DocketNumber: Docket No. 13908-92
Citation Numbers: 108 T.C. 358, 1997 U.S. Tax Ct. LEXIS 18, 108 T.C. No. 18
Judges: HALPERN
Filed Date: 4/30/1997
Status: Precedential
Modified Date: 1/13/2023
P purchased operating and applications software for use in its banking and related businesses. The software was acquired subject to license agreements that entitled P to use the software on a nonexclusive, nontransferable basis for an indefinite or perpetual term. P did not purchase any exclusive copyright rights or other intellectual property rights underlying any of the software in issue and was not permitted to reproduce the software outside P's affiliated group.
*358 HALPERN,
Year | Deficiency |
1983 | $ 2,605,571 |
1984 | 2,442,134 |
1985 | 29,187 |
1986 | 19,301,530 |
*19 Respondent also determined that the provision for increased interest under section 6621(c) applied for 1983, 1984, and 1986. Unless otherwise noted, all section references are to the Internal Revenue Code in effect for the years in issue, *359 and all Rule references are to the Tax Court Rules of Practice and Procedure.
After concessions by the parties and the continuation of other issues, the sole issue for decision is whether certain computer software expenditures made by petitioner during the years in issue qualify for the investment tax credit. Resolution of that issue depends on the characterization of the acquired software as either tangible or intangible property, as only investments in tangible property are eligible for the investment tax credit. We conclude that the acquired software is tangible personal property eligible for the investment tax credit.
FINDINGS OF FACT 1
Petitioner is a group of affiliated corporations (the Norwest affiliated group) that provides banking and other financial services. Petitioner *20 files consolidated Federal income tax returns. At the time the petition was filed, petitioner's principal place of business was located in Minneapolis, Minnesota.
Petitioner extensively uses computers in processing data and in providing essential accounting and other business functions. During the years in issue, petitioner utilized three types of computer systems: (1) large-scale "mainframe" computers, which were used to process large amounts of data and transactions at a central location, (2) minicomputers, which were typically used to process self-contained single business applications, such as processing transactions from automated teller machines (ATMs) or controlling the work stations that tellers use to process transactions in a bank, and (3) personal computers (PCs), which were generally smaller stand-alone devices used for word-processing and spread-sheet applications.
Each of the above-described computer systems requires operating software (also called systems software) and applications software to enable the computer to function and perform specific tasks. Operating software is used to manage the operations of a computer; it schedules and controls jobs, *360 keeps track of *21 the placement and storage of information, manages traffic, and generally enables a computer to process a particular application. Applications software provides specific business functions like accounting, transaction processing, calculating interest, and producing customer statements. Petitioner purchased both operating and applications software during the years in issue.
Software enables a computer to function and perform specific tasks by providing instructions, or commands, to the computer system. The instructions are written in a programming language, or source code, understandable to humans, such as COBOL (Common Business Oriented Language) or FORTRAN (Formula and Translation code). The source code is written, line by line, by programmers in accordance with the overall design of the computer program and the specific tasks a computer is to perform. 2*22 A completed computer program may contain hundreds of thousands of lines of source code and is eligible for copyright protection.
A compiler is used to convert source code into a machine-readable computer language, known as executable, or object, code. Executable code is composed of sequences of binary digits (zeros and ones). Each digit is called a "bit", and eight-bit sequences are called "bytes". 3 A computer program can be written onto a magnetic disk or tape by encoding its particular executable code on the surface of the disk or tape. 4*23 That magnetic recording allows the computer processor to read the executable code and to perform the specific tasks directed by the code.
Generally, the cost of a blank tape, similar to one upon which the computer programs acquired by petitioner were placed, was less than $ 25 during the years in issue. An *361 encoded computer program can easily be transferred or copied onto additional blank tapes and disks, resulting in identical reproductions of the program. A computer program can also reside on media other than magnetic tapes and disks, such as punch cards and CD-ROMs (compact disk read-only memory). 5 Moreover, computer programs can be received preinstalled on a computer's hard disk drive (internal storage device) and can be transferred from one computer to another via electronic transmission over telephone lines without the use of intervening tapes and disks. Although telephonic transmission was technologically possible during the years in issue, it was slow and unreliable and, therefore, was not a feasible method of transferring *24 a large computer program. All of the software in issue was delivered to petitioner as computer programs encoded on magnetic tapes and disks. The software was purchased separately from computer hardware.
