Tuesday, December 23, 2014

Minnesota Supreme Court Upholds Tax on Sale of Partially Customized Software

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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