Federal tax treatment of computer software under Norwest v. Commissioner.

• Author: Castillo, Eric W.

1. INTRODUCTION

   Since the birth of the computer software industry in the 1970's, the courts and lawmakers have been repeatedly faced with the task of classifying software under the common law labels of tangible or intangible property. One area of the law in which these classifications for software are of great importance is federal taxation. Under the Internal Revenue Code, taxpayers receive favorable treatment for investments in tangible personal property through business investment credits(1) and accelerated depreciation deductions.(2) With the unprecedented growth of the software industry and the reliance on computers in nearly all types of businesses, the property classification of software is now a crucial issue in determining the tax liabilities and credits for almost every corporation today. However, since it has qualities of both tangible and intangible property, software has given rise to a conflict between corporations and taxing authorities, with billions of dollars at stake.(3)

   On April 30, 1997, the United States Tax Court issued a pair of decisions that redefined the court's approach towards the tangibility of computer software. First, in the en banc decision in Norwest Corp. v. Commissioner,(4) the U.S. Tax Court held for the first time that computer software acquired for use in the taxpayer's business operation was tangible personal property, and therefore qualified for the Investment Tax Credit ("ITC").(5) While its previous decisions held that software was intangible property, the court in Norwest ruled in favor of the taxpayer and held that software was in fact tangible, thus saving the company approximately twenty-five million dollars in taxes.(6) The second case, Sprint Corp. v. Commissioner,(7) applied the tangible interpretation of software to allow the taxpayer to use favorable accelerated depreciation methods.

   This Note examines the U.S. Tax Court's decision in Norwest in light of traditional property classifications, precedent set by the U.S. Tax Court and federal circuit courts, and a statutory analysis of the Investment Tax Credit. Part II describes the emergence of the computer software industry, and the characteristics of software that result in its difficult fit under common law property classifications. This section also introduces Investment Tax Credit, and surveys the case law leading to the court's reexamination of software in Norwest. Part III provides an overview of the facts in Norwest and describes the court's analysis in determining that software is tangible property.

   In Part IV, this Note evaluates the Tax Court's decision in Norwest in light of the principle of deference established by the U.S. Supreme Court in Chevron U.S.A., Inc., v. Natural Resources Defense Council, Inc.(8) It will show that the Norwest decision sharply departs from the firmly established law, and may be inconsistent with traditional rules of statutory interpretation and deference to agency decisions. Nevertheless, this Note concludes that the interpretation of software as tangible property is a positive result for businesses and promotes the fundamental policy objectives of the Internal Revenue Code and the ITC.

2. BACKGROUND

   1. The Emergence of the Computer Software Industry

      In June, 1969, IBM began "unbundling" its products, and for the first time, the company separately priced and marketed software.(9) Prior to 1969, computer companies sold software and hardware together in a combined package.(10) Thus, prior to IBM's unbundling, software did not raise legal issues since it was simply considered part of hardware for tax purposes.(11)

      IBM's new policy resulted in the creation of one of the fastest growing sectors of the global economy, the software industry.(12) The software industry has experienced rapid and enormous growth, from $590 million in revenues in 1980(13) to expected revenues of $154 billion in 1999.(14) In 1992, software spending was expected to equal spending for mainframes and now represents a major segment in the computer industry.(15) Specifically, experts predict that sales of enterprise software alone, like the programs purchased by the Norwest Corporation, will grow 32%, to nine billion dollars in 1999.(16) Moreover, with the emergence of Internet commerce and the demand for e-commerce programs, experts predict that the software industry will continue to surge with triple-digit growth rates.(17)

   2. Software and Hardware Defined

      A computer consists of two basic components - hardware and software.(18) Hardware encompasses "the machines and physical devices, which make up the computer system."(19) A "computer is not capable of performing any operation, function, or application without a proper set of instructions."(20) Software is the series of instructions that direct the computer to process data in a specified manner.(21) These instructions are first "written, line by line," in a programming language (source code), and are then converted into a "machine-readable computer language."(22)

