98-060

Response May 6, 1999

FIRST REQUEST LETTER

MEMORANDUM

DATE: August 19, 1998

RE: Request for Advisory Opinion

I need some advice on whether some software is exempt from personal property tax as inventory held for resale pursuant to Article XIII Sec.2(4) of the Utah State Constitution.

In this particular case, a leasing company (company A) has leased the software to a software vendor (company B) claims that they do not use the software internally, but only sell the software to third parties.

In looking at the lease contract, I have determined that the lease between company A(the lessor) and company B(the lessee) is not a true lease. At the end of the term of the lease, the lessee may obtain possession of the software for $1. As a result, I interpret this transaction to be an installment purchase under the Uniform Commercial Code and therefore, the lessee (company B) is the owner of the software.

The question I need answered is does the software constitute inventory held for resale and is it therefore subject to the exemption allowed in the Utah State Constitution. Software is a somewhat unique property in that the real value is intellectual property. The actual value of the physical medium required to transfer that intellectual property is negligible. In this case, the company purchases the software and is allowed to make as many copies as they need and then sell the software to libraries that use this particular type of software. They will always have the software at their location and it does fit the definition of canned software.

I appreciate your consideration of this matter.

SECOND REQUEST LETTER

FROM:

DATE: March 8,1999

RE Request For an Advisory Opinion

Pursuant to administrative rule 884-24P-33, canned computer software is taxable as tangible personal property. The property is classified as class 1, short life property and is given a three year economic life with a 10% residual. As with all personal property, the taxpayer is required to report the acquisition cost of the software. A problem that arises is when software is acquired through a licensing agreement. Instead of paying a lump sum in many licensing agreements, payments are made on a monthly or yearly basis for the software license. There may also be provisions in the licensing agreement for the right to acquire upgrades at a discount. This creates a problem for administrative purposes in deciding how to apply the administrative rule to software under a licensing agreement.

As a result of this problem, I am requesting some clarification from the Tax Commission concerning software under a licensing agreement.

The first question pertains to whether purchasing a license to use software is in fact a transaction where the licensee is purchasing tangible personal property from the licensor? Licenses for the most part are treated as an intangible, however in this case, the licensee is purchasing a bundle of rights that allows them to use what Tax Commission Administrative Rules define as a tangible asset. The software development company retains intangible rights relating to copyrights of the software but in essence sell the use of that property similar to the case of a video tape where the Film Company licenses the use of the tape for home use.

Assuming that the software is tangible asset and is subject to the property tax, the next

question pertains to whether the owner of the software is the licensee or licensor? Is this arrangement similar to a lease or purchase agreement? Clearly for administrative purposes, it would be easier to assess the licensee because they are in possession of the software. The problem would be how to apply the administrative rule on the self-assessing affidavit. When an available retail price of the software is available, applying the administrative rule would simple. The problem arises when the bundle of rights contained in the licensing agreement have no relationship to a retail price of the software. Licensing agreements usually restrict in some ways the use of the software in terms of number of users allowed, ability to copy to different mediums, etc. This is reflected in the licensing agreement. Sometimes, the only retail price that can be found is a price that allows unlimited usage and duplication for the customer who purchases the software. The price therefore reflects a different bundle of rights than those contained in the licensing agreement For example, if we find a licensing agreement for a particular software of $200/mo and a retail price of $50,000 for that software, I would conclude that unless extraordinary circumstances exist, the bundle of rights cannot be the same. No one is going to pay $50,000 up front when they can pay $7,200 over a three year period.

The third question pertains to a methodology proposed to arrive at an estimate of effective acquisition cost pursuant to Administrative Rule 884-24P-33 I propose that the total projected license payments over a three year period be used as the acquisition cost pursuant to the administrative rule. The reasoning for this is that we have made the determination that software has a 3 year life with a low residual. Therefore, if our administrative rule does a fair job of depreciating the cost of software, I would expect that the licensing agreement would recapture the cost of the software over approximately a three year period.

The last question is based upon the assumption that software under a licensing agreement is taxable to the licensee and that the methodology or any other methodology arrived at by the Property Tax Division is reasonable for assessing software under a licensing agreement The Utah State Constitution in Article XIII declares that "all tangible property in the state, not exempt under the laws of the United States, or under this Constitution, shall be taxed at a uniform and equal rate in proportion to its value " Under this Scenario, we have a difficult problem in that we have not given any guidance to taxpayers on how to properly file their affidavits and report their software under a licensing agreement. However, we also don't have the power to exempt that property. If we apply the proposed methodology, or any other methodology, the taxpayer can claim, perhaps correctly, that their property is being assessed differently until we can get the word out to other taxpayers about how to file their affidavit and include the software under a licensing agreement.

It should be pointed out that this issue has confronted us relatively recently, and taxpayers have not sought clarification from us how to report the software. This issue has arisen out of finding software during personal property audits.

Personal property auditors do periodically place a value on assets for which no acquisition cost is available. In many small businesses, taxpayers bring equipment and furniture from home and use it in their business. In many of these cases, the taxpayer has no records about how much was paid for that asset and the auditor has to make a judgment as to the value of the property based upon their expertise as an appraiser I view this case in a similar vein. We have an asset that is taxable under the State Constitution and the auditor has to use whatever methodology works best at arriving at the fair market value of the asset. The fact that the methodology has not been used before for other like assets does not exempt the software from taxation. That has been my interpretation but I review of that interpretation by the Commission would be welcome.

