S.W.3d 138 (Tex. App. 2015) (Texas franchise tax is not an income tax or a tax measured by net income)
• Wash. Rev. Code § 82.04.220 (Washington B&O Tax is based on gross proceeds/gross income by business classification, not net income)
• P.D. 17-94 (6/9/2017) (identifies broad-based gross receipts taxes some states use in lieu of a corporate income tax)
• P.D. 10-228 and P.D. 19-110 (cited by the Department as related documents on BPOL exclusions/deductions)

Subject

Exemptions: Computer Software Deductions: Out-of-State

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 22-117

Original ruling text

July 21, 2022

Re: Appeal of Final Local Determination

Taxpayer: *

Locality: *

Business, Professional and Occupational License Tax

Dear *:

This final state determination is issued upon the application for correction filed by you on behalf of * (the “Taxpayer”), with the Department of Taxation. You appeal assessments of the Business, Professional and Occupational License (BPOL) tax issued to the Taxpayer by *** (the “County”) for the 2017 through 2020 tax years.

The BPOL tax is imposed and administered by local officials. Virginia Code § 58.1-3703.1 authorizes the Department to issue determinations on taxpayer appeals of BPOL tax assessments. On appeal, a BPOL tax assessment is deemed prima facie correct, i.e., the local assessment will stand unless the taxpayer proves that it is incorrect.

The following determination is based on the facts presented to the Department summarized below. The Code of Virginia sections, regulations and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department’s web site.

FACTS

The Taxpayer describes itself as a provider of technology solutions designed to make connected properties safer, smarter and more efficient. To the public, it holds itself out as a provider of software for interactive security, video monitoring, intelligent automation, energy management and wellness solutions. The Taxpayer’s suite of software enables its service provider partners or dealers to deploy either bundled or stand alone services and allows end users (the dealer’s customers) to access various features.

For the tax years at issue, the Taxpayer had a definite place of business in the County and filed its BPOL tax returns under the business service classification. The Taxpayer claimed an exclusion for a portion of gross receipts under the County’s BPOL ordinances for gross receipts derived from the design, development or other creation of computer software for lease, sale or license based on the payroll of employees located in the County it deemed were part of the software development process. In addition, the Taxpayer claimed a deduction for receipts it attributed to business conducted outside of Virginia. The County audited the Taxpayer, denying the exclusion and only allowing the portion of the deduction for revenues attributed to states that had an income tax. As a result, assessments were issued for the 2017 through 2020 tax years for additional BPOL tax due.

The Taxpayer appealed to the County, contending that it was entitled to claim the exclusion because it developed and licensed software and that the exclusion amount was based on the direct labor method. The Taxpayer also asserted that it was entitled to claim the deduction from gross receipts for states and countries that had a tax based on income. In its final determination, the County concluded that the Taxpayer was performing services and thus was not eligible for the exclusion. It also concluded that the Taxpayer had used an improper methodology to calculate the out-of-state deduction.

The Taxpayer appeals to the Department, contending that it was eligible for the exclusion because it developed and licensed software and development occurred in the County. It also asserts that it was entitled to claim a deduction for gross receipts attributable to states and countries that had a tax based on income.

ANALYSIS

Software Exclusion

Localities may exclude from the BPOL tax those gross receipts that are attributable to the design, development or other creation of computer software for lease, sale or license. See Virginia Code § 58.1-3703 B. The County’s BPOL ordinances provide for such an exclusion, but only to the extent that the gross receipts are attributed to computer software design, development or creation activities actually performed at a definite place of business in the County. The County determined that the Taxpayer was not eligible for the exclusion because the Taxpayer was providing services rather than leasing, selling or licensing computer software.

In its appeal to the Department, the Taxpayer included a list of patents of software products that were registered with the United States Copyright Office. The Taxpayer also included copies of contracts with dealers who provided services to end users utilizing the Taxpayer’s software. The County asserts that the Taxpayer was a service provider because the contracts with its dealers and its financial statements describe the payments as fees for the of delivery services that dealers resold to customers. The Taxpayer argues that the revenue was derived from the license of software because it retained title to the software and received revenue from the dealers to use such software when providing services to its customers.

By reason of their character as legislative grants, statutes relating to deductions allowable in computing income and credits allowed against a tax liability must be strictly construed against the taxpayer and in favor of the taxing authority. See Howell’s Motor Freight, Inc., et al. v. Virginia Department of Taxation , Circuit Court of the City of Roanoke, Law No. 82-0846 (10/27/1983).

The Taxpayer included copies of agreements it entered into with dealers who wished to sell the Taxpayer’s products to their customers. The Department examined each agreement or contract provided with the appeal. One agreement described the Taxpayer’s “services,” which were defined to include:

1) the enabling of wireless transmission of data from the security system at the user’s premises to the Taxpayer’s network operations center;

2) hosting the data in such center;

3) remote access to the data via a user interface;

4) remote control of the security system and any home automation services via a user interface;

5) personalized event-driven phone and email notifications managed by customers via a user interface; and

6) forwarding of alarm notifications to a supported central station.

Under the agreement, dealers paid the Taxpayer fees for such services. This agreement acknowledged that products could contain proprietary software and/or firmware embedded under a license from the Taxpayer and that all right, title and interest to such items remained with the Taxpayer.

The other contracts submitted with the appeal were structured similarly. Services were defined, and a fee was paid to the Taxpayer allowing the dealer to provide the defined services to their customers. It appears that while software may have been an important and necessary component that allowed the Taxpayer to provide its services, the contracts were ultimately about the sale of services, not the sale, lease or licensing of software specifically.

