Introduction: This Directive sets forth the rules for including computer service agreements in the income measure and the non-income measure of the corporate excise. Computer service agreements are often purchased in conjunction with the purchase of canned software, and these agreements often include the delivery of future computer upgrades. These agreements are treated as advanced payment for tangible personal property (upgrades) and services (software support) in the income and non-income measures of the corporate excise formulas. Software vendors will include receipts from sales of computer service agreements in their sales factors. Purchasers of computer software will include the value of the software and software upgrades in their property factors, and in calculating the non-income measure of the corporate excise, based on their treatment under Generally Accepted Accounting Principles (GAAP).

Issue: How are computer service agreements, usually purchased in conjunction with the purchase of canned software, treated in determining a corporation's tax liability under the income measure and non-income measure of the corporate excise?

Definitions: For the purposes of this Directive, the following terms have the following meanings.

1. Canned software, a software program held for general or repeated sale or lease, including a program developed for in-house use which is subsequently offered for sale or lease to others, and including any standard documentation or manuals designed to facilitate the use of the program by the customer.

2. Computer software, programming, routines, or codes on magnetic or optical media, keypunched cards, or any other medium readable only by computer, to be used in operating a computer.

3. Depreciation or Amortization, the allowance for cost recovery provided under the Internal Revenue Code.

4. Inconsequential element, generally means a cost of less than ten percent of the total contract price. This definition is only a guideline and may vary depending on the facts and circumstances of a particular transaction.

5. Mandatory Service Agreements, an agreement, which must be purchased with canned software, for the following: (a) service, repair or maintenance (including consultation and technical assistance) of computer software; and/or (b) to furnish upgrades or updates of computer software. These agreements are also known as mandatory maintenance agreements.

6. Optional Service Agreements, are of two types:

a. Optional Service Agreements Without Upgrades, an agreement for only service, repair, or maintenance (including consultation and technical assistance) of computer software. The agreement must be optional, as contrasted with a Mandatory Service Agreement.

b. Optional Service Agreements Plus Upgrades, an agreement to furnish upgrades or updates of computer software, in addition to an agreement for service, repair, and maintenance (including technical assistance and consultation) of computer software. This agreement must be optional, as contrasted with a Mandatory Service Agreement.

These agreements are also known as Optional Maintenance Contracts.

7. Presumption, a conclusion of law or fact that is assumed to apply to a taxpayer unless the Commissioner or the taxpayer affirmatively rebuts the presumption by presenting contrary evidence of the actual facts and circumstances applicable to the taxpayer.

Directive #1: The following rules apply to the treatment of Mandatory Service Agreements in the apportionment of income formula, under 830 CMR 63.38.1.

(a) Treatment of Mandatory Service Agreements in the sales factor. Receipts from the sale of Mandatory Service Agreements are considered part of the sales price of canned software and are treated as sales of tangible personal property.

(b) Treatment of Mandatory Service Agreements in the property factor. The costs of Mandatory Service Agreements are part of the initial cost of canned software and are part of a corporation's tangible personal property included in the property factor of the Apportionment of Income formula as described in 830 CMR 63.38.1 (7).

Directive #2: The following rules apply to the treatment of Optional Service Agreements Without Upgrades in the apportionment of income formula, under 830 CMR 63.38.1.

(a) Treatment of Optional Service Agreements Without Upgrades in the sales factor. Charges for Optional Service Agreements Without Upgrades are sales other than sales of tangible personal property for sales factor purposes, within the meaning of 830 CMR 63.38.1 (9)(d).

(b) Treatment of Optional Service Agreements Without Upgrades in the property factor. Optional Service Agreements Without Upgrades are not treated as tangible personal property and are not included in the property factor of the Apportionment of Income formula.

Directive #3: The following rules apply to the treatment of Optional Service Agreements Plus Upgrades in the apportionment of income formula, under 830 CMR 63.38.1.

(a) Treatment of Optional Service Agreements Plus Upgrades in the sales factor.

