State Tax Notes - September 2, 2013
The Chicago personal property lease transaction tax (CTT) is the city's version of a lease or rental tax on personal property.1 It is an 8 percent tax that applies to any lease or rental of personal property in the city of Chicago, and the use in Chicago of personal property leased or rented outside the city.2 Personal property subject to the CTT includes property such as computer software. The CTT also taxes lease time for the use of computers and computer software.3
Effective September 1, the Chicago Department of Revenue has modified CTT Ruling 5 (originally Ruling 9) to expand the CTT to some perpetual licenses of computer software (Amended Ruling 5). Previously, Ruling 5 did not impose the CTT on perpetual licenses of computer software because it equated those licenses to sales rather than leases. To extend the reach of the CTT, Amended Ruling 5 now subjects to the tax any license of computer software that qualifies as a nontaxable license under the Illinois retailers' occupation tax (ROT) software regulations.4 Because non-perpetual licenses of software that qualify as nontaxable licenses under the ROT software regulations have always been subject to the CTT, Amended Ruling 5 has expanded the CTT to those perpetual licenses of software that are likewise nontaxable under the ROT.5
When the scope of the CTT was first interpreted as applying to computer software, the Chicago DOR decided to issue a ruling to instruct taxpayers on the application and limitations of the CTT. On February 1, 1987, it promulgated a ruling to clarify that a lease could encompass some licenses of computer software. However, the Chicago DOR had to be mindful of the Illinois Constitution's prohibition on municipalities taxing sales of services or intangibles.6 Consequently, when the DOR drafted the ruling, it distinguished licenses of computer software that were similar to sales in that some ownership interest in the underlying software copies was provided- that is, the copies could be used for an indefinite period of time—from licenses of computer software for a limited duration that were more like leases.7
Regarding leases of computer software, section 4 of Ruling 5, effective before September 1, 2013, states:
This would include all agreements for the use or possession of such software including license agreements .... However, if title or ownership of the software passes in an agreement, then a sale occurs and no lease tax would be due.
The section gives examples:
(a) A computer software owner (or licensor) and a Chicago user sign an agreement called a copyright license agreement which transfers the possession and use of certain software to the user, and allows such user to use such software on a month to month basis for a payment of a specific monthly fee. No other fees are charged the user. At the end of the contract term or upon cancellation by the parties, the software is either returned to the owner (or licensor) or erased. Only incidental training and a question answering service is provided and is a part of the monthly fee. In this case, the total monthly fee is taxable as a lease charge for the use of the software.
(b) Same facts as (a) above, except that the agreement provides for an indefinite use of the software for a flat fee of $2,000.00. The user does not have to return the software but can use the software for as long as he or she desires. In this case, an ownership interest in the software is transferred, so no tax is due.
Since the issuance of Ruling 5, the Chicago Department of Law has cited it in at least two letter rulings and said that perpetual licenses of computer software are not leases subject to the CTT. For example, in 1989 the department issued a letter ruling that a perpetual software license giving a user the right to use the software "for as long as it desires," with a license fee paid over eight installments, was not a lease because it involved the transfer of an ownership interest in the software.8 In 1996 it issued another letter ruling confirming that perpetual leases of software were not taxable leases unless the parties indicated an intent to lease the software.9
Since 1987, the basic difference between perpetual licenses and non-perpetual licenses for CTT purposes has continued without controversy. But the Chicago DOR recently decided that too many taxpayers are taking advantage of the distinction by making sure their software license agreements were both nontaxable under the ROT and perpetual. That has resulted in no ROT or CTT being due because both laws consider those licenses to be sales of intangibles. To put an end to taxpayers structuring their licenses as nontaxable under both the CTT and the ROT, the Chicago DOR decided to amend Ruling 5.
Amended Ruling 5 now subjects to the CTT licenses of computer software that are not taxable sales under the ROT software regulations.10 And even though the amended ruling does not mention perpetual licenses, in reality it is limited solely to perpetual licenses that are nontaxable under the ROT because non-perpetual licenses that are nontaxable under the ROT have always been taxable as "leases" under the CTT. Therefore, the changes to Ruling 5 are designed purely to target perpetual licenses.
Moreover, while the ROT software regulations plainly treat perpetual licenses that meet its requirements as nontaxable sales of intangibles and not leases, Amended Ruling 5 now declares otherwise and states that those regulations support its position that perpetual licenses should now be deemed leases. In short, Amended Ruling 5 is not only a 180-degree departure from how the Chicago DOR has historically treated perpetual licenses of software under the CTT, but there are also serious questions about the ruling's legal justification and validity.
B. Analysis of Amended Ruling 5
Ruling 5 was designed to interpret the expansion of the CTT to the new software environment blossoming in the 1980s. Because transfers of software do not easily fall under the category of either sales or leases, the Chicago DOR decided to use fundamental legal principles and logic to categorize a software license as either a sale or a lease. Because the key difference between a sale and a lease is that a sale is a transfer for an unlimited period of time while a lease is a temporary transfer, that characteristic was deemed the most important in classifying a license as either a lease or sale for CTT purposes. That reasoning was consistent with Illinois case law that looked to whether sufficient characteristics of equitable ownership were transferred to determine whether a sale occurred.11 It also was consistent with Illinois tax law stating that "revenue collection is not concerned with refinements of title, it is concerned with the realities of ownership."12
It was just as essential for the Chicago DOR to properly classify the license as either a sale or lease because of the restrictions on taxing sales of intangible property under the Illinois Constitution.13 Therefore, because the Illinois Supreme Court held licenses of computer software to be sales of intangibles, the Chicago DOR had to make sure any classification of a software license as a lease had substantial justification.14 That made it even more important for the Chicago DOR to look for commonsense and legally significant differences between software licenses to be able to justify deeming some as leases.
