Wisconsin Supreme Court Affirms That Enterprise-Wide Software Is Exempt as "Custom" Computer Program

In a 4-3 decision released July 11, 2008, the Wisconsin Supreme Court (Supreme Court) upheld the ruling of the Wisconsin Tax Appeals Commission (Commission) that Menasha Corporation’s license of SAP’s R/3 System, an enterprise-wide software system used to integrate various segments of its business, was a license of a “custom” computer program exempt from Wisconsin sales and use tax under Section 77.51(20) of the Wisconsin Statutes. Wisconsin Dept. of Revenue v. Menasha Corporation, 2008 WI 88 (Menasha). The decision is the culmination of more than 20 years of conflict between Wisconsin businesses and the Wisconsin Department of Revenue (Department) regarding the taxation of computer software.

The Commission’s Menasha Ruling
The decision in Menasha hinged on the interpretation and application of Wis. Admin. Code sec. Tax 11.71(e) and (k) (Rule), the Department’s administrative rule that defines custom computer programs as “utility and application software which accommodate the special processing needs of the customer.” The Rule provides that the determination whether a program is custom, and therefore exempt from sales and use tax, is based on all the facts and circumstances, including seven factors enumerated in the Rule. The Rule also states that “prewritten” programs — canned programs prepared, held, or existing for general use and normally for more than one customer — are not exempt.

The Department has long contended that purchases or leases of sophisticated enterprise-wide software systems (e.g., systems produced by SAP, Oracle, PeopleSoft, BAAN, JD Edwards) are taxable as tangible personal property because the systems initially are delivered as prewritten modules, notwithstanding that the modules need to be customized and integrated to fulfill their intended function. The Commission ruled in Menasha that the fact the basic modules of the SAP R/3 System were written in advance of their sale is immaterial. Instead, the determination whether a program is custom or prewritten depends on “the amount of effort necessary to get the software operational for a particular customer’s needs.”

Based upon the undisputed facts, the Commission found that Menasha Corporation expended significant resources, time, and effort to customize the SAP R/3 System to make it usable for its particular operations. Specifically, applying the Rule factors, the Commission found that the implementation of the SAP R/3 System required significant planning, testing, training, enhancement, and maintenance, all at a significant cost to Menasha Corporation, and therefore constituted exempt custom software rather than taxable prewritten software.

The Supreme Court Decision
The Supreme Court first addressed the degree of deference to be accorded to the Commission’s ruling. The Department argued that because it promulgated the rule at issue, its rule interpretation was entitled to controlling weight. The Supreme Court rejected the Department’s argument and agreed with Menasha Corporation’s position that it is the Commission’s interpretation, not the Department’s, that is entitled to controlling weight. The majority recognized that otherwise, “the average taxpayer does not receive a fair hearing before a neutral tribunal.”

Turning to the merits, the Supreme Court majority determined that the Commission’s interpretation and application of the Rule were reasonable and consistent with the language of the Rule. The majority agreed with the Commission that the factors in the Rule describe how to determine whether a particular program accommodates a customer’s special processing needs and therefore is custom. The majority rejected the dissenters’ view that the SAP R/3 system did not qualify as custom under the Rule because, as leased to Menasha Corporation and before it was customized, the program was not usable and therefore did not accommodate the customer’s special processing needs. The majority further reasoned, “Under the rule’s current language, it is irrelevant whether the vendor or an independent consultant carries out the modifications, and it is irrelevant whether those modifications take place before or after it leaves the vendor.” The majority therefore affirmed the Commission.

What This Means for Wisconsin Businesses
The Menasha decision is significant for Wisconsin businesses because, depending on the facts and circumstances of the particular installation, it may entitle companies to obtain an exemption from Wisconsin sales and use tax on the purchase or lease of expensive enterprise-wide software systems or other complex computer programs. Also, any amounts paid to a software provider for the annual maintenance of such software may be considered exempt. In addition, if the software is considered custom, expenses incurred for third-party services to install or implement the system would not be taxable.

Companies currently negotiating the purchase or license of enterprise-wide software systems or other complex computer programs may be able to avoid paying sales or use tax based on Menasha. Purchase or license agreements (and related agreements) with the vendor should be carefully structured to strengthen the company’s position that the software is exempt.

Preserving Your Refund Claim
If your company already purchased an enterprise-wide software system or other complex computer program and paid sales or use tax on the purchase and any related maintenance paid to the software provider, Menasha opens the door to filing refund claims to recover these taxes. The statute of limitations for refund claims is generally four years. Taxpayers who entered into agreements with the Department to extend their time to file a refund claim pending a final decision in Menasha have six months from the date of the decision to file their claims.

In light of the “all facts and circumstances” test set forth in the Rule, companies who are considering filing refund claims should carefully evaluate and present the facts of their particular installation to mirror the factual foundation and legal reasoning of the Menasha decision as closely as possible.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information to our clients and colleagues. If you have any questions about or would like to discuss this topic further, please contact your Foley attorney or any of the following individuals:

Maureen A. McGinnity
Milwaukee, Wisconsin
414.297.5510
[email protected]

Andrew L. Nelson
Madison, Wisconsin
608.258.4990
[email protected]

Internal Revenue Service regulations generally require that, for purposes of avoiding United States federal tax penalties, a taxpayer may only rely on formal written opinions meeting specific requirements described in those regulations. This newsletter does not meet those requirements. To the extent this newsletter contains written information relating to United States federal tax issues, the written information is not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties, and it was not written to support the promotion or marketing of any transaction or matter discussed in the newsletter.