The Tax Policy Division of the Texas Comptroller of Public Accounts issued guidance summarizing certain federal statutes and regulations related to Internal Use Software (IUS) that are now incorporated-by-references into Texas’ research and development (R&D) laws. Specifically, for purposes of the franchise tax R&D credit laws and the sales tax R&D exemption, the Comptroller incorporates-by-reference certain definitions that, prior to the amendment, were only recognized if taxpayers were required to apply those regulations to the 2011 federal income tax year. Instead, the Comptroller now recognizes these federal laws if taxpayers were allowed to apply those regulations to the federal 2011 income tax year.

In federal tax year 2011, taxpayers were given the election between two different versions of Treas. Reg. § 1.41-4(c)(6): the version adopted in 2003 (contained in IRB 2001-5) and the version proposed in 2022 (contained in IRB 2002-4). Both versions of Treas. Reg. § 1.41-4(c)(6) have some identical provisions, including: (1) the general rule and exemptions from IUS treatment; (2) the definition of “computer services”; and (3) most—but not all—of the language and application of the High Threshold of Innovation Text (which must be satisfied in addition to the Four-Part Test).

The two versions, however, contain some differences: (1) how IUS is defined; (2) details on the treatment of hardware and software developed together as a single product; (3) applicability of a portion of the High Threshold of Innovation Test; (4) the exception for software used to provide noncomputer services; and (5) the examples used in each version of the regulation.

  1. Definition of IUS. IRB 2001-5 is more limited, defining IUS as any software developed to be used internally and clarifying that the sale of the software does not remove its IUS classification. Instead, IRB 2002-4 establishes a presumption that software is IUS unless it is developed to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to unrelated third parties, as determined at the start of the research.
  • Hardware and Software Developed Together as a Single Product. Both versions of the regulation state a new or improved package of hardware and software developed together as a single product, of which the software is an integral part, will be exempt from treatment as an IUS, so long as the product is used directly by the taxpayer to provide services to customers in its trade or business. IRB 2001-5, however, states that the services provided by the taxpayer must be “technological services,” whereas IRB 2002-4 provides that the services can be any services.
  • High Threshold of Innovation Test. While most of the High Threshold of Innovation Test is the same between both versions, IRB 2001-5 has detailed rules for its application.  Note that both versions provide that only the activities related to the new or improved software are considered for the test (i.e., the effect of modifications to related hardware or other software are not taken into account). 
  • Exception for Software Used to Provide Noncomputer Services. IRB 2001-5 uniquely exempts software used in providing noncomputer services to customers from the IUS exclusion. The exception was eliminated entirely in IRB 2002-4—the IRS considered that software eligible for the exception would be credit-eligible under other provisions, making the exception unnecessary.
  • Examples. IRB 2002-4 eliminated one of the two examples provided in IRB 2001-5, and uniquely modified the other. IRB 2002-4 also includes twelve additional examples.

The memo clarifies that taxpayers have the option to elect between the two versions—but any version they select will be applied in full (i.e., they may not elect between different provisions within both versions). The memo also clarifies that additional provisions from the 2016 regulations are not incorporated-by-reference.

Texas Comp. Of Pub. Accounts, Tax Policy Division, Mem. 202302001L (February 6, 2023).  

The California Office of Tax Appeals (OTA) held that a taxpayer was liable for use tax on parts used to repair equipment in California before shipping it back to out-of-state customers. The taxpayer is a distributor, retailer, and repairer of endoscopes and other medical devices, and as part of its optional lump-sum maintenance contracts, the taxpayer performed repairs at its California facility free of charge to the customers. The taxpayer purchased repair parts without tax and stored them in California. Upon completion of the repairs, the taxpayer shipped the repaired equipment via common carrier to its customers. The taxpayer did not accrue use tax on the repair parts, because the out-of-state customers were the consumers of the repair parts.

The OTA disagreed with the taxpayer’s position, instead holding that the taxpayer’s performance of the repairs was a taxable use within California. The OTA relied on two California regulations which state that a person obligated under an optional warranty contract to furnish parts, materials, and labor necessary to maintain property is deemed to be the consumer, and the repairer under an optional lump-sum maintenance contract is the consumer of the parts and materials. Therefore, the OTA held that use tax applied to the repair parts.

In the Matter of the Appeal of Olympus Am. Inc., 2023-OTA-087 (Cal. OTA Dec. 20, 2022).

Calling all trivia fans! Don’t miss out on a chance to show off your SALT knowledge!

We will award prizes for the smartest (and fastest) participants.

This week’s question: Which state recently dismissed a class action lawsuit because the tax at issue was actually an excise tax, rather than sales tax?

E-mail your response to SALTonline@eversheds-sutherland.com.

The prize for the first response to today’s question is a $25 UBER Eats gift card. This week’s answer will be posted on Saturday in our SALT Shaker Weekly Digest. Be sure to check back then!

