Taxability of Software

By Rick Bell, Ratio Section Supervisor

The Department of Revenue has received several questions regarding the taxability of software, and the differences between canned software, custom software, and embedded software. In 1991, the Legislature defined computer software (see WAC 458-12-251) and established valuation methods. Computer software is a set of directions or instructions that exist in the form of machine-readable or human-readable code, is recorded on a physical or electronic medium, and directs the operation of a computer system or other machinery and/or equipment. Computer software can be canned, custom, or a mixture of both.

What is custom software?

Custom software has been specially designed for the specific needs of a user. This includes modifications to canned software. It can be created in-house, by an outside developer, or by both. Custom software is exempt from property taxation, unless it is embedded.

What is canned software?

Canned software is designed for and distributed “as is” for multiple users without modifying its code. It is also referred to as prewritten or standard software. Canned software that is sold with computer hardware retains its identity as canned software, and should be valued as such if possible. Canned software is valued at 100% of its full acquisition cost for the first year, 50% its second year, and is exempt in its third year.

What is embedded software?

Embedded software can be either canned or custom, and resides permanently on some internal memory device in a computer system or other machinery/equipment that is not removable in the ordinary course of operation. This software is necessary for its routine operation – the computer system or machinery equipment will not operate without it. Embedded software typically has no separate acquisition cost, and is not a separate purchase from the computer system or machinery/equipment.

Embedded software is valued as an integral part of the computer system or other machinery/equipment in which it is housed, at the established life of the equipment.

What are some ways to determine if software is embedded?

The first question you need to ask: “Is this software necessary to make the equipment operate?” If the answer is yes, then it is embedded software. If the software is not needed to make the equipment operate, but instead enhances the operation of the equipment, then it is either custom or canned software.

How a company books the acquisition cost of the software may cause some uncertainty. It becomes confusing when a company separately itemizes the software needed to operate the equipment, because it often appears to meet the definition of canned software. Therefore, it is important to ask whether software listed separately is needed to operate the equipment or not. If the equipment will not operate without the separately listed software, then it meets the definition of embedded. Also, sometimes a company may allocate a portion of the cost as software; this is a pretty strong clue that the software is embedded.

Examples

· • ABC Company hires an outside vendor to create a new accounts receivable program for their computer system. The software the outside vendor creates is custom software and is exempt.

· • ABC Company has “off the shelf” software purchases of $1,000 for the last three years. How is it valued? This is canned software, so for the 2011 assessment year:

· 2010 software purchased for $1,000 is valued at 100%

· 2009 software purchased for $1,000 is valued at 50%, so its value is $500

· 2008 (and older) software purchased for $1,000 is exempt

· • ABC Company purchased a CNC (computer numeric controlled) lathe for $10,000. They claim that the lathe itself was $9,000 with a software component of $1,000 to make up the $10,000 total. The first question to ask is if the $1,000 software is needed to make the equipment operate or is it an enhancement. Chances are the software is needed for the lathe to operate; therefore, it is embedded software and should be valued as an integral part of that lathe. So a trend III MM is applied to the lathe as a whole unit.

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