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Software Audits for Buyers & Sellers – and the 3 Key Questions

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Perhaps the most difficult single type of sale or purchase I encountered as an auditor was one involving computer software. Each side of the transaction, sale and purchase, had its own set of problems while other issues were common to both.

Auditing the Seller

Tax laws dealing with computer software differ between states but they all recognize that it can be delivered by different means. The very first question in the audit is to determine if software of any type is involved. The second question to be dealt with in an audit is how the software was transferred. I had occasion to audit several companies that contracted with the U.S. Government. These companies sometimes acted purely as research and development facilities and sometimes as manufacturers/retailers. Sometimes they performed both services in the same contract.  Believe me, reading the Statement of Work and trying decipher deliverables could be a real challenge. At least auditing the seller/contractor allowed me to access to the entire contract and I was able to ask for clarification.

Assuming software was involved in the sale, the next step was to establish how it had been transferred. Again, auditing the seller simplified the process. Documentation was usually readily available, multiple sales could be examined to establish patterns, and the people involved could be interviewed. Because California exempted all types of software if it was transferred electronically, additional audit effort was required only if the transfer involved tangible personal property.

The next question, if it had to be asked, was often the most difficult to answer. Was the software involved custom or pre-existing (canned)? Frequently, this came down to a judgment call based on information provided. The decision was somewhat easier after a “safe haven” was introduced into the applicable sales tax regulation. Simply stated, if the customized version of the software sold for at least twice the amount of the pre-existing version, then the entire program was considered to be custom.

Auditing the Buyer

The same three basic questions (Is software involved? How was it transferred? Is it custom?) had to be asked and answered when auditing the other side of the transaction. These questions became more difficult to answer because much less information was typically available. Unless a written contract was involved, the documentation was generally limited to the seller’s invoice and perhaps a purchase order issued by the buyer. One might ask why simply looking at which general ledger account was charged wouldn’t provide the answer. Unfortunately, most companies charge a wide range of expenses to their “software” account(s). These might include services for providing/maintaining websites and consulting so there would be no guarantee that something booked to the software account was actually software.

The delivery question probably seems like it would be the easiest to answer but many times is the most difficult. An invoice for the purchase of software that includes a shipping charge is rather solid evidence that something tangible has been received. Or if the company uses receiving tickets, these can be reviewed to see if one is written up for the purchase in question. The lack of shipping charge on the invoice coupled with  no receiving document doesn’t establish an electronic transfer. In this case, the buyer has to prove a negative—that they didn’t receive anything tangible. If they were lucky, or had been wise enough to require it, the seller had noted on the invoice the transfer was electronic and provided a copy of the transmission log. Beyond that, it came down to auditor experience (perhaps the seller’s operating methods had been established in other audits) and judgment (which way does the sum of available information point). And quite frankly, the dollars involved and the overall audit results did too. If the rest of the audit was clean and the dollars involved here were “small”, it was much easier to give the buyer the benefit of the doubt. But if the dollars were large and/or if the audit was already being contested, there was little reason not to include the transaction in the audit findings and move it to the next level.

An interesting aspect of the electronic transfer issue is the restriction against receiving any tangible personal property as part of the transaction. All parties are aware this means the buyer cannot receive a backup copy on CD or disc. (Or maybe I should say “most” parties. In one audit, tax was assessed on a software purchase only because the taxpayer made a point of showing the auditor the box of CD’s he’d received.) But that is not the only kind of tangible property that will make an otherwise transfer taxable. Oftentimes software requires a “key” to activate it. Without this key the software is useless. Just as the software can be transferred electronically or in a physical form, so too can the key. But there is a physical version of the key known as a "dongle." In several audits tax was assessed on software purchases valued at $100,000 or more simply because a small token worth a few dollars at most had been included.

When the software was transferred as tangible property, the only remaining way for it to be exempt from tax is for it to be custom. If proving it qualifies as custom was difficult for the seller, it can become even more difficult for the buyer. The intended use of the software, the software’s description on the invoice, and other documentation must all be considered when making a determination. Again, auditor judgment and experience can play a large part in the final decision.

I know many readers will cringe when they read about “auditor judgment and experience” being part of the basis for making an audit decision. And in some cases, with good reason. A response to my last article mentioned an auditor who was bribed so he would issue favorable audit findings. While the result was good for the taxpayer, I’d call that extremely bad judgment on the part of the auditor. Fortunately “judgment” almost always means coming to a reasonable conclusion based on less than perfect information. Like the rest of the population, some auditors have good judgment and others “not so much.”

How about some stories about either type?

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