May 29, 2019
Alabama high court finds all software is tangible personal property subject to sales tax; nontaxable services should be separately stated, invoiced
The Alabama Supreme Court has ruled that a series of transactions involving the sale of custom computer software and accompanying equipment was subject to the state's sales tax.1 The decision is significant in that it appears to directly contradict a long-standing Alabama regulation2 that classifies custom software programming as nontaxable.
Between February 2012 and October 2014, an Alabama hospital purchased computer software and accompanying equipment from a software provider to help operate various aspects of the hospital. As part of the transaction, the software provider also configured and installed the software. Although the hospital originally paid approximately $18,000 in sales tax on the transactions, it later sought a refund of the tax from the Alabama Department of Revenue (Department). The Department denied the hospital's refund request, but the Alabama Tax Tribunal reversed this decision and directed the Department to grant the refund. On appeal, the Russell County Circuit Court overturned the Alabama Tax Tribunal, and the Alabama Court of Civil Appeals affirmed. The Alabama Supreme Court granted certiorari to the hospital's appeal.
Alabama law has long defined "tangible personal property" as "something that can be seen, felt, handled, sold commercially … and has physical substance."3 However, the Department's view on whether software is tangible personal property has evolved over time.
In 1977, the Alabama Supreme Court (Court) found in State v. Central Computer Services4 that the essence of a software transaction was the purchase of nontaxable intangible information when the software was conveyed to the user on magnetic tapes or punched cards and was used to program the user's computer, with the tapes or cards then returned or discarded. In that case, the Court found that the physical media used to transfer the "information" was incidental to the sale of the information.
Nineteen years later, however, in Wal-Mart Stores, Inc. v. City of Mobile,5 the Court noted the proliferation of canned software and found that a "shift in the view of courts" had occurred. The Court assumed that the "information" making up canned software would be conveyed through a tangible medium, and suggested that information is tangible once it is recorded somewhere. In response, the Department enacted Ala. Admin. Code, Reg. 810-6-1-.37, effective March 1, 1997, formalizing its position that canned computer software is tangible personal property, subject to the Alabama's sales tax, while expressly stating that "custom software programming is not subject to tax regardless of the manner or medium of transfer to the customer" because it represents a service and not tangible personal property.
Taxability of software
In affirming the Court of Appeals' ruling in Russell County Community Hospital, LLC, the court concluded that all software is tangible personal property for Alabama sales tax purposes, regardless of whether it is canned or custom software. The court also noted that when a seller provides an invoice for computer software, the gross amount charged for the software is subject to sales tax, while related services that are separately stated are not subject to sales tax. Citing Ala. Admin. Code Reg. 810-6-1-.37(5), the hospital argued that its software purchase qualified as nontaxable custom software programming. The Court rejected this position, noting that it is not bound by administrative regulations. The Court cited Wal-Mart to support its findingthat all software, whether it is canned software or custom software created for a particular user, is "tangible personal property" for Alabama sales tax purposes. The Court noted that the software in this case was preexisting software and equipment that was available for purchase by any hospital, and the software provider "implemented" it so that hospital personnel could use it efficiently. The implementation included determining how the hospital functions, setting up hardware and similar equipment, data entry and selection of "configuration options" for the software to make it function efficiently with the hospital's existing systems, and training hospital personnel on how to operate it. The parties did not dispute that sales tax was not collected on the separately stated charges for the software implementation services and the items for which tax was collected were considered tangible personal property. Therefore, the Court found the evidence sufficient to support the trial court's judgment denying the sales tax refund to the hospital.
Two justices issued concurrences in this case, and one issued a dissent. Justice Bolin encouraged the Alabama legislature to clarify how a transaction involving software and services is to be documented and invoiced. Justice Shaw, also concurring in the result, suggested that the Alabama legislature is best equipped to define tangible personal property and clarify distinctions regarding what should and should not be taxed. Justice Bryan, in his dissent, criticized the majority opinion for "conflat[ing] a regulation with an agency's interpretation of the regulation," while noting that "[r]egulations, of course, have the force of law and are 'binding' on everyone, including this Court."
At this time, the Department has not indicated whether it will seek to apply the decision retroactively. However, given that this ruling represents a departure from the state's historic distinction between canned and custom software, Alabama taxpayers should evaluate their software transactions to determine the extent of any potential additional sales tax liability. Furthermore, they should ensure that nontaxable services that are provided in conjunction with software sales are separately stated on invoices to ensure these charges are not inadvertently included in the taxable software sales total.
It also is worth noting that the Department's long-standing position that software as a service (SaaS) constitutes a non-taxable service should remain unaffected, provided that the purchaser does not download or possess any software code. Nevertheless, taxpayers should monitor the Alabama legislature to see whether it addresses the taxability of SaaS transactions, or the issues suggested by the two concurring justices — namely, clarifications of the requirements for documenting and invoicing transactions involving software and services and which transactions should be subject to tax.
1 Ex parte Russell County Community Hospital, LLC, d/b/a Jack Hughston Memorial Hospital v. Alabama Department of Revenue, No. 1180204 (Ala. S.Ct. May 17, 2019).
2 Ala. Admin. Code Reg. 810-6-1-.37(5).
3 State v. Advertiser Co., 257 Ala. 423, 429 (1952); Ala. Code § 40-12-220(8) ("Tangible Personal Property. Personal property which may be seen, weighed, measured, felt, or touched, or is in any other manner perceptible to the senses").
4 State v. Central Computer Services, Inc., 349 So. 2d 1160 (Ala. 1977).
5 Wal-Mart Stores, Inc. v. City of Mobile, 696 So. 2d 290 (Ala. 1996).