All of the software expenditures in issue were for software developed by third parties and sold to members of the Norwest affiliated group for use in their banking and financial services operations. The software was either of a type available to the general public or a specialized type of software used by financial institutions like petitioner. The software was sold subject to license agreements that entitled petitioner to use the software on a nonexclusive, nontransferable basis for an indefinite or perpetual term. Petitioner did not purchase any exclusive copyright rights or other intellectual property rights underlying any of the software in issue; petitioner did not purchase the right to reproduce such software outside the Norwest affiliated group. *25
All mainframe software purchased by petitioner during the years in issue consisted of computer programs encoded on magnetic tape (for large applications, on several reels of tape) and was either shipped or personally delivered by a service representative to petitioner's mainframe site. Each computer program was loaded (copied from the magnetic tape) onto the mainframe computer's own storage medium, known as a *362 "disk pack". The computer program would then be tested and modified, as necessary, over a period of several weeks or months. Modifications were made, for example, to change the layout of a screen, to add or revise reports, or to conform the title of a field to normal usage in petitioner's business operations. 6*26 After the computer program was installed, petitioner retained the original tape or an exact copy in case a problem occurred that required the program to be reloaded onto the mainframe computer. 7 Typically, one copy was kept on site for immediate access, and a second copy was kept off site as a second backup to the on-site copy in the event of a disaster. 8
Petitioner typically entered into a maintenance and support agreement with the vendor (usually for an additional periodic fee) in conjunction with the purchase of mainframe or minicomputer software whereby the vendor agreed to correct errors in the computer program and *27 to provide updated versions of the software as they became available. If a copy of software had been lost or destroyed (and a backup had not been made), a replacement copy would have been provided to petitioner by the vendor without charge.
Petitioner was entitled to only one running version of each copy of software purchased. Thus, if petitioner desired to load a copy of software onto a second computer (which it did), additional copies had to be purchased (sometimes at reduced rates) or a multiple-machine license was required.
*363 OPINION
I.
A.
Petitioner purchased during the years in issue operating and applications software for use in its banking and financial services businesses. The software was acquired subject to license agreements that entitled petitioner to use the software on a nonexclusive, nontransferable basis for an indefinite or perpetual term. Petitioner did not purchase any exclusive copyright rights or other intellectual property rights underlying any of the software in issue and was not permitted to reproduce the software outside the Norwest affiliated group. The sole issue for decision is whether petitioner's software expenditures qualify for the *28 investment tax credit (ITC). Resolution of that issue depends on the characterization of the acquired software as either tangible or intangible property. We conclude that the acquired software is tangible personal property eligible for the investment tax credit.
B.
Petitioner contends that the computer software it purchased during the years in issue constitutes tangible personal property eligible for the investment tax credit under
In addition to relying on the cases cited above, petitioner contends that computer software should be eligible for the investment tax credit for the following reasons: (1) Congress did not intend the term "tangible *30 personal property" to be defined narrowly; (2) the Commissioner has held in
Respondent contends that computer software is intangible property and that our holdings to that effect in
*365 II.
A.
B.