Out of State Deduction

Virginia Code § 58.1-3732 B 2 provides a deduction from gross receipts otherwise taxable for any receipts “attributable to business conducted in another state or foreign country in which the taxpayer ...is liable for an income or other tax based upon income.” Pursuant to Title 23 (VAC) 10-500-80 A 2, a taxpayer must file an income or income-like tax return in a state or foreign country even if there is not actual tax liability in a given year, in order to claim the deduction in that state or foreign country.

While the County allowed the out-of-state deduction claimed for gross receipts attributed to business conducted in states in which it filed an income tax return, the Taxpayer contends the County did not allow the out-of-state deduction for gross receipts earned in Ohio, Texas, and Washington because those states do not have an income tax return filing requirement. The Taxpayer asserts that it should be allowed to claim the out-of-state deduction for gross receipts attributed to these states because they were required to file returns for an income-based tax. Ohio’s Commercial Activity Tax (CAT), Texas’s Margin Tax, and Washington’s Business and Occupation (B&O) Tax are broad based gross receipts taxes which such states have in lieu of corporate income tax. See Public Document (P.D.) 17-94 (6/9/2017).

Ohio Commercial Activity Tax

The Taxpayer was subject to the Ohio CAT for the tax years at issue. Pursuant to Ohio Rev. Code § 5751.02(A), the Ohio CAT is a tax on each entity with taxable gross receipts for the privilege of doing business in Ohio. It is not a transactional tax subject to Public Law (P.L.) 86-272. The Ohio CAT excludes items from the computation of taxable gross receipts that would normally be considered items of income, including interest, dividends, and capital gains. See Ohio Rev. Code § 575.01. Because the Ohio CAT is based on gross receipts, rather than net income, it is not an income or income-based tax for purposes of the out-of-state deduction.

Texas Margin Tax

The Taxpayer filed franchise returns and paid the tax on the apportioned margins. In accordance with Tex. Tax Code Ann. § 171.001(a), a franchise tax is imposed on a taxable entity, including electing federal S corporations, if they do business in Texas or are organized in Texas. The franchise tax is based on an entity's margin. Generally, an entity has four ways to compute taxable margin including (i) 70% of total revenue or subtracting (ii) cost of goods sold (COGS), (iii) compensation; or (iv) $1 million from total revenue. In addition, total revenue is equal to revenue amounts reported for federal income tax less certain statutory exclusions.

When legislation creating the margin tax was passed, the legislature contemporaneously enacted a separate section that expressly stated that “[t]he franchise tax imposed by Chapter 171, Tax Code, as amended by this Act, is not an income tax.” See Act of May 2 , 2006, ch. 1, § 21, 2006 Tex. Gen. Laws 1, 38.

Further, 34 Tex. Admin. Code § 3.586(e) specifically states that the franchise tax is not subject to the limitations provided under P.L. 86-272. Finally, in Graphic Packaging Corp. v. Hegar , 471 S.W.3d 138 (2015), the Third District Court of Appeals of Texas concluded that the Texas franchise tax was not an income tax or a tax imposed on or measured by net income.

Washington Business and Occupation Tax

The Taxpayer was subject to the Washington B&O Tax. Wash. Rev. Code § 82.04.220 assesses a tax on entities for the privilege of engaging in activities. The tax is based on the value of products, gross proceeds of sale, or gross income of business, according to various business classifications. The tax bases are determined with reference to the type of business, and none of its bases are equivalent to or measured by net income. Therefore, the Washington B&O Tax is not an income tax or tax based upon income that is eligible for the deduction.

Foreign Taxes

The Taxpayer contends that it was subject to withholding tax in certain countries including Turkey, Brazil, Chile, Columbia, Ecuador, Israel, Panama, and Peru. It has not provided any documentation or other evidence that it was subject to an income tax or tax based on income in these countries. The Department, therefore, is unable to make a determination regarding whether the Taxpayer qualifies for the deduction because of tax paid to these countries.

Local Ordinance

The Taxpayer contends that it should be allowed a deduction for the portion of the receipts attributable to activities conducted outside of the Commonwealth in accordance with the County’s local ordinance. The Taxpayer asserts that the County’s local ordinance extends the deduction to all receipts attributable to business activity with a taxable situs in a jurisdiction outside of Virginia, whereas Virginia Code § 58.1-3732 B 2 is limited to receipts attributable to a state or foreign country in which a taxpayer is subject to an income tax or tax based on income. The County did not address the applicability of its ordinance.

The Department is not required to interpret any local ordinance, and the Department declines to do so in this case. See Title 23 VAC 10-500-632. This determination, therefore, is limited to whether the Taxpayer may claim the deduction as allowed under Virginia Code § 58.1-3732 B 2.

DETERMINATION

After considering all of the evidence provided, I find that the gross receipts generated from fees the dealers paid the Taxpayer were for performance of services. As such, the Taxpayer was not eligible for the exclusion for gross receipts derived from the design, development, or other creation of computer software for lease, sale, or license for the 2017 through 2020 tax years.

In addition, the Taxpayer could not claim an out-of-state deduction for gross receipts it attributed to Ohio, Texas, or Washington because they do not assess an income tax or tax based on income. Further, the Department is unable to determine based on the information provided whether the Taxpayer was eligible to claim the deduction for gross receipts it attributed to foreign countries. The assessments, therefore, are upheld.

If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3928.B

Related Documents

10-228

17-94

19-110