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It may be a truism that “technology develops quicker than the tax laws” but what’s less apparent is that each state has addressed tax questions regarding computer software with their own peculiar nuances that can frequently be overlooked. The developments of the past 20 years – the personal computer, new communications technologies, the Internet – have presented remarkable challenges to the states. Software, digital movies, books, music and graphics are treated with little consistency in New York, New Jersey and Pennsylvania.

History of state taxation of computer software

In the initial state tax cases of the late 1970s and early 1980s, state tax administrators viewed computer software as akin to vinyl phonograph records, magnetic music tapes and celluloid motion picture films, whose sale or rental was usually held to be taxable. At the time, taxpayers argued in favor of tangibility because the tangible media was the basis for investment tax credits and the like. In the mid-1980s, courts began to reject this view and focused on whether or not the software was “canned” (shrink-wrapped) or “custom” (designed for a specific user). Custom software was considered more in the nature of a “service” (intangible, despite the embodiment of the program in a tangible medium) and canned software was considered to be like other tangible personal property that was subject to the sales taxes of the states.

By the mid-1990s, almost every type of traditional medium was being digitized with the Internet. Whole industries such as graphic arts, printing, photography, music, and books had migrated to intangible delivery, transmission without the need for paper, film, plates, mechanicals, records, cassettes, CD Roms, or DVDs. Tax administrators distinguished between data files which were likely to be used and re-used and the software that was running on the computer. Overlapping that development was the advent of cell phones, and ultimately, where we are today…with the “convergence” of the computer, television, telecommunications, information services and audio-visual entertainment within a single (even portable) device – that hates anything tangible. Consumers and businesses became comfortable working in a “virtual” environment and state and local taxation has struggled to keep up. Nomenclature is blurring. For example, software “maintenance” means “version upgrades and enhancements” in one state, and “correcting faults” in existing versions in another. “Broadband” means one thing in telecommunications and another in data transmission, with different state tax results for each.

Software taxation by state

In 1993, New York State defined “computer software” to be “tangible personal property.” This rule is the same one applied today. Because software is “tangible” in New York, when delivered “online,” so called “canned” software is taxable despite the fact that physically, no medium embodies the program (when it’s received and downloaded onto a workstation inside the State).

In New Jersey, however, software delivered online for business use is non-taxable on the theory of the absence of the delivery of a tangible disk, tape, CD Rom, or other tangible medium. Also, New Jersey taxes downloaded music, ring tones, movies, books, audio/video works and “similar products” under the category “digital property.” These items are not considered “computer software.”

In New York, music, artwork and computer graphics are non-taxable when delivered online even though computer software is taxable, the reverse of New Jersey. New York also deems these products to be categorically different – they are not considered “software,” rather the character of the item is related to the underlying content.

In Pennsylvania, “canned” software including updates, enhancements and upgrades is taxable regardless of the method of delivery. Software installation and maintenance services are also taxable. However, downloaded music, artwork, books and video works are non-taxable.

The ‘take-away’

Electronic commerce does not observe geographical borders. A software vendor in New Jersey can deliver to a New York client; and a New York graphic arts house can deliver material online for printing in New Jersey. In both cases, the home state considers the item tax exempt, and the destination state considers the same item taxable. New York recognizes the possibility of multiple points of use and deems software delivered to out-of-state workstations to be non-taxable even where a company’s server in the state may be hosting the software.