I have noticed that people use the term “service,” “product,” and “intangible” interchangeably in relation to software. For example, I was recently going through a client’s website to learn more about their technology and business, and I asked my husband (an engineer) to help me. He started explaining what they did with various acronyms like WLAN, CMOS, LTE-capable and so on, but it didn’t take long for me to get lost in his tech jargon. After seeing my blank face, he boiled it down to this: they sell a software product. But what does that really mean? What is licensing of software considered? And really, why does it matter?
For state income tax purposes, the classification of software as tangible or intangible property or as a service has important consequences for sourcing of revenue and state apportionment. In February 2011, the California superior court held that royalties for licensing of computer software to California licensees constituted receipts from the sale of tangible personal property, and sales of tangible property are sourced to the state the property is shipped to (Microsoft Corporation v. Franchise Tax Board, California Superior Court for San Francisco County, No. CGC08-471260, February 17, 2011). Microsoft had argued that it was sale of an intangible, and as such, should be sourced based on cost of performance to the state in which the greatest income-producing activity occurred (in this case, sourced to Washington). *Please Note: There has been a new development in this case. Microsoft Corp v FTB Ct of Appeal No. A131964 – Appellate Court reversed lower court decision and holds that the right to replicate and install software is a property right, which is an intangible. Case has been remanded back to Superior Court. (This update was added on 8/5/13).
If licensing of software is considered sale of tangible property as the above court ruling suggests, does the throwback rule apply? Generally, the sale of tangible personal property shipped from California to a buyer in another state is generally assigned, or “thrown back” if you will, to California for sales factor computation purposes, provided that the seller is not subject to tax in the destination state. If the software is electronically delivered for download by the user, where is the software considered to be “shipped from”? What if the software is downloaded from a server outside the state? In these cases, to figure out if sales throwback applies, you should ask yourself the following:
- Where is the key or code to access the software that the customer receives being sent from?
- Is your company’s website accessible in, but not located on a server in the state?
- Is your company’s website accessible in and located on a server in the state?
Your answers to the above can provide you with guidance and rationale for analyzing if throwback rule applies in your situation. With cloud computing, where software is accessible to users over the network, new questions are arising about sourcing. This is an area growing more complex; however, there is little guidance to date from the state.