The Taxability of Computer Software in Colorado

• Publication year: 2003
• Pages: 91

32 Colo.Law. 91 Colorado Lawyer 2003.

2003, December, Pg. 91. The Taxability of Computer Software in Colorado

---

91

Vol. 32, No. 12, Pg. 91

The Colorado Lawyer
December 2003
Vol. 32, No. 12 [Page 91]

Specialty Law Columns
Intellectual Property and Technology Law
The Taxability of Computer Software in Colorado
by Andrew W. Swain
C 2003 Andrew W. Swain

This column is prepared by the CBA Technology Law and Policy Section

Column Editors

Nathaniel T. Trelease, WebCredenza, Inc., Denver - (720) 937-9930

ntrelease@webcredenza.com; Jim Brogan, Cooley Godward, LLP, Broomfield - (720) 566-4190,

jbrogan@cooley.com

Andrew W. Swain
About The Author:

This month's article was written by Andrew W. Swain, Denver, an assistant attorney general in the Office of the Attorney General - (303) 638-6324, andrew.swain@state.co.us.

This article was written and submitted for publication before Swain joined the Attorney General's Office and while he worked as a state and local tax consultant for KPMG LLP. The opinions and views expressed in this article are solely those of the author, have not been reviewed by any Colorado governmental entity, and do not represent any tax opinion or position accepted or taken by any governmental entity.

The taxation of software is complex because of uncertainty surrounding state software regulations, ways in which Colorado jurisdictions impose sales taxes on software sales, and the inherent vagaries of software itself. This article reviews how Colorado and local taxing jurisdictions tax computer software.

Colorado and its political subdivisions impose sales and use taxes on purchases of tangible personal property and enumerated services.1 Computer hardware, including monitors, external hard drives, and cables, meet the definition of taxable tangible personal property adopted by Colorado and its local taxing jurisdictions. Computer hardware's taxability presents no conceptual problems. This is because such hardware can be seen and felt, otherwise is readily perceived and, more important, can be easily understood as machinery. Therefore, absent an exemption or exclusion from taxation or an industry-specific tax refund,2 computer hardware is taxable in Colorado and the state's local taxing jurisdictions.

The taxability of computer software is not as clear-cut due to the complexities caused by Colorado having numerous autonomous taxing authorities, combined with software's inherent vagaries. This article reviews how Colorado, its local taxing jurisdictions, and its autonomous home-rule cities cope with these complexities and, thus, tax computer software.

Canned or Custom
Software and Tangibility Issues

Computer software is a general term for the specific instructions (programs) written in programming language, such as Java, Pascal, or C, and compiled into binary codes (a string of ones and zeros) that direct a computer to perform a specific task or function.3 These instructions or programs are a classic form of intellectual property.4 The binary code may be fixed or recorded magnetically onto a tape or diskette. It also may be transmitted by laser onto a CD-ROM to store the program or facilitate its transmission (downloading) to a computer.5 Accordingly, the computer software on which taxing jurisdictions seek to impose their sales or use taxes comprises: (1) an intangible component - namely, the program language and binary code; and (2) an incidental tangible component, such as the tape, disk, or CD.6

This tangible/intangible dichotomy is why many taxing jurisdictions distinguish between "canned" and "custom" software.7 Canned software is pre-written and prepackaged software (for example, Microsoft Word or Adobe Photoshop), which manufacturers mass-produce and vendors resell to the general public. Taxing jurisdictions generally treat canned software the same as any other tangible personal property subject to the jurisdiction's transaction tax. On the other hand, custom software has been uniquely created (written) for a specific customer. Therefore, taxing jurisdictions sometimes treat this type of software as a non-taxable service.

Despite this distinction between canned and custom software, the tangible/intangible dichotomy often makes it difficult for taxing jurisdictions to conceptualize the taxability of software. As such, many jurisdictions are unsure whether software is: (1) taxable tangible property; (2) non-taxable intangible property; or (3) a non-taxable, non-enumerated service.

