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Court Decision Impacts Wisconsin Sales and Use Taxation of Computer Programs

January 31, 2007

On January 25, 2007, the Wisconsin Court of Appeals issued a very significant decision addressing the Wisconsin sales and use taxation of computer programs. Godfrey & Kahn filed a “friend of the court” brief for Wisconsin Manufacturers and Commerce in support of the corporate taxpayer, which has now prevailed.

The case, Wisconsin Department of Revenue v. Menasha Corporation, No. 2004AP3239 (Wis. Ct. App. Jan. 25, 2007), presented the question of whether pre-existing, mass-marketed software that requires extensive modification and customization before it can be used by a customer is a “custom computer program” and, therefore, exempt from Wisconsin sales and use tax. If the program were a non-custom program (also referred to as a “canned” or “prewritten” program), it would be subject to Wisconsin sales and use tax. The Court of Appeals held that the software is customized software, overturning a decision of the Dane County Circuit Court and affirming a decision of the Wisconsin Tax Appeals Commission (commission) in favor of Menasha Corporation.

The software in question consisted of over seventy modules that provide business and accounting software for different segments of a user’s business. The software is not usable as sold, but must be modified to fit a user’s business operations. In the present case, this modification cost Menasha more than $17 million beyond the cost of the core software system.

In reaching its conclusion, the Court of Appeals decided that the commission’s initial decision was entitled to “due weight deference,” or that the commission’s reasonable interpretation of an administrative rule should be upheld if the interpretation comports with the purpose of the rule and the court cannot find a more reasonable interpretation. Significantly, the court decided that the commission’s interpretation of the rule, and not the Department of Revenue’s (DOR) interpretation, was entitled to deference. In fact, the court stated that the DOR’s “interpretation and application of its rules are not entitled to any deference.” Menasha, No. 2004AP3239, ¶ 21 (emphasis added).

The crux of the distinction between the commission and DOR interpretation was whether the classification of software as custom or non-custom should be made by considering all the relevant facts and circumstances, including seven specifically listed in the Wisconsin Administrative Code (as asserted by the commission), or only by considering two of those factors (as argued by the DOR). Finding the DOR’s interpretation of the rule narrow and unreasonable, the Court of Appeals agreed with the commission’s determination that it must consider all of the relevant facts. Id. at ¶ 49. Since the first five factors in the Administrative Code, which concern “the degree to which the software is ready for use off the shelf,” supported the determination that the software in question was a custom program, the court upheld the commission’s determination: the sale of the software was exempt from Wisconsin sales and use tax. Id. at ¶¶ 55, 57.

The court’s decision is extremely important for Wisconsin businesses that purchase computer software. It clarifies that “the distinction between custom and prewritten programs hinges on the amount of effort necessary to get the software operational for a particular customer’s needs…[T]he more pre-sale planning, the more testing, the more training, the more written documentation, the more enhancement, and the more maintenance, then the more likely the software is custom software.” Id. at ¶57. The decision further clarifies that even software that contains standardized components is not prewritten if “the program is not usable as sold and requires substantial effort to render it useful.” Id. at ¶ 65.

While it is likely that the DOR will appeal this decision by asking the Wisconsin Supreme Court to review it, the decision nevertheless is an important affirmation of the commission’s sound policy judgments about Wisconsin tax provisions that support business development.

If you have any questions concerning this decision and how it impacts your business, please contact Jed Roher, a member of Godfrey & Kahn’s Tax and Corporate Practice Groups, at 608-284-2269 or jroher@gklaw.com.

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