Software and Income Tax Nexus

Companies that transfer software to customers that are not in the same state and the software company face issues as to whether income tax is owed in the state where customers are located. Nexus guidance of PL 86-272 only applies if the transaction involved the "sale" of "tangible personal property." Software transactions generally challenge both of these terms. That is,

• Software is typically "licensed" rather than "sold." However, for prewritten/canned software, the result looks a lot like when one buys a book. Tax rules have typically viewed this as equivalent of a "sale" (such as Income Tax Reg. Section 1.186-18).
• Software is really intangible. Considering physics, it has no mass. However, cases and state laws have sometimes either just labeled prewritten software as tangible (typically so they can apply sales tax to it) or may find it to be tangible because it is on tangible media or needs to be on tangible media (such as a hard drive) to function. However, for federal depreciation rules, software is intangible (see for example, Internal Revenue Code Section 197).

So, it would seem that PL 86-272 can never apply to software. However, that was not the result found in a recent NJ Tax Court decision involving two different software vendors who transferred canned software on tangible media (AccuZIP and Quark).

I've got a short article from the AICPA Corporate Taxation Insider (11/12/09) that summarizes the case and explains some of the income nexus issues - see Software and Nexus.