1. Where charges for upgrades and services are not separately stated, the following rule applies:

If charges for upgrades and services are not separately stated, the sale of Optional Service Agreements Plus Upgrades creates a presumption that receipts from sales of these agreements are treated as sales of tangible personal property, within the meaning of 830 CMR 63.38.1 (9)(c).

2. Where charges for upgrades and services are separately stated, the following rules apply:

If an Optional Service Agreement Plus Upgrades separately states reasonably estimated charges for the service and upgrades portions of the contract, charges for the upgrade portion are treated as sales of tangible personal property, within the meaning of 830 CMR 63.38.1 (9)(c). Charges for the service portion are sales other than sales of tangible personal property, within the meaning of 830 CMR 63.38.1 (9)(d).

(b) Treatment of Optional Service Agreements Plus Upgrades in the property factor.

1. The value of all computer upgrades that have been delivered under Optional Service Agreements Plus Upgrades are part of a corporation's tangible personal property included in the property factor of the Apportionment of Income formula as described in 830 CMR 63.38.1 (7), to the extent that the costs of such upgrades are capitalized on the books of the corporation under GAAP. [1] Amounts expensed under GAAP are not included in the property factor.

2. Where costs for upgrades and services are not separately stated, the following rule applies:

If an Optional Service Agreement Plus Upgrades does not separately state the cost of the upgrade, the value of the upgraded software is its total cost up to the fair market value of the upgraded software. Total cost is the amount paid by the purchaser for the original software, the Mandatory Service Agreement, and any amounts paid on the Optional Service Agreement. Fair market value is the suggested retail value of the upgraded software at the time the upgrade is installed.

3. Where costs for upgrades and services are separately stated, the following rule applies:

If an Optional Service Agreement Plus Upgrades separately states reasonably estimated charges for the service and upgrades portions of the contract, the value of the upgrade is the cost of the computer software originally purchased plus the separately stated cost for the upgrade under the contract.

Directive #4: The following rules apply to the treatment of Mandatory Service Agreements and Optional Service Agreements in the determination of whether a corporation is a tangible property corporation or an intangible property corporation under M.G.L. c. 63 § 30.10 and 30.11. These rules also apply to the calculation of net worth of intangible property corporations under M.G.L. c. 63 §§ 30.8 and 30.9.

The value of all computer software and Mandatory Service Agreements are treated as tangible personal property and are part of a corporation's assets, as that term is used in M.G.L. c. 63 §§ 30.8, 30.9, 30.10 and 30.11. The value of computer upgrades that have been delivered under Optional Service Agreements are treated as tangible personal property and are part of a corporation's assets, as that term is used in M.G.L. c. 63 §§ 30.8, 30.9, 30.10 and 30.11, to the extent that the costs of such upgrades are capitalized on the books of the corporation under GAAP. Amounts expensed under GAAP are not treated as tangible personal property or as part of a corporation's assets. These assets are valued at their book value.

"Book value" means the original cost of the computer software plus the cost of any Mandatory Service Agreement plus the cost of the upgrade less any depreciation or amortization or other allowance for cost recovery taken against such property on the books of the corporation maintained under GAAP for making financial reports to shareholders. Where a corporation retires the computer software originally purchased, the book value of the upgraded computer software is the suggested or reasonably estimated retail price of the upgraded computer software, less any depreciation or amortization or other allowance for cost recovery taken against the upgraded computer software on the books of the corporation maintained under GAAP for making financial reports to shareholders.

Directive #5: The corporate excise rules in this Directive have prospective application. The existing sales and use tax rules related to computer software upgrades and service agreements in the "Computer Industry Services and Products" regulation, 830 CMR 64H.1.3, are not affected by this Directive and continue in force.

Example: InventData, Inc. (InventData) is a Massachusetts corporation that sells inventory control computer systems and software to retail stores nationally. All-Builders, Inc. (All-Builders) is a builder's supply warehouse store, with its headquarters in Massachusetts and retail outlets in thirty states. InventData sold its latest software system, InvenTrak 1.0, to All-Builders for $10,000,000, in Tax Year 1. In addition, InventData sold All-Builders a mandatory one-year maintenance contract for $500,000, which covered repair and support services during Tax Year 1.