For example, "customized" software consists of prewritten software modules that are placed together in varying configurations or are modified or adapted specifically for each customer. Customized software could be considered either taxable canned software or non-taxable custom software. Similarly, the configurations and modifications could constitute a non-taxable transfer of intangible property (code language) or the performance of a non-taxable, non-enumerated service.

Taxing jurisdictions that distinguish between canned and custom software often are confronted with the question of whether customized software constitutes taxable canned software or non-taxable custom software. In addition, as soon as a jurisdiction imposes a taxing scheme to cope with the uncertainty created by the tangible/intangible dichotomy, new computer software media appear and challenge the scheme's applicability. For example, this might include electronic downloads and application service providers ("ASPs"), which offer fee-based access to software over the Internet.

The tangible/intangible dichotomy, along with uncertainties created by changing software delivery methods, cause taxing jurisdictions to inconsistently apply their tax laws. In turn, the inconsistent application prevents tax practitioners from adequately advising taxpayers.

Colorado's Tax Regime

Colorado has one of the more complex sales and use tax regimes in the United States.8 The state imposes a 2.9 percent sales tax on sales and purchases of tangible personal property and enumerated services. The state also collects a complementary consumer use tax on the privilege of storing, using, or consuming in the state any article of tangible personal property purchased at retail.9

In addition to collecting state sales and use taxes, the Colorado Department of Revenue ("CDOR" or "department") administers and collects local sales taxes on behalf of 157 statutory (non-home-rule) cities and forty-eight statutory counties.10 The CDOR also administers Colorado's special district sales and use taxes for the Regional Transportation District (0.6 percent), Metropolitan Scientific and Cultural Facilities District (0.1 percent), and Metropolitan Football Stadium District (0.1 percent).11 With minor exceptions, the tax base for these taxes is the same as that used to calculate Colorado's state sales and use taxes. The exemptions that apply for purposes of Colorado sales and use taxes also apply to special district and local taxes administered and collected by the state.12

Colorado permits statutory cities and counties to impose a local use tax, but only on motor vehicles and building materials and supplies used in construction projects.13 Nevertheless, the CDOR does not administer or collect these local use taxes.14

Colorado Regulations
Addressing Software

As noted, Colorado imposes its sales and use taxes on the purchase price paid in conjunction with the sale, storage, use, or consumption of tangible personal property in the state.15 However, Colorado's tax statutes are silent with regard to the taxability of computer software. Further, the statutes do not address whether software constitutes tangible personal property.16

The taxability of computer software and the classification of it as taxable tangible property or non-taxable intangible property have been left to the CDOR and its tax regulations. In 1977, the CDOR promulgated its first special regulation pertaining to the taxation of computer software, the 1977 Special Regulation For Computer Software ("1977 - 1980 Special Regulation").17 After being amended and substantially changed in 1980, this special regulation has remained unchanged. (The original and amended regulations are provided in this article as Appendices A and B, respectively.) However, there recently have been attempts to modify or amend it and, thereby, significantly change Colorado's taxation of software.

1977 - 1980 Special Regulation

The 1977 - 1980 Special Regulation (see Appendix A) promulgated by the CDOR was significantly different from the one that it promulgated three years later. The 1977 - 1980 Special Regulation, although distinguishing between canned and custom software, in essence permitted the taxation of almost all software, regardless of its categorization. Taxable canned software included any program "prepared, held, or existing for general or repeated use."18 Software was taxable even if it had to undergo modification to operate on a customer's operating system. If the purchaser recorded the software without receiving title to it, the state still could impose its tax on the purchase.

The 1977 - 1980 Special Regulation provided that Colorado exempted custom software only if it was: (1) prepared to a customer's special order; and (2) transferred to the customer in the form of written programming code. Software prepared to a customer's special order was taxable if it was transferred in any tangible form, including punch cards, tape, disk, or drum.19

1980 - 2002 Amended
Regulation

The 1977 - 1980 Special Regulation was amended in 1980 ("1980 - 2002 Amended Regulation")20 (see Appendix B). The 1980 - 2002 Amended...