The Tennessee SUT Department issued an important verdict in November 2023, determining that customized software services are taxable and not allocable to users outside of Tennessee. The important contractual points and takeaways from the judgment are highlighted below:
KEY CONTRACTUAL TERMS
- The tax assesse had acquired an ERP package and had the same downloaded and installed in their server.
- An outside vendor was hired by the tax assesse to migrate the legacy system and implement the new system, a cloud based software-as-a-service (‘SaaS), across the business.
- A consolidated Master Services Agreement, supported by 3 ‘Statement of Work’ schedules was signed. The first SoW comprised the following phases:
- Phase I of the project – for identification/ documentation of business needs.
- Phase II of the project – configuration, customization, and testing; the time involved for these functions were separately captured for billing purposes.
- Phase III and IV comprised of employee training and post implementation support.
KEY POINTS FROM THE RULING
- While most services are not taxed under Tennessee SUT laws, there are provisions that bring customization of computer software within the SUT In line with this provision, Tennessee SUT was levied on the customization portion alone under Phase II of the project SoW. The Configuration portion was not taxable.
- The ruling also explained that in the instant case, there was distinction between the configuration and customization parts of the project; however, when a contract has taxable and non-taxable elements bundled into a single package, the non-taxable components also might become taxable. Whenever two or more items are sold for a single sale price and at least one of the items is subject to sales tax, the entire sales price (including the non-taxable component) would fall under the SUT net. In other words, any contract, MSA or SoW would need to draw a clear line of distinction between the taxable and non-taxable components.
- The ruling relies on a Tennessee Supreme Court judgment, stating that “if a contract is found severable and operate independently according to the intention of the parties, then the taxability of the services would need to be analyzed separately.”
- The ruling has noted that software configurations that did not involve any customization will not fall within the purview of the Tennessee SUT.
- Another interesting point to be noted from the above ruling was that the taxable customization part of the SoW cannot be allocated to any other state on the grounds that there are out of the state employees who use the same, since, the ERP software was downloaded by the above assesse to their server first, only after which the other state employees started using the same.
An important take-away from the above ruling would be to draft the contracts/ MSA/ SoW, clearly distinguishing the taxable and non-taxable work components. If this aspect is ignored and the taxable/ non-taxable work components are inseparable, the concerned party might end up paying SUT on the non-taxable components also.
