Comptroller of the Treasury v. Equitable Trust Co.

Rodowsky, J., delivered the opinion of the Court. This is a sales tax case. It involves computer programs in the business data processing field. At issue is how the computer program license transactions presented here are to be conceptualized under the statute which reaches sales of "any tangible personal property.” Md. Code (1957, 1980 Repl.

Vol.), Art. 81, § 324 (f). Did the taxpayer, a computer user, acquire from the proprietors of canned, transactional computer programs 1. intangible personal property, namely, the right to use the programs, with copies of the programs transferred by the medium of magnetic tapes; or ⁴⁶¹ 2. intangible personal property, namely, "knowledge” or "information,” which was transferred to the taxpayer by the temporary medium of magnetic tape; or 3. tangible personal property, namely, magnetic tapes which had been enhanced in value by the copies of the programs coded thereon? Alternatives 1 and 2 result in no tax. An amicus, Data Processing Management Association, has raised the first alternative.

The taxpayer, Equitable Trust Company (Equitable), emphasizes the second analysis. The Comptroller urges the third position, which we adopt. As of September 16, 1974, Equitable entered into a written contract, delineated "License Agreement,” with Auxton Computer Enterprises, Incorporated (AUXCO). AUXCO granted Equitable a nontransferable and nonexclusive right to use a program, the "AUXCO Project Management System,” at a one-time price of $20,000.

There was no termination date. Equitable covenanted not to publish or disclose to any third person any information concerning the program and not to copy the program tapes or documentation except for internal use. Paragraph 10 of the agreement in part provided that "[l]egal title to the System shall remain with AUXCO, and [Equitable] agrees that AUXCO may repossess the System” upon breach by Equitable of its obligations. This program was acquired for use by Equitable’s systems and programming people in tracking project performance.

By a "License Agreement” of December 13, 1974 with PACE Applied Technology, Inc. (PACE), Equitable acquired the right to use two PACE programs in perpetuity. One was the "KOMAND Data Acquisition System” for the price of $10,800. The other was the "KOMAND Resource Billing System” for a price of $4,365. The agreement placed restrictions on Equitable’s disclosing PACE’s proprietary information.

The PACE programs were described in testimony as an accounting system which would allow Equitable to know exactly how much its computer and peripheral equipment ⁴⁶² were used for running specific applications, such as the main deposit program or the time deposit program. - During an audit in 1975, the Comptroller assessed sales tax against Equitable based upon the prices paid pursuant to the foregoing agreements. That assessment was affirmed by a hearing officer in the Sales Tax Division whose decision was affirmed by the Maryland Tax Court. On appeal to the Baltimore City Court (now the Circuit Court for Baltimore City), the assessment was abated. That court concluded as a matter of law that the dominant purpose or essence of the transactions was the programs and that computer programs are intangible.

The Comptroller appealed to the Court of Special Appeals. 1 We issued the writ of certiorari on our own motion prior to consideration of the matter by the intermediate appellate court. (1) Before the legal contentions can be considered, some fundamentals should be stated. A computer is a machine. It does not think.

It is designed to execute predetermined instructions. Ultimately a "program” is a set of such instructions. An "applicational program,” as we shall use the term, is a set of instructions that will cause the machine to perform a specific task. An example from the banking field would be a program which listed certain information with respect to each installment loan account for which any payment was delinquent.

Unless otherwise specified, "program” as used in this opinion will mean an applicational program. 2 ⁴⁶³ Development of a program requires knowledge, time and effort. A program may be said to exist in different levels of language and in different physical forms. Theoretically, a program could exist in the mind of the programmer, but, as a practical matter, programs as obviously complex as those involved here must be recorded somewhere in some physical representation. In human readable form on paper, this representation might be in a procedure oriented language, e.g., COBOL or FORTRAN, in a symbolic language, or in machine language.

"Machine language ... is a series of numbers, letters of the alphabet, or special characters that are used to represent bit [(binary digit)] patterns which can be recognized by the computer and cause specific operations to take place.” W. Fuori, Introduction to the Computer, at 270 (2d ed. 1977). Symbolic language is "very closely related to machine language in that, in general, one symbolic instruction will translate into one-machine language ⁴⁶⁴ instruction.” Id. at 273. The representations might also be in machine readable form as a code on tape, disc or punched cards. The code might directly represent procedure oriented language or symbolic language which may be converted into machine instructions by operational programs called compliers or assemblers.

