Alabama: All computer software subject to sales and use tax


Brad Brown
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Jamie C. Yesnowitz
Washington, D.C.
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Chuck Jones
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Lori Stolly
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Patrick Skeehan
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On May 17, 2019, the Alabama Supreme Court decided Ex Parte Russell County Community Hospital LLC, ruling that the sale of all computer software in Alabama is subject to sales and use tax, regardless of whether such software is custom or canned software.1 The decision contradicts a long-standing Alabama regulation providing that charges for custom software programming are not subject to sales and use tax. The Court clarified that certain services sold with such software may be nontaxable if separately stated.

Background Russell County Community Hospital purchased computer software and accompanying equipment from Medhost of Tennessee, Inc. (Medhost) from February 2012 to October 2014. Medhost contracted to install this software in one of the taxpayer’s hospitals and collected approximately $18,000 in sales tax in connection with these transactions. The hospital then filed a refund request with the Alabama Department of Revenue, arguing that the software at issue was exempt custom software programming according to a Department regulation.2 The Department denied the refund request, finding that the software was canned software that had been customized, and that the nontaxable customized portion was not separately stated on the invoice. The taxpayer appealed to the Alabama Tax Tribunal, which reversed the Department’s decision and directed it to grant the taxpayer’s request for refund. The Department then appealed to the state trial court, which overturned the Tax Tribunal’s decision and affirmed the Department’s denial of the refund petition. The taxpayer appealed to the Alabama Court of Civil Appeals, which affirmed the trial court’s judgment. Neither the trial court nor the appeals court addressed the issue of whether all software should be subject to tax. The taxpayer filed petition for a writ of certiorari with the Alabama Supreme Court, which agreed to hear the case.

Court finds no distinction between canned and customized software In considering the taxation of computer software, the Alabama Supreme Court reviewed its case law on the subject. In State v. Central Computer Services, Inc., the Court considered the issue of whether a rudimentary form of computer software common in the 1970s constituted tangible personal property.3 The software in this case was conveyed to the purchaser via magnetic tapes or punched cards that were used to program computers that provided data processing services for banks. The user would transfer the information contained on the tapes or cards to its own magnetic discs and then return or discard the tapes or cards. The Court held that the user had not purchased tangible personal property because the essence of the transaction was the purchase of “nontaxable intangible information,” and that the physical media used to transfer the information was incidental to the sale of the information.

Nearly 20 years later, in Wal-Mart Stores, Inc. v. City of Mobile,4 the Court considered the issue of whether computer software is intangible personal property, given the proliferation of canned computer software since the Central Computer Services decision. Finding that the information comprising canned software is necessarily conveyed by way of a tangible medium, the Court concluded that the sale of such software involved the sale of tangible personal property. Central to the Court’s conclusion was the analysis that the “information” itself becomes tangible once it is recorded on a tangible medium. With canned software, purchasers receive an “arrangement of matter” that will make their computer perform a desired function. The Court determined that this arrangement of matter “constitutes a corporeal body” and thus tangible personal property.5

Against this backdrop, the Court considered the taxpayer’s argument that it did not purchase canned software that was the subject of the Wal-Mart case. Rather, the taxpayer asserted that it purchased nontaxable services in the form of “custom software programming.”6 The Court disagreed, holding that “all software, including custom software created for a particular user, is ‘tangible personal property’ for purposes of Alabama sales tax.” The Court found there was no distinction between canned and custom software, consistent with the majority’s understanding of the Court’s analysis in Wal-Mart. The Court clarified that charges for certain nontaxable services accompanying the conveyance of software would be nontaxable if the costs of such services are separately stated and invoiced.7 As such, the Court noted that the pertinent distinction between taxable software and nontaxable services depends on how the transaction is documented and invoiced, which is left “strictly in the hands of the seller and purchaser.” Thus a seller’s invoice for nontaxable services when separately stated is not subject to tax. Finding that Medhost correctly collected sales tax on the sale of computer software, the Court affirmed the judgment of the appeals court and upheld the denial of the taxpayer’s refund request.

Concurrences encourage action from state legislature Two justices wrote separately to concur in the result reached by the majority. The first concurring opinion encouraged the Alabama legislature to clarify how a transaction involving software and services should be documented and invoiced, noting that this determination should not be left to private entities. The second concurring opinion emphasized that since the software purchased by the hospital was not customized computer software when chosen and purchased by the hospital, the Court was not required to distinguish between canned and customized computer software. Again, this concurrence contained a directive for the Alabama legislature to define what constitutes tangible personal property rather than the courts, and to “clarify any distinctions as to what should and should not be taxed.”

