Annette Nellen
Annette Nellen

Software and Nexus

A recent New Jersey case illustrates a tax issue faced by software businesses.

November 12, 2009
by Annette Nellen, CPA/Esq.

In August 2009, the New Jersey Tax Court issued a consolidated ruling (PDF) on the income tax treatment of two software companies with customers in New Jersey (New Jersey). This article summarizes  and makes observations about this case.

Facts and Holdings

Two software companies challenged findings of the director, division of taxation, that they were subject to the New Jersey Corporation Business Tax (CBT). The taxpayers, AccuZIP, Inc. (Docket No. 005744-2003) and Quark, Inc. (Docket No. 004692-2002) both transferred software on tangible media under a licensing agreement. Both were incorporated and headquartered outside of New Jersey. AccuZIP had no employees in New Jersey while Quark had one employee there working out of his home.

The director argued that the companies owed CBT because they were "doing business" or owned property in the state as evidenced by the presence of their licensed software in the state.

The court noted that to sustain the director's position under the commerce clause, there would need to be evidence that the companies had "substantial nexus" with New Jersey.

The court found that Quark, but not AccuZIP was doing business in New Jersey. Per the court, AccuZIP sold tangible property to New Jersey customers but did not have any property in the state and generating just two percent of its total sales in the state was de minimus. Thus, AccuZIP was not subject to CBT. The court noted though, that if AccuZIP were doing business in New Jersey, only the minimum tax would be owed because its activities fell within the protections of PL 86-272.

In contrast, Quark was found to be doing business. However, it was held to only be subject to the minimum tax because the activities of its New Jersey employee were protected by PL 86-272 in that they merely helped to generate sales orders.

Court's Rationale

The court's holding was dependent on reaching two preliminary conclusions. First, the companies were selling tangible personal property, and second, they owned no property in New Jersey.

Tangible? The nature of what the companies transferred was relevant because the nexus protections of PL 86-272 only apply when tangible personal property is sold. The court pointed out that for New Jersey sales tax purposes, prewritten software is treated as tangible personal property even if delivered electronically. The court noted that federal income tax law would also treat the sales as transfers involving tangible property. The court referred to Income Tax Reg. §1.861-18(g)(1), which treats a transfer of software on a disk for a one-time payment as the sale of the copyrighted article (rather than the copyright right). Per the court, the companies "sell tangible copyrighted property in the form of CD-ROMS containing prewritten computer software" and were "not generating income from the use in New Jersey of their intangible personal property, as was the case with the trademarks and trade names at issue in Lanco." [AccuZIP (PDF), p. 14]

Lanco was a New Jersey case also involving nexus for CBT purposes (188 New Jersey 380 (2006) (PDF), cert. denied 551 U.S. 1131 (2007)). Lanco, a Delaware corporation, licensed use of its marks to a related entity in New Jersey. The New Jersey Supreme Court found that Lanco had substantial nexus in New Jersey even though it had no physical presence in the state. (Note: the New Jersey Tax Court had ruled that physical presence was required (21 New Jersey Tax 200 (2003)).

The court also applied the "real-object test" to conclude that the companies were selling software rather than information.

Property in New Jersey? Ownership of property was also relevant because such ownership may cause the companies to have a substantial nexus in New Jersey. The court noted that transfer of the disks was not a transfer of the owners' copyright rights. Transferring ownership of the disks with the software, but without any ownership rights in the software "does not mean that Quark and AccuZIP own property in New Jersey; such finding would lead to illogical results. If the location of the physical disks evidenced a substantial nexus for CBT purposes then the customers would determine Quark's and AccuZIP's CBT fate." [p. 19]

Alternative Nexus Arguments

The court also briefly addressed additional nexus arguments raised by the director. The director suggested that the "frequency, quantity, and systematic nature of a taxpayer's economic contacts" with N.J. indicated "substantial nexus" under the "significant economic presence test" as formulated in a West Virginia case, MBNA, 640 SE2d 226 (2006), cert. denied 551 U.S. 1141 (2007). This test was applied in MBNA where the company had no physical presence in the state and was not subject to PL 86-272, but generated revenue in the state. The New Jersey court noted that the MBNA approach was not binding on the court.

The director also argued that the companies received economic benefits from New Jersey that warranted imposition of the CBT. The court noted that was not the standard under state law.