The machine readable representation might also be in machine instructions, the binary code which the machine executes. See generally Gemignani, Product Liability and Software, 8 Rutgers J. Computers, Tech. & L. 173, 181-183 n.27 (1981). The programs involved here are stipulated to be existing, prepackaged programs of general application, called "canned” programs. The stipulation further states: The programs assessed were not developed exclusively for use by Equitable but were developed to be sold to many different purchasers.

None of the assessment for computer software relates to programs specially designed and developed exclusively for Equitable [, i.e., a custom program]. The advantage to a computer user of a canned program is that the user need not start from the beginning in developing the particular program. Reinventing the wheel is avoided. However, because the developer or proprietor is marketing a program for use by many different organizations of the same general type, and possibly for use on machines of various manufacture, there will ordinarily be a need for a particular user to make some adaptations in a canned program to meet the specifics of that user’s situation.

Equitable made some adaptations, but they are not described in evidence. Each program received by Equitable was delivered to it on magnetic tape. This means that the proprietor of the program made a copy of it, directly or indirectly, from a master which was in some physical form. The physical form of the program copies, as delivered, was a coded series of magnetic impulses.

Each code was readable by Equitable’s computer ⁴⁶⁵ and seems to have been in machine instructions. 3 Equitable loaded the program copy tape into computer memory and started the process of adaptation. At that point, Equitable had no further need for the particular copy delivered from the standpoint of instructing its computer. That copy, however, was retained by Equitable. 4 In order for a program to instruct computer execution, the magnetic tape copy of the program is loaded into memory. "In loading a program, nothing is taken from the storage media and nothing is added to the memory; rather, the user’s computer reads the storage media and rearranges its memory to create a corresponding pattern of magnetic impulses.” Note, Software and Sales Taxes: The Illusory Intangible, 63 B.U.L. Rev. 181, 189 (1983) (the B.U. Note) (Emphasis in original.

Footnote omitted.). See also Note, Software Taxation: A Critical Reevaluation of the Notion of Intangibility, 1980 B. Y.U.L. Rev. 859, 871-72. The process of making changes to a program also takes place while the program is in memory. Equitable did not store the reproductions of the subject programs, or any adaptations thereof, in memory when they were not in use.

They were stored peripherally. On any day when adaptations were made to a program, Equitable represents that it produced at least two tapes of the program, as changed. One was for storage on the computer premises, and the other was for storage off premises. ⁴⁶⁶ (2) The Comptroller’s position is that Equitable acquired tapes containing program copies. Magnetic tapes are tangible personal property.

Acquisition of such tapes under the license agreements is a sale, because Art. 81, § 324 (d) provides that "sale” means "any transaction whereby title or possession, or both, of tangible personal property is or is to be transferred by any means whatsoever for a consideration including rental, lease, or license to use ....” Amicus says that the transaction is a license to use the program, and that such a license is a form of intangible property. Equitable contends that the predominant purpose or essence of the transaction governs classification of the sale as involving either tangible or intangible property. In the transfer of computer programs via magnetic tape, the purpose is to obtain the program, an intangible, and not the tangible tape. In taking this position, Equitable is supported by the overwhelming numerical majority of reported cases applying tax statutes restricted to tangible personal property.

This Court has dealt with the taxation of programs once before. Computer software was involved in Greyhound Computer v. St. Dep't. 271 Md. 674, 320 A.2d 52 (1974), an ad valorem tax case. The property consisted of a computer, clearly tangible, and associated software, all of which had been acquired at a single price — a "bundled” transaction. Included in the software were programs, educational services and systems engineering services.

The assessment had utilized the cost of the bundled transaction, without any allocation.-We remanded for allocation between tangible and intangible property. What Greyhound teaches with respect to tangibility of programs is a subject on which unanimity is lacking among other courts and commentators. Later in this opinion we shall return to Greyhound for a more detailed analysis. ⁴⁶⁷ (3) The starting point for our legal inquiry is the effect of the license agreements. There is no evidence that the subject programs are patented, or are part of any patent, even if we assume that programs can be patented.