An administrative law judge at the New York Division of Tax Appeals found that a company’s vendor management fees were taxable as the sale of pre-written software. The company offers a web-based application that helps to manage and procure staffing services from requisition through billing. The company argued that its fees are not taxable because “the primary purpose of its service was to act as a “matching” agent for suppliers of temporary labor and customers needing such labor and not the license of software.” The Department countered that the primary function test does not apply because they are licensing tangible personal property.  While the company also provided certain customization services, such charges were not assessed by the Department.

The ALJ found the company used the same software for all of its customers; thus, the product was pre-written software – a type of tangible personal property and the primary function test should not apply. Nonetheless, even if the primary function did apply, the ALJ noted that the primary function of the sale was a license of software. In particular, “the software technology and license appear to be completely intertwined with all the services petitioner offers in the contract” and “the ultimate goal was to provide customers a seamless, automated and efficient system of fulfilling and monitoring their temporary employment needs, and that required, as the contract reflects, utilization of the software technology license.”

In the Matter of the Petition of Beeline.com, Inc., DTA No. 829516, (N.Y. Div. Tax App. Feb. 9, 2023).

As cute as he is cuddly, meet Zorro, our February Pet of the Month! Zorro is an adorable Cardigan Welsh Corgi that turned two this past Halloween. His proud parent is Jéanne Rauch-Zender, Editor in Chief of Tax Notes State.

Beyond snacking on tasty treats, he loves to play baseball with Jéanne’s kids, and brings sweet and protective energy to their household. He’s also a little bossy!

His current trick is an ability to carry his own leash, which comes in very handy. He loves to run as fast as possible, which often results in tripping over his short legs, common with his Corgi brothers and sisters.

We’re glad to feature you, Zorro!

In 2021, the Georgia Tax Tribunal ruled that a non-profit hospital was entitled to use Quality Jobs Tax Credits (QJTC) against its unrelated business income tax and its payroll withholding tax. The Tribunal’s decision was affirmed by the Fulton County Superior Court. In response to these court decisions, the Department has proposed legislation, to purportedly “clarify” the plain language of the QJTC statute. Rather than a mere clarification, HB 482 changes the existing law and if enacted as a clarification, the proposed legislation could deprive taxpayers of the credit for prior years and establish troubling precedent.

Read the full Legal Alert here.

In the latest episode of the SALT Shaker Podcast, Eversheds Sutherland Associate Jeremy Gove is pleased to welcome back Doug Lindholm, President and Executive Director of the Council On State Taxation (COST).

Doug dives into the background of COST, how he came to assume his current position, and COST’s role in the state and local tax realm. Doug and Jeremy also touch on the founding of the State Tax Research Institute (STRI), the research and educational arm of COST, which is designed to enhance the public dialogue and understanding of state and local tax policy. 

Jeremy’s newest overrated/underrated question deals with winter accessories. How do you feel about wearing scarves?

Questions or comments? Email SALTonline@eversheds-sutherland.com. You can also subscribe to receive our regular updates hosted on the SALT Shaker blog.

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Calling all trivia fans! Don’t miss out on a chance to show off your SALT knowledge!

We will award prizes for the smartest (and fastest) participants.

This week’s question: As showcased in the SALT Scoreboards for 2022, how many significant corporate income taxpayer wins were there for the entire year?

E-mail your response to SALTonline@eversheds-sutherland.com.

The prize for the first response to today’s question is a $25 UBER Eats gift card. This week’s answer will be posted on Saturday in our SALT Shaker Weekly Digest. Be sure to check back then!

Members of the Eversheds Sutherland SALT team will present during COST’s 2023 Sales Tax Conference & Audit Session in Denver, CO from February 22-24, 2023. The conference features presentations on the most recent transactional tax developments, initiatives and case law topics. SALT team speakers and topics include:

  • What’s Happening with Digital Service Taxes (DST) and Taxes on Digital Products? The New Frontier – Jeff Friedman
  • On-Demand Services and the States’ Marketplace Rules – What’s the Impact? – Michele Borens

For more information and to register, click here.

The King County Superior Court in Washington dismissed a class action lawsuit which alleged that Kroger, Whole Foods, Safeway, and Town & Country Markets improperly collected sales tax on exempt items. In dismissing the claim, the court found that the sales tax at issue is an excise tax. Further, the court found that the exclusive remedy for a wrongfully collected excise tax is to seek a refund from either the retailer or the Department of Revenue, and after that, pursue a civil action in Thurston County Superior Court. The class representatives argued that they were contesting the legality of the tax, and thus not required to follow the statutory procedures for refunds. The court disagreed, holding that the statutory procedural requirements applied regardless of whether the challenge was to the application of the tax as a whole or as to a factual or computational error in imposing or collecting the tax. Because the court did not reach the merits of the underlying claim, the court dismissed the matter without prejudice, allowing the class to re-file with the Department within 21 days.

Caneer v. The Kroger Co., No. 22-2-08219-4-KNT (King Cnty. Sup. Ct., Jan. 20, 2023).