The Fifth Circuit in The method used in collecting the seismic data needed to produce such pictures was to introduce sound into the ground and then capture the various reflected vibrations from the subterrain in microphone-like receivers. Those receivers then transmitted the electronic impulses to recording stations where the impulses were transcribed onto magnetic computer tapes known as "field" tapes. From there the impulses recorded on the field tapes were taken to a processing center where background noise or signals were eliminated. With the retained or primary signals sharpened by the editing process, a "final" or "output" tape was produced. Using a computer, *366 the information contained on the output tapes as electronic impulses was then transformed into a picture representing a vertical slice of the earth. The computers through which the field tapes were processed are digital *33 computers and the reflex signal data were placed on the output tapes in digital form. [
The Fifth Circuit explained its holding as follows: The value of the seismic data is entirely dependent upon existence of the tapes and film. If the tapes and film were destroyed prior to any reproduction of the film analog, nothing would remain. An investment in the data simply does not exist without recording of the data on tangible property. Thus the basis of the tangible tapes and films must include the costs of collecting seismic * * * data and recording it on the tangible property, with the result being an asset constituting "tangible personal property." [
This Court in
This Court found inapplicable the series of cases in the Ninth Circuit holding that certain master sound recordings and motion picture negatives were tangible personal property eligible for the ITC. We distinguished the master negatives in the The Internal Revenue Service took the position that the investment was in the cost of the intangible, the seismic data, and not in the tangible films and tapes. The Fifth Circuit interpreted the Internal Revenue Service's argument to suggest "that property is intangible if its intrinsic value is attributable to its intangible elements rather than to any of its specific tangible embodiments." Based on this "intrisic value" [sic] test, *35 the court *367 held that the taxpayer's investment in the information was an investment in tangible property because "the value of the seismic data was totally dependent upon the existence of the tapes and films. If the tapes and film were destroyed prior to any reproduction, nothing would remain. An investment in the data simply does not exist without recording of the data on tangible property." In looking at the property's "intrinsic value," the court found that the information placed on the tangible disks and tapes was tangible personal property because the seismic data did not exist as property separate from the physical manifestation. * * * [
More recently in
First, the Sixth Circuit, citing the statutory language, acknowledged that Congress extended the ITC to tangible personal property in general, subject only to specified exceptions inapplicable *37 to the case at bar.
The Sixth Circuit then analyzed the line of cases beginning with
In disposing of the Government's argument that the "inextricable connection" between the intangible information *38 and the tangible tapes in We find neither of these arguments persuasive. Sound waves and brain waves are about equally incorporeal, it seems to us--and the connection between the information and the medium embodying it is no less inextricable in this case than it was in
The court in The intangible information (seismic data) and the tangible medium (magnetic tape) were inextricably connected. The former could not exist without the latter. In the present action, the intangible information (the software) is not necessarily dependent upon the tangible medium (the magnetic computer tapes). The application programs exist on paper and conceivably in the mind of the programmer as well. The placement of the program on the tape, facilitates the sale of the program--it is not, however, the only way that the program can exist. The computer tape functions merely as one type of conduit for the ideas contained on it. The nexus between the intangible information and the tangible medium is far more attenuated in this action than in
The Sixth Circuit also addressed our opinion in We express no view as to whether the Fifth Circuit's "totally dependent" test was applied correctly in
C.
This Court in
For the purposes of applying the intrinsic value test as interpreted by this Court, there is no fundamental difference between seismic data and a computer program. Seismic data theoretically exists in the geologic features of the subterrain in the same way that a computer program theoretically exists in the mind of its creator. Similar to a computer program, seismic data may exist in various forms and occupy numerous tangible residences in that it can be embodied *43 in field tapes, output tapes, analog film, or even seismic pictures. The compilation of both types of information requires human exertion.
*371 Those who see a distinction between seismic data and a computer program may contend that the fundamental difference between the two types of information is that a compilation of seismic data is an original recording of physical events that could never be perfectly reproduced; in other words, it is a particular rendition of human exertion, whereas numerous renditions of human exertion in writing a computer program could result in identical source codes. That distinction, however, is illusory. First, the fact that seismic data may differ each time the same subterrain is bombarded with sound waves is relevant only if differences in the data create material changes to the seismic pictures that would be purchased by oil and gas explorers. It seems unlikely that changes in geologic features, which generally occur over long periods of time, qualitatively affect the nature of the corresponding seismic data. Second, even if the seismic picture of an unchanging feature would be different because of changes in the recording and editing process, it is still *44 theoretically possible to disregard those different processes and to reproduce a materially indistinguishable seismic picture, just as it would be theoretically possible to disregard different programming languages and to rewrite a computer program in the language used to create the original source code. The essential point is that there is no material distinction in the theoretical duplicability of the human exertion required to gather both types of information.
Those who see a distinction between seismic data and a computer program may also assert that, although the inextricable connection between both types of information to its respective tangible residences may be analogous, seismic data does not exist
In sum, seismic data embodied in field tapes as electronic impulses are analogous to a computer program embodied in tapes and disks as a master source code written in COBOL, FORTRAN, or any other programming language. Thus, operating and applications software, which is the product of converting a source code by means of a compiler into configurations of machine-readable computer language known as executable code, is analogous to the output tapes that were produced from the field tapes using a digital computer. See
D.
