Wednesday, November 21, 2018

Alabama Court of Civil Appeals Confirms Denial of Sales Tax Refund on Software Purchase

In 2016, former Chief Judge Bill Thompson of the Alabama Tax Tribunal held that the taxpayer-hospital (Russell County Community Hospital, LLC) was entitled to a refund of the sales tax paid on the purchase of software that it contended was customized for its particular functions.  The hospital contracted with a well-known healthcare management company to provide the hospital with various computer software programs.  The vendor started with canned software, and then arguably customized it to meet the specific needs of the hospital.  The hospital paid sales tax to the company on the software, and the hospital and the company later jointly petitioned for a refund, which was denied by the Department.

In ruling for the taxpayer, the Tax Tribunal relied heavily on the Alabama Supreme Court’s decision in Wal-Mart Stores, Inc. v. City of Mobile and County of Mobile, 696 So 2d 290 (Ala. 1996), which held that unmodified, “canned” computer software sold to nonexempt customers was subject to Alabama and local sales or use tax.  Following that ruling, the Department issued Regulation 810-6-1-.37 (the “Regulation”), which the Department cited in support of its refund denial.  Judge Thompson found the Regulation to be internally inconsistent.

Paragraph (5) of the Regulation states that software is entirely exempt from sales tax if it is customized, but the same paragraph also states that only the itemized charges for customizing the software are exempt from sales tax.  The Department had denied the joint petition in issue because the charges to the hospital were not itemized between the canned software and the customized portion.  Judge Thompson added a footnote explaining that it is extremely difficult to determine whether software is custom or canned and that he would support the imposition of sales tax on all software.

Apparently relying on Judge Thompson’s footnote, the Department argued on appeal to the Russell County Circuit Court that sales tax should apply to the purchase of all software, whether canned or customized.  This position, if it had been adopted, would not only have removed the court‑mandated exemption for custom software, but would have also meant that the Department was disavowing its own regulation, which specifies that custom software is not subject to sales tax.

On January 26, 2018, the Circuit Court affirmed the Department’s denial of the refund request and thus reversed the Tax Tribunal.  The Circuit Court ruled that it was not custom software programming because the CEO of Medhost testified that none of the software was custom, rather the software was prefabricated and could be configured to a particular customer’s needs at their location, and the configurations did not require the dispatching of programmers to the hospital.  Importantly, the Circuit Court did not address Judge Thompson’s footnote or the Department’s new argument in support of imposing sales tax on all software.

The Alabama Court of Civil Appeals has now weighed in and its decision, found here, affirms the decision of the trial court.  Readers should carefully watch to see if this case is taken by the Alabama Supreme Court to further clarify its past rulings on the taxability of sales of computer software.

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