Dissent argues that majority misapplied regulation The dissent looked to the plain language of the Alabama regulation in support of the Alabama Tax Tribunal’s decision that the software at issue constituted nontaxable custom software programming. Contending that the Court was not asked to decide whether the regulation conflicts with any underlying statute, the dissent suggested that the majority conflated the regulation with the Department’s interpretation of the regulation. Noting that the majority’s holding drew a bright-line distinction between software of all types and nontaxable services related to the software, the dissent suggested that the majority excised a portion of the applicable regulation without providing a rationale for doing so. Rather, the dissent argued, the Court should simply apply the regulation to the facts of the case as best it could, also noting that any unclear language in the regulation be construed against the Department. The dissent interpreted the term “custom software programming” as used in the regulation to apply to certain software customized for purchasers, concluding that the evidence supported the taxpayer’s argument that it purchased nontaxable customized software.

Department issues guidance on taxability of software On June 19, 2019, the Department issued guidance in response to the Russell County decision.8 The Department explained that the Court’s decision was “consistent with the [D]epartment’s long-standing administrative stance” that software transactions are subject to tax, but that separately stated or invoiced services involving the transfer of software are nontaxable transactions. The Department advised that it is reviewing and updating its administrative regulations to be consistent with the terminology used by the Court to distinguish between taxable software and nontaxable computer programming services.

Commentary Erasing the long-time distinction between canned and custom software for purposes of Alabama sales and use tax, the Court’s decision is expected to have broad implications for both vendors and purchasers of software in the state. As noted in the dissent, it is somewhat surprising that the Court’s majority declared that all software, including custom software, is considered tangible personal property in Alabama, given that the Court was not specifically asked to determine whether Alabama’s regulation on custom software programming conflicted with any statute. Instead of merely ruling that the software at issue was canned software, the majority felt obligated to issue broader guidance given the evolution of computer software since the Court’s Wal-Mart decision.

The question remains whether the Court’s decision will apply prospectively, or whether the Department will seek to apply the decision retroactively. While the Department released guidance explaining that it is currently revising its regulation on computer software programming to be consistent with the Court’s decision, the Department was silent on the issue of prospective versus retroactive application. This leaves open the possibility that the Department may audit both sellers and purchasers of custom software during open periods until further clarifying guidance is released. In accordance with the Court’s decision, taxpayers purchasing both software and related services from vendors should evaluate purchase invoices to ensure that charges for nontaxable services are separately stated or invoiced to ensure that such charges are not inadvertently included in the total purchase price.

While the Russell County ruling represents a large shift in the taxation of software in Alabama, the decision is unlikely to impact the Department’s unofficial position that software as a service (SaaS) constitutes a nontaxable service, as long as the purchaser does not download or possess the software code.9 Given the Court’s decision, it will be interesting to see whether the Alabama legislature accepts the invitations of the Court’s concurring and dissenting justices to clarify the statutory definitions of tangible personal property and the specific taxability of software and related services.

1 Alabama Supreme Court, No. 1180204, May 17, 2019.
2 ALA. ADMIN. CODE § 810-6-1-.37(5) (“Custom software programming is not subject to tax regardless of the manner or medium of transfer to the customer since the charge for the custom software programming is a charge for professional services and the manner or medium of transfer is considered incidental to the sale of the service.”).
3 349 So. 2d 1160 (Ala. 1977). 
4 696 So. 2d 290 (Ala. 1996).
5 After Wal-Mart, the Department promulgated regulations specifying that canned computer software constitutes tangible personal property subject to the state’s sales and use tax. ALA. ADMIN. CODE § 810-6-1-.37(4).
6 “Custom software programming” is defined as software programs created specifically for one user and prepared to the special order of that user. ALA. ADMIN. CODE § 810-6-1-.37(5). The term includes programs that contain pre-existing routines, utilities, or other practical components that are integrated in a unique way to the specifications of the specific purchaser. Id.
7 The Court noted that such nontaxable services included determining a particular software user’s needs, designing and programming new software for a particular user, modifying or configuring existing software programs to meet a particular user’s needs, installing software or training users to operate software.
8 ADOR Issues Guidance on Taxability of Computer Software, Alabama Department of Revenue, June 19, 2019.
9 See ALA. ADMIN. CODE § 810-6-1-.37(3) (noting that canned computer software includes all software, except custom software programming, regardless of its function and regardless of whether it is transferred to the purchaser in physical form or by another alternative form of transmission).

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