Application of this Court's interpretation of the intrinsic value test to the facts in
In addition, the Sixth Circuit's interpretation of the test of tangibility created by the Fifth Circuit in
In sum, it is reasonable to state that the Fifth Circuit's test of tangibility set forth in
E.
Petitioner acquired operating and applications software that was subject to license agreements entitling petitioner to use the software on a nonexclusive, nontransferable basis for an indefinite or perpetual term. Petitioner did not purchase any exclusive copyright rights or other intellectual property rights underlying any of the software in issue and was not permitted to reproduce the software outside the Norwest affiliated group. We must determine whether the software acquired by petitioner constitutes tangible personal property for purposes of *50 the ITC.
As an initial matter, the relevant statutory provisions and regulations thereunder provide limited guidance and do not resolve the issue of whether the term "tangible personal property" includes operating and applications software. The Revenue Act of 1962, Pub. L. 87-834, sec. 2, 76 Stat. 962, first enacted the investment tax credit. S. Rept. 1881, 87th Cong., 2d Sess. (1962),
Intangible intellectual property rights and the tangible or physical manifestations or embodiments of those rights are distinct property interests. See, e.g.,
Although we have not relied here on a consideration of intrinsic value, we do not necessarily disagree with the conclusion in
III.
Petitioner's software expenditures during the years in issue qualify for the ITC.
Reviewed by the Court.
SWIFT, WELLS, RUWE, WHALEN, COLVIN, BEGHE, VASQUEZ, and GALE,
CHIECHI,
FOLEY,
I agree with the majority that "resolution of the issue before the Court should begin *55 with the term 'tangible personal property' and end with an examination of the legislative history of the ITC." Majority op. p. 24. In the absence of legislative guidance on this issue, it is reasonable and appropriate to analyze the nature of the rights petitioner acquired and conclude that petitioner's software qualifies for the ITC as tangible personal property.
PARR,
JACOBS,
Preliminarily, computer software possesses both tangible and intangible characteristics. Computer programs like the ones in issue are configurations of executable code that instruct a computer to process data in a specified manner. The encoded information is intangible *56 property; the computer tapes and disks on which the information is embodied is tangible property.
*378
When one acquires computer software, the item desired is the intellectual property stored on the tangible disk or tape, i.e., the computer program, not the disk or tape itself. See
The software here acquired was sold subject to nonexclusive, nontransferable license agreements. Pursuant to those agreements, petitioner was entitled to use the software it purchased in its banking and related activities but was not permitted to reproduce or resell the software to others. It is clear from the license agreements *57 that petitioner was interested only in using the intangible programs contained on the tapes and disks. This point is demonstrated by the description provided in a license agreement entered into in conjunction with the purchase of "ESTIMATICS" software from Management and Computer Services, Inc.: The intangible knowledge, information and know-how to be made available hereunder shall be provided on 5 1/4" diskette for the IBM personal computer.
Software's intellectual property is fluid. The intellectual property was placed on a tangible medium simply for ease of transmission. The initial housing of the intellectual property on a tangible medium is temporary, and ultimately, the program's intellectual property is mirror-image transferred onto a computer. And it is this mirror-image transfer that the purchaser of the computer software desires when acquiring the software. Upon the subsequent transfer to the computer, the intellectual property becomes dually housed: (1) On the disk or tape, and (2) on the computer. Moreover, an unlimited number of mirror-image transfers of the computer program can occur; the computer *58 program can even be mirror-image transferred from one disk or tape to another.
*379 A computer program can be transferred electronically over telephone lines, although during the years in issue, telephonic transmission was slow and unreliable. A computer program can be erased from the disk or tape and typed in exactly anew by programmers from written documentation of the source code without destroying the underlying intellectual property. Clearly, a computer program is not inextricably bound to any single tangible medium.
Beginning in 1988, this Court held in
The Court of Appeals for the Sixth Circuit in
A discussion of the case law in this area is set forth in the majority opinion pp. 12-18; no useful purpose would be served by repeating it here.
