The canned software conundrum: Inconsistent state corporate income tax treatment

By Lauren Biyiasas, J.D., Silicon Valley, Calif., and Caralee Hall, CPA,Washington

Editor: Mary Van Leuven, J.D., LL.M.

Taxpayers and state tax practitioners alike often scratch their heads at the fact that there is so much established guidance on the treatment of prewritten ("canned," or noncustom) software for sales-and-use-tax purposes but so little when it comes to state corporate income tax treatment. This item discusses the interplay between Public Law 86-272 (15 U.S.C. §§381-384) and the federal treatment of computer software, as well as two states' approaches to the corporate income tax treatment of canned software, and how—despite similar characterization of software for sales tax purposes—these states arrive at disparate corporate income tax jurisdictional and apportionment results.

P.L. 86-272: Federal treatment of computer software

P.L. 86-272 provides that no state may impose a net income tax on a person engaged in interstate commerce if that person's business activities within the state are limited to solicitation of sales of tangible personal property (and certain activities ancillary to solicitation); its orders are approved outside the state; and shipment/delivery originates outside the state. This federal law limits state jurisdiction to tax even where the taxpayer has otherwise established constitutional nexus. As a federal statute, P.L. 86-272 should be interpreted in accordance with federal definitions and federal treatment of tangible personal property. However, P.L. 86-272 itself does not define tangible personal property, nor does it provide any suggestion of whether computer software is included within that term. In addition, there are no federal regulations interpreting P.L. 86-272.

Absent any specific P.L. 86-272 guidance, other federal laws must be looked at to help define tangible personal property, under the concept of in pari materia (i.e., the principle that statutes or regulations relating to the same subject or theme should be interpreted in light of each other). In the case of software, other federal law dealing with sourcing of taxable income from sources within the United States has been interpreted—via regulation—to treat the sale of canned computer software as a deemed sale of tangible property, regardless of whether the parties characterize the transaction as a lease or license, provided that none (or no more than a de minimis amount) of the following transfers of rights occur:

  • The right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease, or lending;
  • The right to prepare derivative computer programs based on the copyrighted computer program;
  • The right to make a public performance of the computer program; or
  • The right to publicly display the computer program (Regs. Secs. 1.861-18(c)(1) and (2)).

The use of the term "lease" or "license" in a computer software sale agreement is not dispositive as to whether it may be treated as the sale of a copyrighted article, under Regs. Secs. 1.861-18(g)(1) and 1.861-18(h), Example (7). For federal income tax purposes, a copyrighted article is sourced as a sale of tangible personal property (Regs. Sec. 1.861-18(c)(1)). In other words, the sale of a canned (off-the-shelf, noncustomized) computer program copied onto a CD-ROM and made available for sale to the general public or for resale is deemed to be the sale of a copyrighted article for federal income tax purposes and is treated as a sale of tangible personal property, provided no more than a de minimis transfer of the above-enumerated rights occurs (Regs. Sec. 1.861-18(h), Example (1)).

Federal law has not addressed whether canned computer software delivered via electronic (rather than tangible) media may also be considered the sale of tangible personal property. In the absence of federal guidance, state taxpayers performing a P.L. 86-272 analysis might look to available state-specific guidance for the treatment of canned computer software delivered electronically.


In a 1997 private letter ruling for a mail-order company that was selling canned software into the state (delivered via tangible medium), the Wisconsin Department of Revenue (DOR) concluded that the taxpayer's solicitation activities in the state were protected by P.L. 86-272 (Wis. Dep't of Rev., Private Letter Ruling W9728006). In more recent years, however, the DOR has taken the position on audit and in response to corporate income tax nexus questionnaires that software—even if delivered via tangible medium—is an intangible, and solicitation within Wisconsin for sales of canned software or the licensing of canned software exceeds the protections of P.L. 86-272 (Wis. Admin. Code §§2.82(4)(a)(9) and (4)(a)(10); see also Private Letter Ruling W1335002, Wis. Dep't of Rev., Tax Bulletin No. 182 (Oct. 1, 2013), Question 3).

As discussed above, the federal interpretation of canned computer software delivered via tangible medium as the sale of a copyrighted article should control in determining whether P.L. 86-272 applies. Regarding canned computer software delivered electronically, Wisconsin should look to its available state-specific guidance. Wisconsin does not define tangible personal property or computer software within its corporate income tax law. For sales-and-use-tax purposes, Wisconsin defines tangible personal property as follows:

"Tangible personal property" means personal property that can be seen, weighed, measured, felt, or touched, or that is in any other manner perceptible to the senses, and includes electricity, gas, steam, water, and prewritten computer software, regardless of how it is delivered to the purchaser. [Wis. Stat. §77.51(20), emphasis added]

Thus, based again on the principle of in pari materia, and on available guidance in Wisconsin, electronically delivered computer software could arguably be treated as the sale of tangible personal property. As discussed, the DOR ignores the state's sales-and-use-tax definition of tangible personal property for corporate income tax purposes and takes the position that canned software—however delivered—is an intangible and therefore outside the scope of P.L. 86-272. It remains to be seen whether the DOR's assertion that canned computer software constitutes intangible property for P.L. 86-272 purposes will survive taxpayer challenges.

