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IL Software Taxability Rules Complex - But Can Provide Refund Opportunities

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In an earlier post, I discussed the taxability of leases in Chicago pursuant to the City’s Lease Transaction Tax. In doing so, I touched briefly on the Illinois Department of Revenue’s taxation of software licenses, and the five prong test laid out in Title 86, Part 130, Section 130.1935 of the Illinois Administrative Code, otherwise referred to as the regulations. Although it’s becoming more common to access software remotely via cloud-based subscriptions, it’s still practical in many cases for companies to purchase software licenses and host the software on the company’s own servers. Those licenses may be exempt from sales and use tax in Illinois when they meet the conditions laid out in the regulations.

Before getting into the law, let’s discuss some important background. In some states, the taxability of sales of canned software is determined by the method of delivery. Many states tax the sale of canned software regardless of how it’s transferred, but some large states like California and Florida only tax software when it’s delivered via physical media, and not when delivered electronically. As a result, most large software vendors are well equipped to deal with this dichotomy in their internal accounting, and tax their sales appropriately.

Illinois takes a different approach. The taxability of sales of canned software in Illinois does not turn on the method of delivery, but rather the definition of a sale versus a lease. As mentioned in my earlier post, Illinois does not collect tax on lease payments, except in the case of capital leases (for example, when the purchaser can buy the property for a dollar at the end of the lease term). So the key question becomes whether a license of software is more like a sale of tangible property, or a lease of tangible property. The answer depends upon the nature and terms of the license. This is where the five prong test in Section 130.1935 is implicated.

Licenses of software that meet the following FIVE provisions are not subject to tax sales or use tax by the State of Illinois if the license:

  1. Is signed by both parties (shrink-wrap or click-through licenses do not qualify);
  2. Restricts the customer’s duplication or use;
  3. Prohibits the licensee transferring or sublicensing to an unrelated third party without permission of the licensor;
  4. Allows the licensee to make an archival copy in the case of loss or damage. Alternatively, the licensor has a policy of providing another copy at minimal or no charge;
  5. Requires the customer to return or destroy all copies of the software at the end of the license term, though the provision is deemed met when the license is perpetual.

In my experience, this is important because some major software vendors do not bother to augment their accounting systems to make up for this non-traditional treatment. They default to taxing their sales in Illinois, even when this test is met. And as you can imagine, a license requiring signatures of both the licensor and licensee is likely to be expensive, and recurring. This means that you may have been paying tax improperly on the same license for multiple years, and that means potential refund opportunities. Bear in mind, however, than when it comes to the City of Chicago, if a transaction is exempt from state sales tax as a lease, it’s taxable under Chicago’s Lease Transaction Tax. So make sure to review your licenses and account for the tax properly. You may be able to reduce audit liabilities, and you may even have some cash coming back.

Are you running into this issue? Do you have additional questions about software licenses?

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Comments

2 Responses to IL Software Taxability Rules Complex - But Can Provide Refund Opportunities

  • Posted by JoAnn on July 22, 2016 2:48pm:

    We use a per user licensed software program for our service center that we sign an agreement to use. They provide constant updates and support for our monthly fee. They are in Florida and we are in IL, are these licenses and services taxable?

    • Posted by williamseitz on July 25, 2016 2:15pm:

      Hi JoAnn,

      Thanks for your comment. I need a little more information to sufficiently address your question.

      1) Was the software delivered to your company, either physically via disk, or electronically? Does the software sit on your servers? Or does the software reside with the provider, accessed remotely by your users? If it sits on your server, the answer depends on whether the license agreement meets the five prong test discussed above.

      2) Are you located within the city limits of Chicago? If the software is not taxable in Illinois (i.e., it meets the five prong test or is remotely accessed), then it is likely taxable under Chicago's lease transaction tax.

      With regard to the maintenance, it will generally follow the taxability of the software, which is to say it will be taxed the same way.

      -Bill

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