Alabama Supreme Court Provides Guidance On Sales Taxation Of Computer Software And Services

The Alabama Supreme Court recently issued an opinion providing guidance on how computer software and related services are taxed by the State of Alabama for sales tax purposes.  This is the first such opinion in this area by the Alabama Supreme Court in over 20 years.

In Ex Parte Russell County Community Hospital, LLC, Medhost of Tennessee, Inc. (“Medhost”) sold Russell County Community Hospital (“Hospital”) computer software and the accompanying hardware/equipment, and which Medhost later installed.   In its invoice to the Hospital, Medhost did not itemize the software and related installation and other service charges.   These charges were simply “bundled” together in the Medhost invoice to the Hospital, and upon which the Hospital paid Alabama sales taxes of almost $18,000.  The Hospital sought a refund of the sales taxes paid from the Alabama Department of Revenue (“DOR”).  After numerous administrative appeals with DOR, the case went to the Alabama Supreme Court.

In a “plurality opinion”, the lead opinion of the Alabama Supreme Court considered sales of computer software, and distinguished “canned” versus “custom” computer software.  Canned software is generally prepackaged or off-the-shelf software that most consumers can purchase (think going to Target to purchase Microsoft Office).  Canned software is subject to sales tax because the consumer is essentially purchasing a physical object, whether it is the CD-ROM or the package with a redemption code inside, and which transfers the software onto the computer.  The lead opinion of the Alabama Supreme Court said it was like the store was making a sale of a book rather than intangible computer code.  Most, if not all, states tax canned computer software while custom (or customized) computer software is generally not taxed.    The lead opinion of the Court agreed that canned software is subject to Alabama sales tax.

Applicable to custom software, the Court’s lead opinion referred to the Alabama Department of Revenue’s definition of custom computer software.  The Department of Revenue defines “custom software programming” (i.e., custom computer software) as both software specifically designed for a specific user under a special order request from that user and pre-existing program/software components that are integrated in a unique way to suit the needs of the customer.  Based on this definition, the lead opinion of the Court held that computer software created for a particular user should be “tangible personal property” and subject to Alabama sales tax.

While the lead opinion of the Court ruled that both canned and custom computer software is subject to Alabama sales taxes, services can also be provided and particularly related to custom software, including specific design and programming services, installation, and training.  These services potentially are not subject to the sales tax in Alabama.  However, in order for services such as these to be exempt, the services must be specifically identified and separately invoiced as such by the provider to the customer/client.

The decision of the Alabama Supreme Court in Ex Parte Russell County Community Hospital was unfortunately not a majority opinion of the Court, but instead a “plurality” opinion of three Justices ruling together.    Under Alabama law, plurality opinions do not constitute binding precedent or legal authority.  However, the collective opinions of three Justices of the Alabama Supreme Court do provide guidance that computer software, whether “canned” or “custom”, should be subject to Alabama sales tax.    Separately-invoice services related to custom software, in the view of these Justices, may not be taxable in Alabama.

Both sellers and buyers of computer software and services in Alabama must now consider the guidance of the lead opinion Ex Parte Russell County Community Hospital, and make decisions of whether transactions are subject to sales tax in full, or in part, and particularly involving the provision of related services and where these services can be separately accounted for and invoiced.

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