RESPONSE LETTER

May 6, 1999

RE: Application of Property Tax to Canned Computer Software

Dear NAME,

We have received your two requests for advisory opinions concerning the application of property tax to canned computer software. You have asked whether computer software owned by a particular company and licensed to a second company is considered inventory held for resale and thus exempt from taxation or whether it is considered inventory that is leased or rented and thus subject to taxation. You have also asked if licensed software is taxable to the licensee and how to determine the acquisition cost of software when the transaction involves a monthly or yearly payment instead of a single set price for the software.

To better illustrate responses to your questions, we apply our analysis to the following fact situation. Company A has leased canned computer software to Company B for $500,000, with the terms of this lease allowing Company B to license the software to third parties. However, the essence of this lease transaction shows that it is, in effect, not a lease, but a conditional sales agreement, which effectively transfers ownership of the software to Company B. Also under the terms of this Alease@ or conditional sales agreement, Company A is responsible for any property taxes on the software that is Aleased@ to Company B.

Next, Company B licenses the use of this software to numerous licensees or end users. There are two purchase plans for the software to accommodate different licensees= needs. Under Purchase Plan 1, an entity can license the software for use on one computer for $400. The license is indefinite, and no other payments are required other than the initial $400 license fee. Should the licensee want to license the software for use on two computers, the price would be $800. Purchase Plan 2 is for those licensees who want to purchase unlimited usage of the software on up to 500 computers. Under this plan, Company B requires a five year license period with license fees due at $25,000 per year.

Company B=s Tax Obligation. Utah Admin. Code R865‑19S‑92(A)(4) provides that a license agreement concerning computer software is the same as a lease or rental of that software. Thus, Company B is leasing or renting the computer software to its various licensees. Utah Admin. Code R884-24P-33(C)(3) provides that property held for rent or lease is taxable, and is not exempt as inventory. Accordingly, Company B=s interest in the computer software is not exempt as inventory. It is taxable as property held for rent or lease.

It should be remembered, however, that custom computer software is exempt from taxation in Utah because it is considered intangible property. Thus, if Company B had contracted with Company A to design and write the software that was purchased for $500,000, this software might be considered custom computer software and exempt from taxation as intangible property. Once Company B licenses that software to licensees without modification, it is no longer custom computer software. It is now considered canned computer software, or tangible personal property, and it is subject to property taxes.

In the example fact situation, Company B is the owner of the computer software because its lease with Company A would be considered a conditional sales agreement. As owner, Company B is responsible for the property taxes due on the property. Utah Code Ann. 59-2-303(1). However, the lessor, Company A, is responsible for reporting on its personal property affidavit all property subject to a lease to which the affiant is a party. Part of the information provided on the affidavit filed by Company A would be the terms of the lease with Company B. From this information, the assessor would determine that the lease was actually a conditional sales agreement and that Company B had acquired ownership of the software. Under these circumstances, Company A has agreed to pay Company B=s tax liability. It may do so, but this act does not change the fact that the tax liability is the responsibility of Company B, nor does it change the character of the conditional sales agreement between the two parties, i.e., Company B is still considered the owner of the software for taxation purposes.

Licensee=s Tax Obligation. Company B owns the canned computer software. Inherent in its rights of ownership is the right to license the software to others. Company B=s licensees do obtain use of the software, but do not receive all the ownership rights held by Company B; i.e., the licensees may not themselves license the software for profit nor use it on more computers than their licenses permit. Accordingly, the tangible personal property owned by Company B is a different property than that licensed by the licensees. Whereas the owner of a tractor may lease that tractor out to a lessee, once the tractor is leased, there is no other property remaining for the owner to lease to others. In contrast, Company B may license the use of its canned computer software to as many licensees as it wishes, because the licensee does not receive the same tangible personal property as that owned by Company B. Also, the differences in the $400 value of the personal property owned by one type of licensee (use of the software on one computer) when compared to the $500,000 value of the personal property by Company B (the right to use and license the software) further illustrates the inherent differences in these tangible personal properties.

As owners of tangible personal property, the licensees are liable for property taxes on that property. Canned computer software is currently classified by Property Tax Division as Class 1 property under Utah Admin. Code R884-24P-33(E)(1). Subsection (b) of that rule provides that the taxable value of Class 1 property to be determined by applying the percent good factor against the acquisition cost of the property. The percent good factor is provided in the rule. A definition of Aacquisition cost@ is also provided in subsection (A)(1) of the rule to mean Aall costs required to put an item into service, including purchase price, freight and shipping costs; installation, engineering, erection or assembly costs; and excise taxes and sales taxes.@ In the case of the licensee who leases the software under Purchase Plan 1, the acquisition cost of the tangible personal property would be the $400 purchase price plus any sales tax required for each license.

However, the acquisition cost is not absolutely stated when the licensee chooses Purchase Plan 2, where the purchase price is based on five equal yearly payments. One could total up the sum of the five payments to arrive at the purchase price, but this approach, while administratively easy, does not reflect the lower present value of the future payments. The better approach is to determine the present value of each payment, then add these present values together. This amount would reasonably approximate a purchase price that could be used to determine the acquisition cost.

The Commission believes that the issues that arise when imposing property tax on software owners should be addressed by administrative rule. Administration Division and Property Tax Division should proceed to draft a rule addressing these issues for the Commission to consider and approve. The proposed rule should address not only those issues discussed in this advisory opinion, but any other issues relevant to imposing property tax on software owners. However, until the proposed rule is adopted by the Commission, Property Tax Division should follow the direction given by the Commission in this advisory opinion. Please contact us if you have any other questions.