US State rules on ERP system tax refund case

Case hinges on whether modifying an SAP system is 'customisation'

A judge has refused to order the state of Wisconsin to refund more than $US340,000 in sales tax paid on a customised SAP system, which may set a precedent that relieves the state of the need to pay a total of about $300 million to corporate users. Lawyers said the decision could also prove costly to companies with large ERP installations in other states with similar tax laws.

At issue in the legal opinion is a sales tax refund sought by Menasha, a pulp and paper manufacturer that claimed modifications it made to SAP's R/3 software were custom development, which is tax-exempt in Wisconsin. Packaged software is taxable.

Menasha's 1995 installation of R/3 cost $23 million, of which $5 million was for a license for the ERP software. The rest of the money was spent on modifications and implementation costs, according to court papers released October 26 by Judge Steven Ebert of Circuit Court Branch 4 in Wisconsin.

After Menasha paid a sales tax of $342,614 on the implementation to the state's Department of Revenue, the company tried to recover the money by petitioning the state Tax Appeals Commission. Menasha is now seeking a total of $500,000, including interest.

The appeals commission agreed with Menasha that the software was custom-written, but Ebert overturned that decision, ruling that R/3 "was existing and prewritten" when sold.

The Department of Revenue "is pleased with the decision," said spokeswoman Eva Robelia, who explained that a Menasha victory would have set a precedent allowing other companies that have paid similar taxes over the past four years to file appeals. The state potentially would have had to refund about $300 million in taxes and interest.

Officials at Menasha, which has up to 90 days to appeal, are unhappy, their lawyers said. "Wisconsin has taken the position that all software is off-the-shelf unless it's written from scratch, which no one does anymore," said Leonard Sosnowski, a laywer at Menasha's law firm. The larger issue, he said, is that not only is the modified software itself taxable, but potentially so are the services required to fix or reprogram it during the implementation. Sosnowski also said the case could be used as a reference in other states, where some IT executives are keeping an eye on its progress.

"Clearly, the judge is not understanding the real world of IT," said Bubba Tyler, CIO at Quaker Chemical, which runs PeopleSoft applications. "There's no such thing as an 'off the shelf' ERP system, and therefore everyone requires 'development' for it to work with a given firm's business," he said. "If I have to write custom reports or create custom output for my customers or construct interfaces for the tool to work with other tools I use, all of this is unique and should not be taxed."

Another lawyer, Andrew Nelson, added that if the case is upheld, some companies might move IT operations to states with more favourable tax laws.

Explaining his ruling, Judge Ebert said R/3 always requires substantial modification to adapt to a given customer's specifications. In this case, at SAP's recommendation, Menasha hired Deloitte to help it make the changes. The implementation team used the R/3 Development Workbench tool kit to customise SAP's proprietary ABAP code to fit Menasha's needs.

In total, the installation required 3,000 modifications, for which Menasha paid some $2.5 million to SAP, $13 million to Deloitte and $775,000 to other consultants.

Even so, wrote Ebert, "the court sees no reason why software that provides the building blocks upon which modifications specific to the particular purchaser are made should not be deemed prewritten software."

Almost all ERP applications must be customised or modified after they're purchased, said John Matelski, deputy CIO for the city of Orlando, which runs PeopleSoft applications. He agreed with Ebert that making such tweaks isn't a true modification.

Moreover, if Menasha's arguments were to hold true, he said, then most implementation consulting costs would need to be considered nontaxable — and that would set a significant precedent that could require the state to refund all taxes to ERP customers that did such customisations.

As a rule, there is no rhyme or reason to how states assess software taxes, said LJ Kutten, a lawyer at the Software Taxation Institute. Some states will allow a company a tax exemption if its software customisation costs exceed half of the purchase price, Kutten said. Others tax out-of-the-box software costs but exempt later customisation expenses.

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