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BY JOHN GENZ, CPA, MST
SENIOR MANAGER, TAX DEPARTMENT; DIRETOR, SALT GROUP

In the summer of 2003, the State of New Jersey repealed a portion of the regulations relating to sales tax on customized software. Following the repeal, there was some question as to whether customized software delivered to New Jersey customers would now be subject to sales or use tax.

The answer will have significant implications to retailers and purchasers of customized software delivered to New Jersey locations. The state may have taken away a bit of the competitive edge for New Jersey-based software developers that lack the capability to transmit their software electronically. In any event, however, it is recommended that retailers and purchasers of software review their internal sales and use tax procedures to ascertain whether they are in compliance with the current regulations. It is also recommended that company management consult with its state and local tax advisers for assistance with the interpretation of these complex sales and use tax rules. To better understand the impact of these changes, a brief review of the old and new rules follows.

Old Rule:
Sales of software were not subject to the state sales tax, provided the software met the criteria specified, since it was considered "intangible personal property." For software to qualify for a sales or use tax exemption, it had to satisfy one of the following criteria:

1. Preparation or selection of the customer’s use must require an analysis of the program for the customer’s requirements by the vendor.
2. The program must require adaptation by the vendor to be used in a specific environment; that is, a particular make and model of computer utilizing a specified output device.

Software, whether placed on cards, tape, disc pack, or other machine-readable media or entered into a computer directly, in any one of the following forms, may qualify for the exemption. The old regs discussed the "following forms" as including systems programs (although "instruction codes" that were an integral part of the computer were taxable as tangible personal property), application programs, pre-written programs (canned), and custom programs.

To expand on this, N.J. Division of Taxation Technical Bulletin No. S&U-9 [5-1-03] states, "In general, off-the-shelf or "canned" software is subject to sales tax as tangible personal property. However, software may be considered intangible property if the vendor has created it for a particular customer or has substantially modified it for the customer in such a way that the customer is purchasing the vendor’s professional services (e.g., consulting, programming) in creating a customized software package. If the software qualifies as a custom package, any licensing fees and maintenance agreements are also exempt from sales and use tax."

New Rule:
Applicable for transactions occurring on or after Aug. 18, 2003, if software is presented to customers in some tangible form, e.g., CD-Rom or disc, the sale of software is taxable as a sale of tangible personal property. However, if a commercially reasonable charge for the customization service is separately stated on the invoice, the charge for this service will be exempt from tax.

If the software does not qualify as a custom package under the new rule, any licensing fees and maintenance agreements for the taxable software are also subject to the State’s sales and use tax.

Comparison:
The old rule was liberal in the sense that it permitted the entire software purchase to be exempt from sales and use tax provided the software satisfied one of the above two criteria. The new rule limits the tax-exempt portion of the software to a "commercially reasonable charge for the customization service." In many cases, this may make a large portion of the software taxable, whereas under the old rule it may have been exempt from sales and use tax. This will require taxpayers to draw that proverbial "line-in-the-sand" to differentiate between the tangible and intangible components of software, thus adding a new level of difficulty to the already complex sales and use tax laws.

Under both the old and new rules, the N.J. Division of Taxation indicates that the sale of software, delivered electronically, e.g., online or via the Internet, constitutes the sale of intangible personal property, not subject to the sales and use tax.

It appears the state’s motivation for doing this is twofold — revenue enhancement and to be in line with the definitions of the Streamlined Sales Tax Project (SSTP). One of the more complex issues with which the SSTP has been contending was whether pre-written (canned) software and digital property should be included in the definition of tangible personal property. Rather than try to answer that question, the SSTP focused on definitions related to computer software.

According to the SSTP, if pre-written software is modified or enhanced for a specific user, it generally would still be considered pre-written. If reasonable charges for the enhancements were separately stated for the purchaser, the enhancements would not be treated as pre-written. Electronic delivery would be defined as delivered from the seller to the purchaser by means other than tangible storage media, unless the tangible storage media is not physically transferred to the purchaser.

The goal of the SSTP is to provide uniform definitions that will allow states to mirror, as closely as possible, their existing tax treatment, while providing retailers with common definitions that will ease their sales tax compliance burden. To find out more about the SSTP, visit www.streamlinedsalestax.org on the web.

John Genz, CPA, MST, is a senior manager with the Amper, Politziner & Mattia’s Tax Department and director of the Firm’s State and Local Tax (SALT) Group.