The intrinsic value test, which the majority criticizes, is a facts and circumstances test first enunciated by the U.S. Court of Appeals for the Fifth Circuit in
We adopted the intrinsic value test in
As noted in
The court in
The majority, as well as the court in
*382 As I read the majority opinion, the sole stated reason for holding that the computer software at issue is tangible personal property, qualifying *64 for the investment tax credit, is as follows: In light of the legislative directive to construe the term "tangible personal property" broadly and "the objective of the investment credit * * * to encourage modernization and expansion of the Nation's productive facilities and thereby improve the economic potential of the country", S. Rept. 1881,
The majority, as well as the court in
Thus, the legislative history does not clarify the narrow problem we deal with herein.
The majority's holding destabilizes existing law without substituting or improving the intrinsic value test with a coherent standard to fill the vacuum. Further, the majority finds fault with the court's interpretation in By focusing on whether a taxpayer's investment can be put to productive use in the absence of the tangible medium, the Sixth Circuit's approach would conceivably characterize both the information underlying a complex patent that could only be conveyed to and used by a purchaser if embodied in some tangible medium
To conclude, I would apply the doctrine of stare decisis in this case. Except for the court in
COHEN, CHABOT, GERBER, and LARO,
1. The stipulation of facts and accompanying exhibits are incorporated herein by this reference. The trial Judge made the following Findings of Fact, which we adopt.↩
2. Typically, a substantial portion of the time used in developing a computer program is spent in the design phase, with considerably less time spent on programming (typing or "keying in") the lines of source code.
3. For example, in the American Standard Code for Information Interchange (ASCII), the binary representation for the letter "A" is 01000001, and the binary representation for the letter "Z" is 01011010.↩
4. The surface of the computer disk or tape is magnetically encoded with the executable code by magnetizing the crystals or particles in the recording medium corresponding to the sequence of zeros and ones making up the binary system of executable code. For example, under the "nonreturn to zero inverted" (NRZI) encoding method, every zero is represented on the disk or tape by a magnet pointing in a certain direction, and every one by a magnet pointing in the opposite direction. The amount of information contained on a disk or tape is a function of the magnetic recording density of the disk or tape. The information on the disk or tape is interpreted by the computer when the magnetic bits are converted into electrical signals.
5. Although CD-ROM technology had been developed, it was not widely used as a means of distributing software during the years in issue. Further, during the years in issue, punch cards had become obsolete.↩
6. In some cases, the computer program source code (or a portion of it) was made available to petitioner to assist in making the desired modifications and in correcting program errors. In those instances, however, petitioner was not entitled to reproduce the source code for use outside the Norwest affiliated group.
7. Pursuant to the license agreements, petitioner was typically permitted to make a limited number of backup copies of each computer program for emergency purposes only.↩
8. The installation process was essentially the same for minicomputer software. A computer program would be received on magnetic tape, loaded onto the minicomputer, and tested for errors before being put into service. Additionally, both on-site and off-site backup copies were maintained. Computer programs for personal computers (PCs) were received on small diskettes (floppy disks) and loaded onto the PC's hard disk drive. Because PC software is significantly cheaper and easier to replace, petitioner did not make backup copies of PC software for off-site storage.↩
9. Some have suggested that the expansive definition of the term "tangible personal property" applies only in relation to fixtures or other items regarded as real property for certain purposes under local law because the examples presented in S. Rept. 1881, 87th Cong., 2d Sess. (1962),
1. I was the trial Judge in this case. The majority opinion adopted my findings of fact. The adopted findings of fact are accurate.↩
Texas Instruments Incorporated, Cross-Appellant v. United ... , 551 F.2d 599 ( 1977 )
Comshare, Inc. v. United States , 27 F.3d 1142 ( 1994 )
Walt Disney Productions v. United States of America, Walt ... , 480 F.2d 66 ( 1973 )
David E. Gantner and Sandra L. Gantner v. Commissioner of ... , 905 F.2d 241 ( 1990 )
Emi North America Holdings, Inc., Capitol Industries-Emi, ... , 675 F.2d 1068 ( 1982 )
bing-crosby-productions-inc-v-united-states-of-america-sussex-pictures , 588 F.2d 1293 ( 1979 )
Walt Disney Productions v. United States , 327 F. Supp. 189 ( 1971 )