MEMORANDUM
TO
Walter Marquez
Office of the Trustees of the California State University
FROM
Winnie Tsien
DATE
February 15, 2006
RE
Financing Computer Software in Connection with Equipment Commercial Paper Program
We have been asked to provide some tax guidance to campuses and other organizations within the
California State University system (each, a “Borrower”) that may want to participate in the
equipment commercial paper program (“TXCP Program”) of the Trustees of the California State
University (the “Trustees”) for the purpose of financing computer equipment and software. The
TXCP Program, which is still being finalized, is intended to provide short-term, low-interest
financing through the issuance of commercial paper, the interest on which is excluded from gross
income for Federal tax purposes. In order for the interest on the commercial paper to be so
excluded, certain requirements regarding the character and use of such property must be met.
Capital Asset, Ownership and Use.
Acquisition of computer hardware and software is generally treated as a capital cost, on the basis
that the purchase price of such property is not a currently deductible expense (which would be
considered working capital).
Computer hardware is often purchased in an outright sale, with title passing to the acquiring
Borrower or the Trustees. Computer software, in contrast, is generally acquired pursuant to a grant,
license or use agreement. Software developers and sellers have represented to us in the past that a
grant or a license by the Borrower to use the software is the same as ownership by the Borrower,
but subject to certain continuing restrictions. The grant or license can be revoked if the user fails to
comply with those restrictions, such as by participating in unauthorized duplication or distribution.
Notwithstanding the form, we have concluded that the user (such as the Borrower) would be treated
as the owner of such software for federal tax purposes.
Similar to other property financed with tax-exempt debt, the computer hardware and software
financed under the TXCP Program may not have an impermissible amount of private use. The
current expectation is that only entities directly controlled by the Trustees, including Borrowers that
may be auxiliary organizations, will be using the property financed through the TXCP Program.
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Useful Life.
An important tax parameter for the TXCP Program is determining the useful life of the property
being financed. The expected useful life helps determine the permitted weighted average life of the
TXCP Program.
Computer hardware is generally treated as five-year property pursuant to Section 168(e) of the
Internal Revenue Code of 1986 (as amended, the “Code”).
Conventional computer software has a useful life of three years,1 beginning the date the software is
placed in service. The Borrower, however, can provide a longer reasonably expected useful life,
based on its particular facts and circumstances. “Substantially modified” software may qualify for a
15-year amortization period if it meets certain requirements set out in Section 197 of the Code.
Stated in the negative, the Code provides that software eligible for a 15-year amortization period
cannot be “computer software that is readily available for purchase by the general public, is subject
to a nonexclusive license, and has not been substantially modified.”
Ancillary Services.
Computer software generally consists of two components: the actual computer software (either in
disk form or in code that is “written” into the hardware), and ancillary services in connection with
the software. Ancillary services can be further divided into at least two categories: installation and
post-installation.
Installation services include all tangible and intangible items and services that are necessary to the
use and integration of the software to the hardware. Such services have included planning, testing,
installation consulting, training and implementation support. We have permitted the financing of all
of these services as being considered part of the cost of the initial software.
Only some post-installation services can be financed on a tax-exempt basis; see “Prepayment”
below. Post-installation services are those that are provided after the software has been successfully
tested and integrated into the user’s system. They include general consulting that occurs after
installation, help line services, field support and other support services. If it is determined that a
post-installation service needs to be excluded from tax-exempt financing, we will need to obtain
from the provider a cost allocation for that service (in order to exclude it from the total costs).
Sometimes, these services are treated by the provider as being “bundled” together with the software
acquisition and are considered to be an integral part of the cost of the software itself. In these cases,
we will need to obtain a certification from the provider that such services cannot be priced
1
See Section 167(f) of the Code.
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separately from the cost of the software in order to treat them as part of the software cost (and
therefore financeable under the TXCP Program).
Ancillary services also commonly include periodic upgrades to the software for a fee. The fee is
generally paid at the time of initial software acquisition, even though the upgrades will not be
delivered until some time later. As we understand the current practice, the exact nature of the
upgrades is sometimes uncertain at the time of the initial software acquisition. If the upgrades take
the form of the original software (i.e., disk or code), then they can be financed under the TXCP
Program.
Ancillary Services Provided by CSU Employees.
Some of the above-described services that are performed by employees of the California State
University system (and not outside contractors or vendors) may be eligible to be financed through
the TXCP Program. Those will likely be installation-related ancillary services. Post-installation
services, such as ongoing efforts to troubleshoot or maintain the software, and costs attributable to
general administrative or normal office overhead will likely not be eligible to be financed.
For qualifying services, the time and description of work performed should be separately tracked.
There should be detailed recordkeeping regarding that activity, such as through timesheets, even
though they are not specifically required.
Prepayment for Product or Services.
Sometimes related to ancillary services is prepayment for products or services in connection with
computer software. Any payment made at the time of initial acquisition of the software for services
and product to be provided in the future may be financed under the TXCP Program if certain
requirements are met. If the requirements are not met, the prepayment can be considered an
impermissible loan or investment under the Federal tax rules, and may lead to yield restriction of
amounts that the Borrower or the Trustees may consider to have been spent already.
Generally, prepayments may be financed under the TXCP Program if they are made on substantially
the same terms, by a substantial percentage of persons who are similarly situated to the Borrower or
the Trustees, but who are not beneficiaries of tax-exempt financing. The relevant tax authorities
also provide a similar, but more specific, exception for computer software products: prepayments
may be made for updates or maintenance or support services with respect to computer software,
provided that the same maintenance, repair, extended warranty, updates or maintenance or support
services, as applicable, are regularly provided to nongovernmental persons on the same terms.
Note that an inquiry to the provider regarding the provider’s business practice is required in order to
obtain the certification described above. In general, we have found that prepayment offers extended
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by suppliers often meet this requirement. However, there are smaller computer software providers
that may not have the necessary business base to make such a certification.
cc: Larry D. Sobel
Rick Hiscocks
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