Ohio Supreme Court Rules Computer Software
is Tangible Personal Property

Mark A. Engel
Bricker & Eckler LLP
June 2006

The Ohio Supreme Court has ruled that canned computer software is tangible personal property that is subject to the personal property tax. The court also hinted that a similar result might obtain with respect to customized software. In reaching this decision, the Court refused to make the distinction between systems software, which is essential for the basic operations of a computer and is included in the taxable cost of the hardware, and applications software, which is intended to perform a specific task or function. Andrew Jergens Co. v. Wilkins, 109 Ohio St. 3d 396, 2006-Ohio-2708 (2006).

For tax years 1996-1998, the Andrew Jergens Company did not report the value of canned, or “off-the-shelf,” computer software programs on its tangible personal property tax returns. On audit, the Department of Taxation assessed the value of the software as tangible personal property used in business. On appeal, the Board of Tax Appeals upheld the assessment on the basis of the Supreme Court’s prior decision in Community Mutual Ins. Co. v. Tracy, 73 Ohio St. 3d 371, 653 N.E.2d 220 (1995).

Taxpayer’s Position. The taxpayer relied upon the decision in CompuServe, Inc. v. Lindley, 41 Ohio App. 3d 260, 535 N.E.2d 360 (Franklin App. 1987), which held that application computer software was intangible personal property that was not subject to tax. In CompuServe, the nature of customized computer software for both sales and property tax purposes was in question. The court of appeals recognized that the essence of computer software was the intangible information it embodied. The tangible medium was merely a vehicle for its transfer. The Court of Appeals concluded that applications software was intangible and was not subject to tax. However, systems software was deemed subject to property tax as a cost incurred in rendering computer hardware used in business. Neither type was subject to sales tax.

Court’s Analysis. First, the Supreme Court distinguished the decision in CompuServe. It correctly observed that CompuServe involved customized computer software, while canned software was involved in this case. It also observed that three of the many authorities upon which the CompuServe court rested its decision have subsequently been modified or reversed. For these reasons, it declined to follow the CompuServe decision.

The Court then turned to its decision in Community Mutual. In that case, the taxpayer had argued that the software was the result of a nontaxable personal service. The Court disagreed and held that computer software embodied on a tangible medium was subject to sales tax. Based upon that decision, the Court stated that when a business acquires canned software, it receives a tangible medium that contains the information. The information is then transferred to the purchaser’s computer hard drive to enable the computer to perform the desired operation. Thus, “the encoded instructions are always stored on a tangible medium that has physical existence.” Consequently, the software was deemed tangible property subject to tax.

Dissent. The dissent would have applied the distinction between systems and application software that was the heart of the CompuServe decision. It noted that software is intangible information and that any tangible personal property used to store or transfer it did not change the character of what was fundamentally a form of intellectual, intangible property. It likened the situation to a patent-license agreement that is reduced to a tangible form, i.e., a writing, but which remains intangible in nature.

Comments. For several years, the Department of Taxation has disregarded the decision in CompuServe. On audit, its position was that all computer software except “non-core” business software was tangible property subject to taxation, while in litigation its stated position was that all software, canned or custom, was taxable. See Information Release PP 2004-01, “Taxation of Software” (February 14, 2004). On a going-forward basis, the Department will expect all computer software to be reported on taxpayers’ personal property tax returns. Even though the tax is being phased out, this increased tax cost will not be insignificant.

The decision in Andrew Jergens expressly does not address customized computer software, nor does it address computer software that is down-loaded electronically. However, the Court’s emphasis on the fact that software is lodged on a tangible medium, such as a tape or hard-drive, provides a strong signal that a similar result might be expected in those two situations. Taxpayers should consider carefully past filing practices and the positions they wish to take with respect to software for future years. The expense may be unexpected and high, but the issue will disappear in two years as the tax is phased out.