Wisconsin ruling could set precedent on modified apps

Von Marc L.

A judge"s refusal to order the state of Wisconsin to refund a half-million dollars in sales tax paid by a Neena, Wis., company on a customized SAP AG rollout may set a precedent that relieves the state from paying out more than a quarter-billion dollars in refunds to software users.

At issue in the short term is a US$500,000 sales tax refund sought by pulp and paper manufacturer Menasha Corp. The company"s 1995 installation of SAP"s R/3 enterprise resource planning application cost $23 million, of which $5 million was for a license for the software.

The rest of the money was spent on modifications and implementation, according to documents issued last week by Judge Steven Ebert of the Circuit Court Branch 4 in Dane County.

After Menasha paid sales tax of $342,614 on the implementation to the state"s Department of Revenue (DOR), the company tried to recover the money by petitioning the state tax appeals commission. In its request, Menasha argued that the modifications it made to R/3 qualified it as a custom-written application. In Wisconsin, custom-written applications are tax-exempt; regular third-party software is not.

Although the appeals commission agreed with Menasha, Ebert overturned that decision, ruling among other things that R/3 "was existing and prewritten" when SAP sold it to Menasha.

For its part, the DOR "is pleased with the decision," said spokeswoman Eva Robelia. "It upholds our prior actions."

She explained that had Menasha won, a precedent would have been set allowing other companies that paid sales tax on modified third-party applications to file similar appeals. If those appeals were successful, the state would have had to pay back an estimated $300 million in taxes and interest.

Menasha officials, who may yet appeal the ruling, are unhappy.

"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, an attorney at the Washington firm Foley & Lardner LLC, which represents the company. The larger issue, he said, is that not only is the modified software itself taxable, but so are the services required to fix or reprogram it during the implementation.

Sosnowski also said the case could be used as a precedent in other states.

Andrew Nelson, another lawyer at the firm, viewed the case as important because the judge"s definition of modified software could make the services around implementing it also taxable. That, he said, might push some companies to move their IT operations to states with more favorable tax laws.

Explaining his ruling, Ebert said R/3 always requires substantial modification to adapt the system to a given customer"s specifications. In this case, at SAP"s recommendation, Menasha hired consultancy Deloitte & Touche LLP to help it make the changes it needed. The implementation team, which included SAP and Deloitte employees, used the R/3 tool kit, Development Workbench, to customize SAP"s proprietary Advanced Business Application Programming code to fit Menasha"s specific requirements.

In total, the installation required 3,000 modifications, for which Menasha shelled out $2.5 million to SAP, $13 million to Deloitte and $775,000 to other outside 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." And given the fact that SAP made only minor modifications to R/3 in this case, the application cannot be deemed as having been custom-written.

It is true that almost all ERP applications must be customized or modified after they are purchased, said John Matelski, deputy CIO for the city of Orlando, which runs PeopleSoft Inc. software. He agreed with Ebert that making such tweaks isn"t really a true modification. Moreover, if Menasha"s arguments were to hold true, then most implementation consulting costs would need to be considered nontaxable -- and that would set a significant precedent that could require states to refund all taxes to ERP customers who did such customizations.

As a rule, there is no rhyme or reason on how states assess software taxes, said L.J. Kutten, a lawyer at the Reno, Nev.-based Software Taxation Institute, which analyzes high-tech taxation issues. However, some states will allow a company a tax exemption if customization costs exceed half of the purchase price. Still others tax the out-of-the-box costs, but exempt later customization costs.

Robelia said the DOR would have to evaluate any appeal by Menasha before deciding how to proceed with the case.