      In addition, software may be further divided into canned and custom varieties. Canned software are prewritten programs that are often manufactured in packages and intended for retail delivery.(23) Consumers commonly purchase these programs "off the shelf" from vendors or directly from the developer. These programs are not specially designed to meet the specifications or the problems of a particular client. The transaction in Norwest involved canned software.(24) Custom software, on the other hand, is designed and written to meet the needs of a specific client.(25) The program is created for a particular situation, and may be adjusted to fit the user's system requirements or budget.

      This distinction between canned and custom software is important because certain courts and state legislatures have treated the two very differently.(26) Some state courts view the sale of custom software as a sale of the programming services and knowledge.(27) Since a transaction for custom programs resembles a sale of personal services, these courts characterize the transaction as a purchase of an intangible asset.(28) On the other hand, canned software more closely resembles a tangible good, and some states tax software in the same way other tangible property is taxed.(29)

   3. Common Law Property Classifications and Software's Mutable Nature

      Under a broad definition, property includes everything that is or may be subject to ownership.(30) Traditionally, the law has divided property into two classes - real and personal.(31) Real property includes "[l]and, and generally whatever is erected or growing upon or affixed to land."(32) "[R]ights issuing out of, annexed to, and exercisable within or about land" are also included in this definition.(33) Personal property is "everything that is the subject of ownership, not coming under denomination of real estate."(34)

      Common law further divides personal property into two subcategories - tangible and intangible property.(35) Tangible personal property refers to "[a]ll property which is touchable and has real existence (physical) whether it is real or personal."(36) Examples of tangible property include plant equipment, motor vehicles, furniture, and animals.

      In contrast, intangible property "[a]s used chiefly in the law of taxation ... means such property as has no intrinsic and marketable value, but is merely the representative of evidence of value."(37) Intangible property "cannot be touched because it has no physical existence."(38) Examples of intangibles include copyrights, trademarks, patents, and goodwill.(39)

      Historically, whether or not property is taxed depends on how it is classified by revenue authorities.(40) Computer software exhibits qualities that make it difficult for the courts and tax authorities to view it solely as a tangible or intangible property.(41) A software program, whether written in programming language or compiled into machine-readable source code, has traditionally been considered intangible intellectual property.(42) These programs can be recorded on magnetic disks, tapes, or CD-ROMs.(43) The disk or other physical medium on which the information is stored comprises the tangible component of software.

      Software is unlike other forms of intangible property because it can interact with a physical device. Whereas licenses, patents, and copyrights merely represent intangible rights, software can actually interact with physical property. However, the underlying program is typically not dependent on its physical media, and in fact, can be entirely purchased and transferred intangibly (i.e., via modem). For instance, after a program is written, it may be recorded on a disk, copied to another computer's hard drive, or transferred over a network. Thus, the software can be viewed as a purchase of a tangible or intangible property, depending on the characteristics of the individual transaction. However, under common law, property must be classified as either one or the other; there is no "mixed" or "dual" property.(44) Hence, these common law labels seem better fitted to the traditional industrial economy, than the technology-based economy of today.

   4. The Investment Tax Credit

      The Constitution vests Congress with the authority to "lay and collect Taxes, Duties, Imposts, and excises...."(45) Traditionally, federal taxation serves several key purposes - raising revenue for the government and its myriad of programs, achieving social justice;(46) and stimulating or regulating the nation's economy. The Investment Tax Credit ("ITC") is an example of legislation designed to stimulate the economy. It is a tax subsidy implemented to achieve specific macro-economic goals.(47) First proposed and legislated during the Kennedy administration, the ITC was designed to spur economic expansion and modernization of the nation's productive facilities.(48)

      At the center of the dispute in Norwest is section 38(b)(1) of the Internal Revenue Code which was enacted...