Nature of software: Federal and states laws are inconsistent, and sometimes silent, in labeling software as tangible or intangible. The New Jersey court referred to Reg. §1.861-18 to support its label of tangibility. Yet, this regulation does not address the nature of software but instead provides guidance on how transactions related to software should be classified. Four possible outcomes are specified:

  1. transfer of a copyright right,
  2. transfer of a copyrighted article,
  3. services or
  4. provision of know-how. The term "tangible" is not used in this regulation.

The New Jersey court did not refer to federal depreciation rules that apply differently for tangible and intangible property. Doing so would have led to the label of "intangible" under Reg. §1.167(a)-14.

The court also referred to the "real-object test" often used for sales-tax purposes. It referred to Spenser Gifts, 3 New Jersey Tax 482 (1981) in which the taxpayer leased computer tapes containing information. The court found that the real object was the intangible information rather than the tangible tapes. In the present case, the court concluded that the companies were selling software rather than information. This reasoning is questionable because what the customers wanted was the software not the disks. This analysis should have led to a conclusion that the software is either intangible or services (it enables a computer to perform particular functions), unless the court was relying on New Jersey's treatment of prewritten software as tangible for sales tax purposes (in which case it wanted to be sure it was not information, which Spenser Gifts found to be intangible).

The court also referred to the federal Norwest case (108 TC 358 (1997)) for the issue of whether the parties owned property in New Jersey. In Norwest, the Tax Court held that software purchased as a copyrighted article could be treated as tangible personal property for investment tax credit (ITC) purposes. The court observed though that the ITC rules were to be interpreted broadly.

Sales tax rules vary among states in their treatment of software. Several states, such as New Jersey, include prewritten software delivered on media or electronically as tangible personal property while a few states, such as California distinguish between software transferred on tangible media versus electronically (intangible). (New Jersey Rev. Stat. §54:32B-2(g) and (CA Regulation 1502 (PDF).)

Location of software is also not clear. The New Jersey court found that the companies did not own property in New Jersey, but did not state where the software was located.

State law specificity: State laws also differ as to their specificity in explaining when software can create income tax nexus. The Multistate Tax Commission (MTC) interpretation (PDF) of PL 86-272 states that neither the licensing of tangible personal property nor transactions involving intangibles is protected under PL 86-272. While the director noted this position, the court nixed it because New Jersey, a Sovereignty Member of the MTC, is not bound by the MTC interpretation. Arguably, given the New Jersey court's labeling of the transactions as the sale of "tangible copyrighted  property in the form of CD-ROMs," the interpretation would not have been applicable anyway.

Some states, such as Kentucky, specifically mention software in their nexus rules. Under Kentucky regulations, owning property in the state includes "owning computer software used in the business of a third party within Kentucky" (103 KAR 16:240).

Transfer mode: Would the New Jersey court have reached the same conclusion if the software had been transferred electronically? Unfortunately, the court did not adequately address whether software is tangible or intangible, but instead added the word "tangible" to Reg. §1.861-18. The court also relied on the New Jersey sales tax definition of tangible personal property as including prewritten software.

If there is no sale of tangible personal property, PL 86-272 does not apply. While the New Jersey court may have still reached a sale conclusion rather than license using Reg. §1.861-18, it is not clear if it would have treated electronically-delivered software as tangible other than by relying on New Jersey sales tax law.

Software versus trademarks: Lanco derived royalties from a related entity's use of its marks. AccuZIP and Quark received one-time payments. In both situations though, the underlying valuable asset is owned by the transferors, not the customers. No customers had rights in the trademarks of Lanco or the copyright of AccuZIP and Quark. However, AccuZIP and Quark customers owned a copy of a copyrighted article they could depreciate while Lanco's customers owned nothing.


The New Jersey case illustrates the lack of clarity in the income tax nexus rules regarding software. When should a customer's use of software be treated as a sale versus a license and should treatment as tangible for sales tax also apply for income tax? Why should such labels matter in determining when a company is subject to state income tax? PL 86-272 is outdated in only applying to sales of tangible personal property. Economic nexus is not a helpful substitute when PL 86-272 does not apply because, for example, it relies on subjective determinations, such as the substantiality of sales in a state. Modernization of PL 86-272 is needed to provide a workable standard to enable all types of companies to be able to identify when they are subject to state income taxes.

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Annette Nellen, CPA/Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.