Nor is there any evidence of copyright. 5 Indeed the "license agreements” involved here were made years prior to the Software and Copyright Amendment of 1980, Pub. L. 96-517, 94 Stat. 3015, 3028 (codified at 17 U.S.C. §§ 101 , 117). One purpose of the license agreements is to protect, by reliance on the law of trade secrets, the economic interest of the proprietors in the expression of the programs and in any ideas embodied therein. The proprietors do not want some pirates to be the ones making money from the proprietors’ having developed the programs.

Furnishing Equitable with a complete copy of each program on tape destroyed, as to Equitable, any secrecy in program expression. With a program copy on tape, Equitable was in a position to make further copies and to distribute them commercially, unless Equitable were contractually restricted. See Root, Protecting Computer Software in the ’80s: Practical Guidelines for Evolving Needs, 8 Rutgers J. Computers, Tech. & L. 205, 225-29 (1981); R. Bernacchi & G. Larsen, Data Processing Contracts and the Law, at 74 (1974); cf. Space Aero v. Darling, 238 Md. 93, 110 , 208 A.2d 74, 82 , cert. denied, 382 U.S. 843 , 86 S. Ct. 77 , 15 L. Ed. 2d 83 (1965) ("A trade secret owner, however, does not abandon his secret by a limited public publication for a restricted purpose.”). 6 ⁴⁶⁸ Space Aero viewed breach of contract to be one basis for the law of trade secrets, in addition to abuse of confidence or impropriety in the means of procurement. 238 Md. at 113 , 208 A.2d at 84 . Here Equitable was willing to pay for copies of the programs on magnetic tape which the proprietors were willing fully to disclose to Equitable, if Equitable contractually restricted its use.

Consequently, the licenses involved here do not grant intangible rights from the proprietors to Equitable. The licenses simply erect contractual limitations on the use which Equitable might otherwise make of the statutorily unprotected program copies it acquired by proper means. 7 But while neither "license agreement” purports to transfer absolute legal title to anything, not even to the specific magnetic tapes used to deliver the program copies, Equitable has the right to use the specific tapes. This is a sale of the tapes under Art. 81, § 324 (d). (4) Equitable’s principal argument is that this Court should conceptually sever the program copy contained on the magnetic tape from the tangible tape itself.

The argument is that the transaction should be viewed as operating on two levels, one the transfer of intangible knowledge or information and the other the delivery of a tangible tape. To have a scalpel for this legal surgery, it would be necessary for us to adopt as part of Maryland sales tax law a principle that the buyer’s predominant purpose for a transaction controls the classification of the acquisition as either tangible or intangible. Quotron Systems v. Comptroller, 287 Md. 178 , 411 A.2d 439 (1980) recognized a predominant purpose test as one of several factors in determining use tax applicability to the type of transaction presented there. That taxpayer undertook concurrently to render two types of interrelated ⁴⁶⁹ performances.

One was to maintain and continuously to update a computerized data bank of economic information, such as the selling prices of securities, which its customers could randomly access through remote terminals. The other was to install Quotron-owned hardware, including the remote terminals, on customers' premises for their use in requesting and receiving electronic transmissions of the economic data. We held that the first analytical step was to characterize the performances as a single, overall function, either rental of equipment or the provision of services. Id. at 186 , 411 A.2d at 443 .

The dominant purpose was to obtain services and not to rent hardware. Based on that factor, on the taxpayer’s retention of control over the hardware, and on the fact that Quotron’s hardware could not be obtained without subscribing to the service, we concluded that the transaction was the provision of services. Id. at 188 , 411 A.2d at 444 . This approach is quite similar to that which we have used to determine whether a contract of sale is one for goods or for services under Art. 2 of the Uniform Commercial Code, where the performance involves both.

See Anthony Pools v. Sheehan, 295 Md. 285 , 455 A.2d 434 (1983); Burton v. Artery Company, 279 Md. 94 , 367 A.2d 935 (1977). Quotron did not say that the dominant purpose of obtaining data made the subject of the contract intangible because information is intangible. The rule of Quotron has been implicitly applied in the case at bar on an aspect which is not disputed by Equitable. In addition to providing program copies on tape, each proprietor agreed to furnish certain installation services.

