Virginia Ruling Says Hardware-Software Connection Is Crucial to Sales and Use Taxation

The Virginia Department of Taxation has released Commissioner Ruling 25-98 regarding the sales and use taxation of computer software. The ruling highlights the importance of the interrelation of hardware and integrated software and relaxes some documentation requirements.

The Department audited a supplier of staffing and supply chain management services and assessed sales and use tax for untaxed purchases of software, maintenance contracts, and licensing fees. After paying the assessment, the taxpayer filed an application for correction on the basis that the purchases and fees were not taxable. 

Sales of Software

Virginia exempts from sales and use tax any services that provide access to or use of the internet and any other related e-communication service, including software, data, content, and other information services delivered electronically. In 1996, the Department said that how the computer software is transferred is critical: Sales (and connected charges) of software in tangible form are taxable sales of tangible personal property, while transactions (and connected charges) involving the electronic transfer of software are generally deemed nontaxable.

The Department uses the “true object” test to determine the taxability of transactions involving both the sale of tangible personal property and the provision of services. If the object of a transaction is to obtain a software program, and any included tangible property is not critical, then the transaction might be an exempt sale. However, if the object of a transaction is to procure tangible property (such as a computer), then the entire charge, including for any software provided, is taxable.

Documentation Requirements

Given the widespread use of e-commerce in the last decade, the Department updated its documentation standards to no longer require taxpayers to provide documentation expressly certifying the e-delivery of software. However, it noted that software programs provided in connection with sales of tangible personal property remain taxable and that it might require taxpayers to provide documentation demonstrating that software was not provided in connection with the sale of tangible property.

Maintenance Contracts

Under Virginia law, half the cost of maintenance contracts that provide both repair or replacement parts and repair labor are subject to tax. It defines the term “maintenance contract” as “an agreement whereby a person agrees to maintain or repair an item of tangible personal property over a specified period for a fee that is determined when the agreement is made.” Those contracts can cover labor only, parts only, or both.

Department Analysis

The Department removed one of the four transactions at issue because there was no evidence that the delivery of software included the provision of tangible property. It removed another on similar grounds, noting further that the transaction involved a nontaxable labor-only maintenance contract that was not connected to the sale of hardware. However, it determined that two of the transactions involved the taxable sale of hardware and integrated software critical to the continued use of that hardware.  

The audit included the entire price of the first transaction involving maintenance contracts because the software was delivered in tangible form; the taxpayer argued that only half should be taxable because the contract covered both parts and labor. The Department agreed that the entire price should be taxed, saying that “when computer equipment is sold with the software and software updates installed, the software and software updates are a component part of the taxable sale of computer equipment.” It also found the transaction taxable because the maintenance contract included both hardware repair and integrated software updates. It did not consider the software’s e-delivery or appearance as a separate line item on the invoice to confer nontaxability on that portion of the contract. 

The other retained transaction involved the purchase of only a maintenance contract. The taxpayer acknowledged that the contract related to hardware but argued that it covered only labor and was therefore exempt from tax. The auditor said that acknowledgement indicated that the purchase was for the license of both software and hardware. The Department sided with the auditor, finding that the subscription license read as a maintenance contract for both hardware and software. Further, the contract was sold in conjunction with hardware, making it taxable.