Graham Packaging Co., LP v. Com.

Citations: 882 A.2d 1076; 2005 Pa. Commw. LEXIS 518

Court: Commonwealth Court of Pennsylvania; September 15, 2005; Pennsylvania; State Appellate Court

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Graham Packaging Company, L.P. sought a refund of sales tax paid for the renewal of licenses for "canned" computer software, amounting to $22,379.40, associated with software such as Windows NT and Office Pro 2000. The Commonwealth's Board of Finance and Revenue denied this refund, leading to the appeal. A key issue is whether the fees for renewing software licenses are taxable under Section 202 of the Tax Reform Code of 1971, which imposes a six percent tax on retail sales of tangible personal property. 

To resolve this, it is crucial to determine if canned software qualifies as "tangible personal property." The parties agreed on several stipulations: users do not own the software but acquire usage rights; physical disks may be provided for free and do not confer ownership; the disks remain the licensor's property; and the software can be delivered without the disks. Notably, the disks were obsolete at the time of renewal. The court examined the definitions in the Code, which includes a wide array of tangible goods but does not clearly categorize software licenses without ownership transfer as taxable sales. The analysis hinges on whether the renewal of software licenses constitutes a sale of tangible personal property under the law.

If canned computer software programs are classified as "tangible personal property," then the fees for renewing software licenses are taxable as they constitute a "sale at retail." Before July 1, 1997, the definition of "sale at retail" included various computer-related services such as programming and data processing, but canned software was not considered a computer programming service. The Department of Revenue's policy prior to this date indicated that computer services, including both canned and custom software, could result in taxable tangible personal property. Canned software has always been regarded as taxable tangible personal property, while custom software was recognized as a taxable service.

Following the 1997 amendments, which removed custom computer-related services from the "sale at retail" definition, the Department issued a new policy effective July 1, 1997. This policy clarified that the aforementioned computer-related services are no longer subject to sales tax, but the sale and use of canned software remain taxable as tangible personal property. Notably, the sale of canned software, including updates and upgrades, continues to be taxed. Additionally, custom modifications to canned software do not change its classification, and any transfer of canned software on a storage medium for use or recording on a purchaser's computer is also subject to tax.

Custom software sales and usage are not subject to sales tax, classified as a non-taxable computer programming service. This includes the retail sale or use of multiple copies or licenses and services related to custom software, such as installation, repair, maintenance, updates, enhancements, and upgrades. In contrast, canned software is considered tangible personal property and is taxable. A revenue ruling from February 2000 indicated that electronically transmitted canned software is not taxed, while the same software delivered on physical media is taxable due to its corporeal nature. This ruling also exempted charges for electronically delivered updates under maintenance contracts from tax. Although the ruling is no longer in effect, the Department continues to uphold this distinction.

On appeal, Graham argues that the 1997 Amendments to the Code repealed the tax on computer programming services, which he believes included canned software. He highlights that a prior policy classifying licenses to use canned software as taxable has been removed, implying that such licenses are no longer taxable. Additionally, Graham asserts that, since license renewals do not involve the delivery of physical disks, no corporeal property is transferred, referencing the Department's earlier ruling indicating that electronic transfers without disks are not taxable. Conversely, the Commonwealth argues that canned software delivered via disk is tangible personal property and that licenses for its use are taxable under the definition of "sale at retail."

The repeal of the tax on computer programming services in 1997 did not alter the taxability of canned software purchases transferred on tangible media, such as disks, which the Commonwealth classifies as tangible personal property, thus subject to taxation. Conversely, if the software is delivered electronically, it is considered non-taxable. The document indicates that neither party has provided appellate decisions from the Commonwealth defining "tangible" or "corporeal" personal property in relation to canned computer software. Various jurisdictions have analyzed this issue differently, leading to conflicting outcomes. Some jurisdictions maintain that the physical medium's presence in a transaction is essential for determining taxability, while others apply tests focusing on the transaction's essence or true object to discern whether the sale involves tangible or intangible property. Examples include Texas, which defined tangible personal property as that which is perceptible to the senses, and cases such as *First National Bank of Fort Worth v. Bullock*, where the method of software transfer was scrutinized to determine tax implications.

The court applied the essence of the transaction test to determine whether software qualifies as tangible personal property. It found that the primary object of the transaction was the acquisition of an intangible "computer process," rather than the tangible tapes themselves. The court noted that the information could have been transmitted without a physical medium and, once transferred, the tape held little value. This ruling was supported by precedent in cases such as Dallas Central Appraisal District v. Tech Data Corp., which affirmed software as intangible property. In contrast, the Louisiana Supreme Court in South Central Bell Telephone Co. v. Barthelemy examined whether software constituted tangible personal property for tax purposes and concluded that it did. The court defined tangible personal property as that which can be perceived by the senses and distinguished it from intangible property. It acknowledged that while software can be stored in physical forms (e.g., magnetic tape), it is not merely incorporeal knowledge but has physical existence that contributes to its function and usability. The court emphasized that the software's physical manifestation allows it to have sensory perception, thus rejecting the notion that software is solely an intangible right or idea.

