November 21, 1988

The ("Council") is an organization representing numerous member software companies in Massachusetts. The Council has a substantial and direct interest in the Massachusetts tax treatment of software transactions. The Council has asked for a ruling on the application of the sales and use tax, as implemented by the Department's regulation on Computer Industry Services and Products, 830 CMR 64H.1.3, (the "Regulation") to the following typical transaction.

1. Facts

Software, Inc. develops four custom software programs for Customers A, B, C, and D, respectively. Each of these programs was prepared in toto to the special order of the customer; the four programs share no common lines of code. Thereafter, Customer E engages Software, Inc. to develop a program to its specifications.

Software, Inc. draws from the programs prepared for Customers A through D in developing the program for Customer E. Into the program prepared for Customer E it incorporates 20% of the code in the program sold to Customer A, 20% of the code in the program sold to Customer B, 20% of the code in the program sold to Customer C, and 20% of the code in the program sold to Customer D. These pre-existing components are incorporated into the program sold to Customer E, together with code, comprising 20% of the total program, which is developed for the first time in connection with the preparation of the program sold to Customer E.

The code taken from the programs prepared for Customers A through D can be characterized as routines or other complete sequences of computer instructions designed to accomplish particular sub-tasks. However, these routines or other code sequences are not sufficient in themselves to accomplish the ultimate tasks set for any of the programs sold to Customers A through E. None of the code sequences drawn from the programs sold to Customers A through D has been sold by itself to any customer.

The sales price of the program sold to Customer E is $1,000. Software, Inc. paid $15 for the medium on which the program is recorded.

II. Analysis

The taxation of computer software sales is based generally on the status of the software as "canned" or "custom" within the meaning of the Regulation. Under 830 CMR 64H.1.3(2), these terms are defined as follows:

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.

Custom software, a software program prepared to the special order of a customer, including a program that incorporates preexisting routines, utilities, or similar program components, and including any custom documentation or manuals designed to facilitate the use of the program by the customer.

Sales of canned software are taxable. See 830 CMR 64H.1.3(4)(a). A sale of custom software is generally exempt from sales tax under 830 CMR 64H.1.3(6)(a), provided that the sale meets the definition of a "professional service transaction" under 830 CMR 64H.1.3(6)(b). Canned software that is modified to meet the requirements of a particular customer is taxable only to the extent of the incorporated canned software, provided that the price of this incorporated canned software is separately stated. See 830 CMR 64H.1.3(6)(d).

Under the definitions of canned and custom software quoted above, the transaction between Software, Inc. and Customer E appears on its face to be a sale of custom software. The program has been prepared to the special order of Customer E, and although it incorporates pre-existing routines taken from the programs sold to Customers A through D, such incorporation is expressly permitted by the definition of custom software.

Before concluding that the program sold to Customer E is custom software, however, we must examine more closely the pre-existing routines incorporated in this program. If these routines meet the definition of canned software, then Customer E's program is a custom modification to canned software under 830 CMR 64H.1.3(6)(d), rather than custom software.

The code sequences taken from the programs sold to Customers A through D are routines designed to accomplish particular sub-tasks within the larger programs. As such, these code sequences are themselves "programs" under 830 CMR 64H.1.3(2), which treats "subdivisions such as...routines" as programs. In order to meet the definition of canned software, however, a program must be held for general or repeated sale or lease.

Whether a program is held for general or repeated sale or lease is a question of fact. Under the facts described here, each of the routines incorporated in Customer E's program constituted only twenty percent of the code of the larger program from which it was taken. These routines were not sold independently or in substantially independent form to Customers A through D. 1 Moreover, they were not independently sold or offered for sale to Customer E. They are consequently not held for general or repeated sale or lease and are not "canned software" within the meaning of the Regulation.

Because the pre-existing routines that it incorporates are not canned software, the program sold to Customer E is custom software rather than a modification of canned software. The sale of the program to Customer E is therefore exempt from sales tax, provided that the sale is a professional service transaction under 830 CMR 64H.1.3(6)(b). Under the facts given, the principal object of Customer E appears to be the professional services of Software, Inc, and the cost of the medium on which the program was imprinted is an inconsequential element in the cost of the entire transaction. The sale to Customer E is therefore exempt from tax.


Very truly yours,
/s/ Stephen W. Kidder
Commissioner of Revenue
November 21, 1988
LR 88-14


Footnotes:


1 If the routines had been sold independently or in substantially independent form to Customers A through D, they would be canned software when sold to Customer E. See 830 CMR 64H.1.3(6)(f).