AUXCO also contracted to furnish a limited amount of training within the fixed contract price. Equitable does not argue, however, that these services predominate. 8 Any intel ⁴⁷⁰ lectual effort rendered in the past in developing the programs is now embodied in the products for sale, the copies of the programs. That effort is reflected in the price for the copies just as engineering costs of a model of a television receiver are part of the selling price of a particular unit of that model. We have no doubt that the dominant purpose of the subject transactions was to obtain a copy of the programs.

But there are problems in adopting a dominant purpose test in order conceptually to sever information or data from the physical medium employed to deliver a copy of the information, and next to declare that the information predominates, so as thereby to classify the transaction as a sale of intangible property. One factor used in determining the dominant purpose is the admittedly insignificant value of a blank magnetic tape when compared to the price paid for a program copy on tape. But § 324 (i) defines "price” to mean the aggregate value in money ... promised to be paid or delivered by a purchaser to a vendor in the consummation and complete performance of a retail sale without any deduction therefrom on account of the cost of the property sold, cost of materials used, labor or service cost, or any other expense whatsoever. While Equitable points out that the question of price is not reached unless it is first determined that property sold is tangible, the legislative policy embraced in the definition of price runs contrary to the conceptual severing of the insignificant blank tape from the valuable program copy superimposed thereon as magnetic impulses.

A second concern is the precedent established for apparently comparable transactions. If the dominant purpose is to obtain knowledge, information or data which thereby results in severing the dominant purpose object from the physical medium of transfer, the analogy to books, motion picture films, video display discs, phonorecords and music tapes immediately comes to mind. In sales of the lat ⁴⁷¹ ter, the purchaser’s dominant purpose ordinarily is to obtain the knowledge, information or data thereby conveyed. While the book is in human readable form, the other media are machine readable.

A purchase of any of these information conveying media is within the imposition of the sales tax as tangible personal property. Such transactions escape taxation only if there is an applicable statutory exclusion or exemption. These analogies, however, have been argued to other courts which have held that tape copies of programs are intangible. We turn now to a consideration of the rationale of those opinions.

(5) The earliest decision, which set the tone for the later cases, is District of Columbia v. Universal Computer Associates, Inc., 465 F.2d 615 (D.C. Cir. 1972). It involved a property tax on hardware which was assessed based on the cost of a bundled IBM data processing installation. Two programs were included, one the usual standard program and the other a custom tax program. Both programs were on punched cards.

The court stated the legal issue to be "whether the two sets of punched cards (the software) represent tangible personal property ... or whether they represent intangible values which are not subject to tax.” Id. at 617 . The custom program was said to be basically a service. However, the canned program was said to represent "an investment of IBM in an intellectual property, which it licenses users like Universal to employ in the computers IBM sells.” Id. at 618 . Another factor of significance to the court was that [t]he punched cards themselves are placed in the machine and then taken out, and in fact could be returned to IBM.

It is the information derived by the machine from the cards which stays in the computer, and which is employed repeatedly by the machine when it is used by [the taxpayer]. What rests in the machine, then, is an intangible — ⁴⁷² "knowledge” — which can hardly be thought to be subject to a personal property tax. The only visible evidence of that knowledge, the punched pasteboard, could be stacked in a warehouse, returned to IBM, or destroyed, without interfering with the efficiency of the computer machine to perform its designed function. [Id.] Here the court is talking about memory in the computer. What rests in a programmed memory is not "knowledge” in any true sense of the word, but machine instructions.

Further, the taxability of a sale of a canned program copy should not turn on whether the buyer stores the program in memory. A tax system cannot be administered dependent upon whether or not, at the time of the transaction, the buyer’s intent is to store the program continuously in memory. Nor should taxability turn on the capacity of memory of the buyer’s machine; otherwise, program copies bought for large storage machines would not be taxed, but those for small storage machines would be taxed. The District of Columbia Circuit also concluded that both programs were to be likened to cartoon mats which had been involved in Washington Times-Herald v. District of Columbia, 213 F.2d 23 (D.C. Cir. 1954).