All-Builders also purchased an optional extended software maintenance agreement. This agreement entitled All-Builders to continuous, twenty-four hour software support services from InventData's help desk, and the rights to receive, free of further charge, any updates to the software, and a specified upgrade version of the software, to be released during the five year extended maintenance period (Tax Years 2-6). [2] The cost of the Optional Service Agreement was 15% of the original contract price, or $1,500,000. The Optional Service Agreement did not separate the cost of the support services from the cost of the software updates and upgrade. The payment schedule of the Optional Service Agreement was $300,000 per year for five years (Tax Years 2-6).

In Tax Years 2 and 3, during the Optional Service Agreement period, All-Builders received software support services, and two computer updates that were intended to repair malfunctions in the original program, but did not add any functionality beyond that originally purchased. In Tax Year 4, InventData issued the new version of the software, InvenTrak 2.0, which it installed at the All-Builders data center. The cost of InvenTrak 2.0, for anyone purchasing the software new was $12,000,000.

Tax implications of the sale of service agreements .

1. InventData.

a. Tax Year 1.

(i) Sales factor. InventData includes $10,500,000 as receipts from sales of tangible property in its sales factor, for the sale of InvenTrak 1.0 and the Mandatory Service Agreement.

b. Tax Years 2-6.

(i) Sales factor. InventData includes $300,000 each year (receipts from the Optional Service Agreement) in the sales factor as receipts from the sale of tangible property. This is based on the presumption that sales of these agreements, when the property and service components are not separately stated, are sales of tangible personal property.

2. All-Builders.

a. Tax Year 1

(i) Property factor. All-Builders includes $10,500,000 as the cost of tangible personal property in the property factor, which represents the cost of InvenTrak 1.0 and the Mandatory Service Agreement.

(ii) Determination of whether All-Builders is a tangible or intangible property corporation, and calculation of net worth, if necessary. All-Builders' tangible personal property includes the book value of InvenTrak 1.0, which is $10,500,000 less any depreciation or amortization taken against InvenTrak 1.0 on the books of the corporation.

b. Tax Years 2 and 3.

(i) Property factor. All-Builders includes $10,500,000 as the cost of tangible personal property in the property factor. No cost of the Optional Service Agreement is included because there were no upgrades delivered. The two updates to InvenTrak 1.0 were actually repairs to the existing software. As such, they are treated as a service to the existing software.

(ii) Determination of whether All-Builders is a tangible or intangible property corporation, and calculation of net worth, if necessary. All-Builders' tangible personal property includes the book value of InvenTrak 1.0 (which includes the value of the Mandatory Service Agreement), which is $10,500,000 less any depreciation or amortization taken against InvenTrak 1.0 on the books of the corporation. There is no book value associated with the two updates to InvenTrak 1.0, which were repairs to the original software and did not change its book value.

c. Tax Years 4-6

(i) Property factor. All-Builders includes $10,500,000 as the value of tangible personal property in the property factor. All-Builders also includes the cost of the amount paid to date on the Optional Service Agreement. The fair market value of InvenTrak 2.0 is $12,000,000. All-Builders should include its total costs up to the fair market value of the software in the property factor. In Tax Year 4 the total cost of InvenTrak 2.0 to All-Builders is $11,400,000 ($10,500,000 plus the $900,000 paid to date on the Optional Service Agreement). In Tax Year 5 the total cost of InvenTrak 2.0 to All-Builders is $11,700,000 ($10,500,000 plus the $1,200,000 paid to date on the Optional Service Agreement). In Tax Year 6 the total cost of InvenTrak 2.0 to All-Builders is $12,000,000 ($10,500,000 plus the $1,500,000 paid to date on the Optional Service Agreement). Note that the value of InvenTrak 2.0 counted in the property factor can never exceed $12,000,000, which is its fair market value.