New Jersey

For corporate income tax purposes, New Jersey defines tangible personal property as "corporeal personal property, such as machinery, fixtures, tools, implements, goods, wares and merchandise, and does not mean money, deposits in banks, shares of stock, bonds, notes, credits or evidence of an interest in property and evidences of debt" (N.J. Admin. Code tit. 18, §7-8.4.(a)). New Jersey does not specifically mention computer software in its corporate income tax definition of tangible personal property, but for sales-and-use-tax purposes, New Jersey defines tangible personal property to include prewritten computer software (including prewritten software delivered electronically) (N.J. Rev. Stat. §54:32B-2(g) and N.J. Admin. Code tit. 18, §24-25.2).

Prior to 2009, the New Jersey Division of Taxation (DOT)—similar to the current position in Wisconsin—took the position that computer software constitutes an intangible and that solicitation of sales of canned software or the licensing of canned software within the state exceeds the protections of P.L. 86-272 (N.J. Admin. Code tit. 18, §7-1.9(e), Example). This position was challenged by at least two taxpayers, AccuZIP and Quark, and in 2009, the New Jersey Tax Court agreed to hear their consolidated case on this issue. Specifically, in AccuZIP, Inc. and Quark, Inc. v. Director, N.J. Division of Taxation, 25 N.J. Tax 158 (2009), the court considered whether two taxpayers, both of which sold canned software delivered to customers on tangible disks, had constitutional nexus with New Jersey, and if so, whether the state was nonetheless prohibited by P.L. 86-272 from imposing its corporate income tax.

AccuZIP had no physical presence in New Jersey but made sales to customers located in the state. AccuZIP's software license agreements provided that the copyrighted software is owned by the purchaser. Quark had one regional sales employee who worked remotely from New Jersey. In addition to soliciting sales from potential New Jersey customers and resellers, the Quark employee provided sample demonstration disks to potential customers to test the software for a limited time. Quark's license agreements provided that purchasers are granted a nonexclusive license to use the software.

The DOT unsuccessfully argued that AccuZIP and Quark were both licensing intangible property in the state, and therefore these companies were not protected by P.L. 86-272 and should be subject to New Jersey's state income tax. Rejecting the DOT's argument, the New Jersey Tax Court cited New Jersey's sales tax definition of tangible personal property and the federal treatment of software under Regs. Sec. 1.861-18. New Jersey clearly defines tangible personal property to include canned computer software for sales tax purposes. The court distinguished that AccuZIP and Quark generate revenue from the sale of their software products and not from any royalty payments or licensing fees. In addition, the taxpayers were not affiliated with any corporations with a physical presence in New Jersey, and neither of the taxpayers acquired any of the rights to replicate, modify, or to publicly display the computer program as contemplated in Regs. Sec. 1.861-18(c)(2).

The court found that both AccuZIP and Quark were selling tangible personal property (copyrighted articles) in the form of CD-ROMs containing prewritten software. AccuZIP did not have salespeople or any other physical presence within New Jersey and therefore did not have substantial nexus. Quark established nexus due to the physical presence of its sales employee. However, the employee was merely soliciting sales of tangible personal property, and therefore Quark's activities were protected under P.L. 86-272.

Consistent with its sales tax definition and the federal treatment of sales of copyrighted articles discussed in AccuZIP and Quark, the DOT now asserts that canned software delivered via CD-ROM, as well as canned software delivered electronically, constitutes the sale of tangible personal property that may fall within the protection of P.L. 86-272, depending on the taxpayer's facts.

Other considerations

The treatment of canned software has implications not just regarding a state's ability to impose its corporate income tax but also the sourcing of receipts for apportionment purposes. Several states have adopted specific provisions to address the sales-factor sourcing of software receipts. For example, Wisconsin generally sources gross receipts from the use of computer software to Wisconsin if the buyer uses the software at a location in Wisconsin (Wis. Stat. §71.25(9)(df)(1)).

Many states have not adopted specific software revenue sourcing rules, in which case sourcing may depend upon whether canned software is classified as tangible or intangible property. Tangible personal property is generally sourced based on destination (e.g., delivery address), while intangible property is generally sourced based on where the intangible property is used. (And although it is outside the scope of this discussion, some states apply the service revenue sourcing rules or other sourcing rules to software transactions that constitute "software as a service.")

Continued uncertainty likely

The classification of canned software as tangible or intangible property is significant to determining applicable state sourcing rules for apportionment purposes as well as whether—if the state would otherwise have jurisdiction to tax—a taxpayer may claim P.L. 86-272 protection. As demonstrated by the Wisconsin and New Jersey examples, states have reached opposite results for similarly situated taxpayers, despite having similar definitions of tangible personal property on the books. Taxpayers selling or licensing computer software are likely to continue facing uncertain or inconsistent results for corporate income tax purposes. At the least, though, in the case of canned software delivered via tangible medium, taxpayers can arm themselves against state taxing authority challenges with the reasoning under AccuZIP and Quark and Regs. Sec. 1.861-18.


Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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