Sales
tax generally applies to the sale of “prewritten” or “canned” software.
However, the majority of states that tax prewritten software do not tax the
customization of prewritten software. Application of this distinction between
prewritten and customized software can create considerable difficulties for
taxpayers and taxing authorities (such as determining the degree of alteration
required to be considered customized software), and it continues to be subject
to controversy.
The
Minnesota Supreme Court recently wrestled with some of these issues in LumiData, Inc. v. Commissioner
of Revenue, No. A14-0254 (Sept. 14, 2014). Minnesota law provides
that customized portions of prewritten computer software are exempt only if the
taxpayer separately states its customization charges in customer invoices.
LumiData significantly customized its software for each of its customers;
however, it failed to separately state customization charges in customer invoices.
Accordingly, the court held that the taxpayer could not qualify for the
exemption.
The
court also rejected LumiData's argument that the sales should have been treated
“in substance” as a sale of customized software, because the company failed to
produce sufficient credible evidence to support its position. The court added
that after the company's initial customization for a customer, the altered
software then became incorporated into subsequent versions of the software,
making each subsequent version more like prewritten software than customized
software.
This
case not only illustrates some of the difficulties inherent in applying the
distinction between prewritten and customized software, but it also reiterates
the importance of providing thorough and credible documentary evidence in
support of any claim for a tax exemption.
Background.
LumiData
provides software that organizes and analyzes sales information at retailers'
cash registers. For instance, the software can help determine the effectiveness
of a particular sales promotion or track the volume of sales during certain
time periods.
LumiData
significantly customizes the software for each customer's particular needs.
However, each new version of the software incorporates the functionality of all
prior versions of the software.
Between
2005 and 2008, LumiData did not pay Minnesota sales tax on its software
revenue. The Minnesota Commissioner of Revenue audited the company and
concluded that its software sales were subject to sales tax as prewritten
computer software under Minn. Stat. § 297A.61(17) because the company did not
separately state customization charges on customer invoices.
The tax court proceedings.
On
appeal to the tax court, LumiData argued that it only sold customized software
and presented testimony that many of its customers refused to purchase the
software without customization. The company also submitted a history of changes
to the software and a checklist of customization requirements for its
customers. LumiData also argued that its software should be treated as
customized software in a “substance-over-form” argument because the cost of
enhancement to the software often exceeded the price it actually charged for
the software. Finally, the company asserted that it had reasonable cause for
failing to pay sales tax because it allegedly relied on advice from its
accountant that the software sales were tax exempt.
The tax
court rejected all of the company's arguments and found that the software was
taxable prewritten computer software because the software was a “substantial
preexisting platform,” rather than software “designed and developed to the
specifications of each customer.”
The tax
court also rejected the company's substance-over-form argument, reasoning that
its sales were structured as “license agreements” rather than “customization
agreements.” The tax court also disregarded testimony that the cost of
customization would exceed the amount the taxpayer charged its customers
because the testimony in this regard was not sufficiently detailed and the
company had not submitted any documentation to support the testimony.
Finally,
the tax court rejected the taxpayer's argument that it had reasonable cause for
failing to file returns because the taxpayer “never formally sought its accountant's
opinion” as to whether the software sales were taxable, and the accountant
“never reviewed the licensing agreements.” The taxpayer appealed.
The Supreme Court focuses on failure to separately state
charges.
The
Minnesota Supreme Court began its legal analysis by pointing out that all
“gross receipts are presumed subject to tax, and the burden of proving that a
sale is not subject to tax is on the seller.” The court noted that sales of
prewritten software are subject to sales tax under Minnesota law (Minn. Stat. §
297.61(3)(f)), but that portions of prewritten software are only exempt from
sales tax based on customization of the software if there is a “reasonable,
separately stated charge for such modification or enhancement.” Minn. Stat. §
297A.61(17).
Applying
the statute to LumiData's sales, the court held that the sales were sales of
partially prewritten and partially customized software. The court emphasized
that although the software was initially customized significantly for each
purchaser, new versions of the software incorporated those customizations.
Although not entirely clear, the court apparently concluded that by
incorporating customizations into subsequent software versions, the company
effectively converted those customizations into prewritten software.
The
court provided no legal support for its reasoning on this point. This ruling
seems problematic. If applied broadly, it would allow exemptions only for
initial software customizations, and would then effectively convert that
customized portion of the software into prewritten software.
Nonetheless,
the court held that LumiData could not qualify for the exemption in any event
because it failed to separately state customization charges in customer
invoices. The Supreme Court emphasized the tax court's finding that “none of
the licenses in the record contained a separate charge for customization,” and
concluded that the failure to separately state customization charges meant that
the sales were taxable sales of prewritten software.
The
Supreme Court also rejected the customization checklists as evidence regarding
the scope of customization because there was “no documentary evidence
whatsoever to verify the magnitude of its alleged custom programming costs,”
such as “time records for development work” or the “hourly rate for software
development or customization work.”
The
Court's decision also reiterates the axiom that where there is any doubt,
exemptions are construed against the taxpayer and in favor of the taxing
authorities. As in this case, a taxpayer's failure to produce strong
documentary evidence in support of its claim will almost certainly result in a
rejection of its exemption claim on appeal.
Substance-over-form argument rejected on lack of credible
evidence.
The
Minnesota Supreme Court also upheld the tax court's rejection of the company's
“substance-over-form” argument. Although it acknowledged that, under “proper
circumstances,” the court would “disregard a transaction's form in favor of its
economic substance,” it declined to apply the principle here due to lack of
documentary evidence presented to the tax court.
LumiData
argued that its software sales should be treated in substance as sales of
customized software based on oral testimony from its employees that “the cost
of customizing [the software] exceeded the software's sales price.” However,
the tax court found that the evidence was “entitled to little if any weight,”
and the Minnesota Supreme Court upheld that finding because the employee
testimony was “general, conclusory, and not corroborated by documentary
evidence.” The court deferred to the tax court on this point because the tax
court “is in the best position to evaluate the credibility of witnesses.”
Near
the end of its substance-over-form analysis, the court seemed to cast doubt on
its willingness to apply a substance-over-form analysis in statutory
interpretation cases. The court refused to look beyond the statutory
requirement to separately state customization charges, stating: “We will not
ignore the plain language of the law under the guise of pursuing its spirit.”
This
suggests that the court may not be willing in reality to apply a
substance-over-form analysis in statutory interpretation cases, except perhaps
in very rare circumstances. The court did not attempt to reconcile this
statement with its earlier statement that it would apply the
substance-over-form doctrine in appropriate circumstances. Nor did the court
indicate when it would be appropriate to apply such an analysis.
Court finds there can be no reliance on advice neither
sought nor obtained.
Finally,
the court also deferred to the tax court's findings of fact regarding whether
LumiData had “reasonable cause” to believe that it was not required to file tax
returns or to believe that no tax was due. If the company had been able to
establish reasonable cause, no penalty would have been due. Minn. Stat. §
270C.34(1).
LumiData
argued that it had reasonably relied on its accountant's advice that the sales
of its software were not subject to sales tax. However, the tax court found “no
evidence” that the company actually sought an opinion from its accountant. In
fact, the accountant specifically testified that, “had she known that [the
company] was not filing tax returns, she would have advised it to do so.”
If you
would like more details about this decision or any other aspect of the new law,
please do not hesitate to call.
Amare
Berhie, Senior Tax Accountant
(651) 621-5777, (952) 583-9108, (612) 224-2476, (763)
269-5396
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