Tennessee Ruling Addresses the Taxability of IT Services Including Software Customization

By: Tracey Stewart, SALT Associate

At a glance

• The main takeaway: A Tennessee ruling explains that when multiple taxable and nontaxable services are provided under a single contract, it is necessary to review the contract terms as the entire contract may be taxable.
• Assess the impact: Taxation of services varies among states. This ruling illustrates the importance of carefully analyzing all the services and/or products being provided under a single contract.   
• Take the next step: Aprio’s State and Local Tax (SALT) team has experience analyzing these types of situations and can assist your business to ensure that you remain in compliance with your sales and use tax obligations.

Schedule a free consultation today to learn more!

The full story:

On November 17, 2023, the Tennessee Department of Revenue (Department) issued a Letter Ruling (Ruling) to a Taxpayer regarding the taxability of certain IT services it received from a third-party Project Team.¹

A closer look at the case

The Taxpayer, headquartered in Tennessee, purchased a new enterprise resource planning (ERP) software system, and its internal IT team downloaded and installed the software. The Taxpayer then engaged a third-party Project Team to migrate the Taxpayer’s old ERP system to the new system and to implement the new system across the business based on the needs of the various business processes.

The parties executed a master services agreement (MSA) and three separate statements of work (SOW). The MSA provides that fees will be based on time and materials, and that the termination of any SOW does not terminate the MSA. The main focus in this ruling is SOW #1, which consisted of four phases as summarized below.

1. Blueprint Phase 1 – The Project Team conducted discovery workshops to identify the needs of the overall project, created documentation that clarified business and application process flows, integration points, and relationships of data, identified the requirements needed to support each business process, and performed data mapping and migration.
2. Build and Validate Phase 2– This phase consisted of configuring the software application, including testing and training. In addition, certain functions were customized as needed with new software code to provide functionality that was not already available in the new ERP software, including related testing of that new code. Time incurred for configuration was tracked separately from customization and that detail was provided on the invoices to the Taxpayer.
3. Validate and Deploy Phase 3 – The Project Team facilitated and coached the Taxpayer’s employees through the user acceptance testing process and supported go-live readiness.
4. Operate Phase 4 – The Project Team provided eight weeks of functional support.

Like most states, Tennessee does not generally tax services. Rather, it taxes only those services that are specifically enumerated as taxable, and those include both the repair and installation of computer software.² However, unlike the majority of states, Tennessee does tax the sale of custom computer software, including when it is created on the premises of the consumer.³

Unpacking the ruling

Applying those rules to the four phases, the ruling concluded that phases 1, 3, and 4 did not constitute taxable services because they did not involve any repairing, installation, or provision of computer software. However, for phase 2, the ruling determined that the customization service was taxable, but not the configuration.

The ruling then explains that when a single SOW or other single agreement contains both taxable and nontaxable components, the nontaxable components may be subject to tax unless it can be shown that the taxable components are severable.⁴ This is determined by the intention of the parties taking into account:

1. The fair construction of the terms and provisions of the contract;
2. The subject matter to which the contract has reference;
3. The circumstances of the particular transaction giving rise to the question; and
4. By the construction placed on the agreement by the parties in carrying out its terms.

Therefore, the ruling examined whether the customization services were severable from the other services in SOW #1, and it concluded that they were. Specifically, the ruling noted the following:

1. The customization was optional, and the rest of SOW #1 was not dependent on any customization,
2. The objective of SOW #1 was to implement the software with a focus on its “out-of-the-box capabilities,” thus highlighting that parties intended to avoid customization,
3. SOW #1 provided that if any customization took more time than expected, then the Taxpayer could seek third-party assistance or perform the work itself, and
4. Customization time incurred was separately tracked.

The bottom line

The taxation of services varies among the states. This ruling illustrates the importance of analyzing all of the services and/or products being provided under a single contract. If some of those items are taxable, additional analysis may be required to determine the risk that the entire contract may be viewed as taxable and if there are alternative ways to structure that contract to minimize that risk. 

Aprio’s SALT team has experience with these types of situations and can assist your business to ensure that you in compliance with your sales and use tax obligations so that you do not incur any unexpected tax liabilities and penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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¹ Tenn. Dept. Rev. Ltr. Rul. 23-10 (Nov. 17, 2023).

² Tenn. Code Ann. §§ 67-6-205(c)(4) and (c)(6).

³ Tenn. Code Ann. § 67-6-231(a).

⁴ See Tenn. Dept. Rev. Ltr. Rul. 11-29 (June 23, 2011) and Pensky Truck Leasing Co. v. Huddleston, 795 S.W.2d 669 (Tenn. 1990).