(ii) Determination of whether All-Builders is a tangible or intangible property corporation, and calculation of net worth, if necessary. All-Builders' tangible personal property includes the book value of InvenTrak 2.0. In Tax Year 4 the book value is $11,400,000 (the original cost of the computer software ($10,500,000) plus the cost of the upgrade paid to date ($900,000)) less any depreciation or amortization taken against InvenTrak 2.0 on the books of the corporation. In Tax Year 5 the book value is $11,700,000 (the original cost of the computer software ($10,500,000) plus the cost of the upgrade paid to date ($1,200,000)) less any depreciation or amortization taken against InvenTrak 2.0 on the books of the corporation. In Tax Year 6 the book value is $12,000,000 (the original cost of the computer software ($10,500,000) plus the cost of the upgrade paid to date ($1,500,000)) less any depreciation or amortization taken against InvenTrak 2.0 on the books of the corporation.

Discussion of Law:

General. The corporate excise is comprised of three elements: the income measure; the non-income measure; and, the minimum excise. M.G.L. c. 63 §§ 32, 39. Both the income measure and the non-income measure of the excise employ the distinction between tangible property and intangible property in their calculations. It is therefore necessary to characterize computer service agreements and upgrades delivered under them as tangible or intangible property to correctly account for them in the corporate excise formulas.

Apportionment of Income. Corporations that do business in more than one state are taxed on the income from business carried on in Massachusetts. M.G.L. c. 63 § 38. This calculation is based on the apportionment formula, found at M.G.L. c. 63 § 38 (c) - (g). The apportionment formula counts tangible or intangible property in its sales factor. It also counts tangible property owned by the taxpayer in its property factor.

The characterization of computer service agreements as tangible or intangible property in calculating the sales factor affects corporations that sell these agreements. Gross receipts from sales of these agreements are counted in the sales factor.

The characterization of computer service agreements as tangible or intangible property in calculating the property factor affects corporations that purchase computer service agreements. Costs of Mandatory Service Agreements are part of the purchase price of canned software, and are treated as tangible personal property. Computer software upgrades delivered under Optional Service Agreements are tangible personal property, and are counted in the property factor if they are (or could be) capitalized for federal income tax purposes. 830 CMR 63.38.1 (7)(a).

The non-income measure of the corporate excise. The non-income measure of the corporate excise is calculated differently for tangible or intangible property corporations. M.G.L. c. 63 §§ 30.7 - 30.11. Costs of Mandatory Service Agreements are included in the purchase price of canned software, and are treated as tangible personal property. In cases where corporations capitalize the cost of Optional Service Agreements on the books of the corporation under GAAP, corporations must value upgrades delivered under these agreements as tangible property, which will affect the determination of the tangible or intangible status of the corporation.

For intangible property corporations that purchase computer service agreements, their characterization as tangible or intangible property will affect the calculation of the corporation's net worth, upon which the non-income measure of the corporation excise is based. M.G.L. c. 63 §§ 30.8, 30.9.

In response to past uncertainty about the characterization of computer service agreements as tangible or intangible in the corporate excise context, the Department will apply the rules set forth in the above Directives.

Rules under the sales and use tax. The sales and use tax rules found in the "Computer Industry Service and Products" regulation, 830 CMR 64H.1.3, continue in force and application. The apportionment and non-income measure rules set forth in this Directive have prospective application.

/s/Bernard F. Crowley
Bernard F. Crowley, Jr.
Senior Deputy Commissioner of Revenue

BFC:DMS:dt

January 28, 2000

DD 00-1



[1] As a matter of administrative discretion, the Commissioner of Revenue recognizes GAAP as a measure for property factor purposes in order to provide clear rules for including computer service agreements in the property factor. This does not change the general principle that costs that are to be included in the property factor are calculated based on statutory rules, and not GAAP. See generally G.L. c. 63, § 38(d), 830 CMR 63.38.1 (7).

[2] Currently under GAAP, computer service agreements that provide for specified upgrades are capitalized to some extent. See 4-98 Journal of Accountancy 91, Statement of Position 98-1, § 26 (American Institute of Certified Public Accountants, Inc. 1998). For the purposes of this example, we assume that the cost of the optional service agreement is capitalized under GAAP.