The purchaser of computer software acquires a physical arrangement of matter that enables a computer to perform specific functions, which constitutes tangible property. The mode of delivery, whether magnetic tape or electronic transfer, is irrelevant; the key point is that software must be recorded in a physical medium to be usable. The court disagrees with the notion that the essence of the transaction is intangible property, asserting that the recorded software, stored on a tangible medium, is essential to the functionality of the computer. The Supreme Court of Louisiana emphasized that purchasing software results in acquiring a physical copy, not merely a right to the intellectual property, thus confirming that the software is tangible personal property. This perspective aligns with the ruling in American Bus. Info. Inc. v. Egr, which classified both customized and standard data delivered electronically or on physical media as tangible personal property, based on a broad interpretation of "tangible personal property" as distinct from intangible rights. Furthermore, some jurisdictions utilize the "incidental to service" test to determine if a transaction is primarily a sale of tangible personal property or a nontaxable service, focusing on the main consideration exchanged in the transaction. If the payment pertains more to the service than the tangible item, it is not considered a retail sale.

The incidental to service test evaluates several factors to determine tax treatment: 1) the buyer's objective, 2) the seller's business nature, 3) whether the goods were offered as part of a retail enterprise with profit motives, 4) if the goods could be sold independently of the service, 5) the contribution of intangible products or services to the tangible product's value, and 6) any other relevant transaction factors. In Catalina Marketing, the court dismissed the essence of the transaction test for overly focusing on the purchaser's view rather than the entire transaction, yet noted minimal practical differences between the two tests. Both approaches deem the transfer mechanism irrelevant; the essence of the sale lies in the software itself, while the physical media is incidental. The essence of the transaction test is favored for its logical consistency, uniform tax treatment for canned software, and prevention of tax avoidance through transaction structuring. It clarifies the nature of licenses for software that has been upgraded, emphasizing that the software's nature—not its delivery package—determines whether it qualifies as tangible personal property. The definition of tangible personal property as "corporeal personal property" is questioned, suggesting legislative intent encompassed a broader scope beyond merely visible and tangible items. The Louisiana Supreme Court's view supports that purchasing canned software involves acquiring an electronic version that is physically stored and operational on a computer. Historical context indicates that prior to 1997, the tax code included computer programming services but did not specify canned software, implying its classification as tangible personal property by the legislature.

The legislature's intent regarding tax applicability on software sales is clarified, indicating that imposing a sales or use tax exclusively on custom software while exempting canned software would be illogical. The 1997 Act removed computer programming services from the definition of "sale at retail," effectively exempting custom software from taxation, but did not alter the classification of canned software as "tangible personal property." The fundamental nature of canned software remains unchanged despite evolving delivery methods. The Department's interpretation, stating that sales of canned software are taxable as tangible personal property, is upheld. It is concluded that all sales of canned software, whether delivered electronically or physically, are subject to sales tax. The sales tax imposed on Graham’s purchase of canned software licenses is affirmed. However, a dissenting opinion argues that the renewal of licenses for canned software should not be taxable under the Tax Reform Code of 1971, asserting that such renewals do not constitute a sale of tangible personal property. The dissent emphasizes that the statutory definitions do not support the imposition of sales tax on these renewals, thereby questioning the validity of the Department's policy in this context. The order of the Board is affirmed, with a dissent regarding the tax status of multiple-user license renewals.

Canned software is defined by the Department of Revenue as computer software that is not custom software, which is specifically designed and developed for an original purchaser. Electronic Data Systems Corporation has submitted an appellate brief as amicus curiae. The court's review of appeals from the Board is de novo, based on either a record created before the court or stipulated facts. Tax statutes must be strictly construed against the Commonwealth, resolving any reasonable doubts in favor of the taxpayer.

Canned software does not qualify as "other computer-related services," which includes a range of services such as consulting, data processing, and software installation. The Commonwealth Documents Law defines a "statement of policy" as a document that sets forth personal or property rights or obligations of the public, excluding adjudications or regulations. The Department of Revenue issues statements of policy in two forms: revenue pronouncements and revenue rulings. Revenue pronouncements interpret laws or regulations and outline future policies or procedures, while revenue rulings provide guidelines and interpretations of tax laws for common factual situations to ensure uniformity. A "regulation" is defined as any rule or order promulgated by an agency under statutory authority in relation to its administration.

Regulations in the Commonwealth must follow the notice and comment procedures of the Commonwealth Documents Law, while statements of policy are exempt from these requirements. A properly promulgated regulation has legal force, unlike a statement of policy. "Storage media" is defined to include various tangible formats for storing computer-readable information. Graham's claims rely on general comments from legislative journals regarding the 1997 Act. During oral arguments, Graham's counsel indicated that license renewals are necessary only for upgraded software; original programs do not require renewals. The Commonwealth references Advent Systems, Ltd. v. Unisys Corporation, which determined that software qualifies as a "good" under the Uniform Commercial Code (UCC). The court illustrated that while software is intellectual property, once stored on a medium, it becomes a tangible, marketable commodity. The UCC defines a "good" as movable items identified for sale. The Board's stance appears inconsistent, as its policy treats all canned software as tangible personal property, contrasting with its previous revenue ruling. Other jurisdictions have legislatively classified canned or prewritten software as tangible personal property for tax purposes. Texas has revised its Tax Code to include software in this definition. In Dallas Central, software was described as intellectual property comprising binary instructions that govern computer hardware operations.

The court determined that software constitutes intangible property, as the focus of the transaction is on the software itself rather than the medium it is stored on. This aligns with previous rulings, such as in First National Bank. In distinguishing between types of software, jurisdictions often classify canned software as tangible personal property since it is designed for general use with minimal modification, while custom software is viewed as a service tailored for specific users and thus considered intangible. Definitions from Black's Law Dictionary clarify that corporeal property has a physical existence, contrasting with incorporeal property. Additionally, a substantive due process argument by Graham, claiming that taxing licenses for canned software is unconstitutional due to the repeal of tax on computer programming services, was found to lack merit based on the court’s analysis.