Equally important was that the test to determine whether a license can be classified as a lease be easy enough to follow so that taxpayers wouldn't be confused about the classification. By generally treating perpetual licenses as sales and non-perpetual licenses as leases, the Chicago DOR based its classification not only on legal differences in the licenses, but also on the logical and realistic differences between sales and leases. Further, that distinction in treatment between perpetual and non-perpetual licenses is consistent with how other state sales taxes treat those licenses. For instance, most states tax leases and sales the same way, but Maine and Arizona do not, thus requiring them to classify a software license as either a sale or lease. Significantly, both Maine Revenue Services and the Arizona DOR have classified perpetual licenses as sales for tax purposes.15
Amended Ruling 5 ignores the above rationale and justifies classifying perpetual licenses as leases by asserting that the Illinois DOR has determined that if a transfer of software meets the five-part test in the ROT software regulations, the transfer is not a sale.16 But that is demonstrably incorrect. The ROT software regulations merely explain that a license that meets the five-part test is not a taxable retail sale, but they go on to make clear that a person who acquires software for retransfer to another can claim that the original purchase was for resale if the retransfer qualifies as a non-taxable license under the test.17 That unquestionably establishes that no lease is occurring because the purchase of software for lease simply does not qualify for the sale for resale exemption under the Illinois ROT.18 Therefore, the retransfer of the software through a nontaxable license is plainly considered a sale (and definitely not a lease) under the ROT software regulations.
Similarly, in ST-00-0031-PLR, the Illinois DOR said acquiring computer software for purposes of transfer as a nontaxable license can nevertheless be tax free under the sale-for-resale provisions of the Illinois ROT software regulations if it meets the five-part license test. Likewise, ST 13-0032-GIL states:
You indicate that your customers have entered into licensing agreements directly with the companies that write the computer software and sell it to you for resale. If the licensing agreement between the companies that write the computer software and your customers meet the requirements of Section 130.1935(a)(1), neither the transfer ofthe software by you to your customers nor the subsequent software updates will be subject to Retailers' Occupation Tax.
In short, if the nontaxable license of the computer software is considered a lease, then no resale could occur. Thus, those letter rulings, like the software regulations, are in direct conflict with the city's suggestion that the Illinois DOR treats nontaxable licenses as leases under the Illinois ROT.
In sum, contrary to Amended Ruling 5 as amended, the Illinois DOR treats transfers of software that meet the five-part license test of the ROT software regulations as sales of intangibles, not leases. The reason for that is straightforward. In 1981 the Illinois Supreme Court ruled that licenses of software were sales of intangibles not subject to the Illinois ROT.19 Consequently, when legislation expanded the Illinois ROT to computer software in 1989, the Illinois DOR needed to distinguish between licenses that would clearly be nontaxable sales of intangibles and those that would be deemed sales of tangible personal property subject to the Illinois ROT. The ROT software regulations in no way suggest that those nontaxable license transfers should be considered leases. On the contrary, classifying those licenses as leases directly conflicts with those regulations. Further, the ROT software regulations are more than 20 years old, so it is difficult to understand how they now support the change in the taxation of perpetual licenses effectuated by Amended Ruling 5. Therefore, while the Chicago DOR may believe it is justified in ensuring that perpetual licenses pay some tax, it seems the sole justification for its modification to Ruling 5 lacks any basis whatsoever.
The taxation of perpetual software licenses under Amended Ruling 5 is a major departure from how the CTT has been applied. While the Chicago DOR should be commended for not trying to apply Amended Ruling 5 retroactively, the change in law is at best questionable. Business groups have expressed alarm over the ruling's financial impact and practitioners have questioned the lack of legal justification for the change. But, those concerns have generally fallen on deaf ears. Businesses should review their software license agreements and be prepared, because a new tax increase on their computer software is here, warranted or not.
Chicago Municipal Code ch. 3-32.
Id. at section 3-32-030.
See Meites v. City of Chicago, 184 Ill. App. 3d 887 (1st Dist. 1989).
See 86 Ill. Admin. Code section 130.1935(a)(1) (Ill. Reg. 130.1935).
See Commercial Nat'l Bank v. City of Chicago, 89 Ill.2d 45 (1981); and Waukegan Community Unit School Dist. No. 60 v. City of Waukegan, 95 Ill.2d 244 (1983).
See ruling 5, section 4.
Chicago law department private letter ruling (Dec. 11, 1989).
Chicago law department private letter ruling (Sept. 14, 1996).
See Ill. Reg. 130.1935(a)(l).
See, e.g., People v. Chicago Title & Trust Co., 75 Ill.2d 479 (1979); Cole Hospital Inc. v. Champaign County Bd. of Rev., 113 Ill. App. 3d 96 (4th Dist. 1983).
Chicago Title & Trust Co., 75 Ill.2d at 489.
See Waukegan Community Unit School Dist. No. 60 v. City of Waukegan, 95 Ill.2d 244, 254 (1983); and Mr. B's Inc. v. City of Chicago, 302 Ill. App. 3d 930 (1st Dist. 1998).
See First Nat'l Bank of Springfield v. Dep't of Revenue, 85 Ill.2d 84 (1981) (transfer of software license was the sale of an intangible).
See Maine Revenue Services, Instructional Bulletin No. 20 (perpetual licenses are taxed as sales); Arizona Information Letter (May 1, 2013) (citing LR 12-003) (perpetual licenses treated as sales and non-perpetual licenses treated as leases).
Amended ruling 5, section 5.
Ill. Reg. 130.1935(a)(2).
See generally 86 Ill. Admin. Code section 130.220 (a lease is not a sale).
First Nat'l Bank of Springfield, 85 Ill.2d 84.