Cartoon mats are the medium by which a cartoonist’s drawings are transferred for reproduction in newspapers. Washington Times-Herald held that the sale of one time use of the mats was a sale of professional and personal services, because the price was paid for the work of the artist and not for the mats which had inconsequential value. Professor Jerome R. Hellerstein in his article, The Scope of the Taxable Sale Under Sales and Use Tax Acts: Sales As Distinguished From Services, 11 Tax L. Rev. 261 , 275 (1956) has criticized the holding in Washington Times-Herald , saying that "[t]his rationale and holding undercut much established sales tax law.” (Footnote omitted.) An assessment of sales tax on the transfer of custom and canned, applicational programs, and of two operational programs, was abated in Commerce Union Bank v. Tidwell, 538 ⁴⁷³ S.W.2d 405 (Tenn. 1976). The Tennessee court adopted all of the reasons advanced in Universal Computer, supra, including the characterization of a programmed memory as intangible knowledge, and added some additional reasons, the first of which may be called the alternative methods approach.

A computer might be programmed without purchasing a copy of a program on any tangible medium. With appropriate equipment at both termini, a program could be reproduced in memory from electronic impulses conveyed over telephone lines; or the proprietor, working from a human readable copy which is not transferred to the customer, could manually type the program into the computer for compilation into machine instructions. Whether these alternatives are ways in which the business of selling programs is actually conducted need not presently concern us. Of significance is that the alternative methods approach does not determine taxability on the basis of a transaction’s actual facts.

The tax collector argued the phonorecord analogy in Commerce Union Bank . In distinguishing, the Tennessee court said that the buyer has no viable method of bringing the particular music into his living room other than by the record, whereas the above-described alternative methods are available for acquiring programs. Secondly the court stated flatly that the tape containing the program copy "is not retained in the possession of the user.” Id. at 408 . This latter point is contrary to Equitable’s representation of the facts in the instant matter.

More importantly, intangibility should not be determined by the extent of use. After all, a book that is read only once is and remains tangible personal property. The court also said that the phonorecord is complete and ready for use at the time of purchase, while a program copy on tape "must be translated into a language understood by the computer.” Id. We are at a loss to understand this distinction.

A computer user purchases a canned program copy on tape because it is considered to be sufficiently compatible with the user’s machine to be read by it and, either directly or after having been compiled, executed by it. ⁴⁷⁴ In 1977, an Alabama intermediate appellate court held that no use tax was payable on canned program copies acquired in the form of punched cards and magnetic tapes, because the purchase was of "the knowledge which went into the development of the eight programs, not the tapes and cards themselves.” State v. Central Computer Services, Inc., 349 So. 2d 1156, 1159 (1977). In part because the cards were destroyed and the tapes were returned after copies had been made on discs, the court conceptually severed the programs from the tangible media on which they had been copied by the proprietor for delivery to the buyer. This judgment was affirmed by the Supreme Court of Alabama in a 5-3 decision. State v. Central Computer Services, Inc., 349 So. 2d 1160 (1977).

The majority relied on the alternative methods analysis to distinguish that court’s holding in an earlier case that the lease of motion picture films for exhibition was subject to sales tax. The dissenting judges pointed out that films can be transmitted by telephone lines or radio waves, so that the prior holding was not distinguishable. The Arizona intermediate appellate court, in a 1977 decision, simply referred to computer software, including programs, as intangible property in a property tax case. Allocation was directed as to the assessment of a hardware manufacturer whose inventory had been valued from list prices for bundled installations.

Honeywell Information Systems, Inc. v. Maricopa County, 118 Ariz. 171 , 575 P.2d 801 (1977). The court made no analysis of the intangibility issue. The authorities relied upon by Equitable also include cases that involve contracts with keypunch operations rather than software purchases. In Bullock v. Statistical Tabulating Corp., 549 S.W.2d 166 (Tex. 1977), a sales tax case, customers brought copies of their business records to the taxpayer whose employees typed out on keypunch machines the data reflected on those copies to produce machine readable cards for use with the customers’ computers.

The taxpayer supplied the cards. It was held that "the true object of this transaction is not the data processing card ... but the purchase of coded or processed data, an ⁴⁷⁵ intangible.” Id. at 168 (emphasis in original). Obviously, the customers were not acquiring any new data. They were simply paying to have produced from a copy of the data furnished in human readable form another copy of the same data in machine readable form.

Janesville Data Center, Inc. v. Wisconsin Department of Revenue, 84 Wis. 2d 341, 346 , 267 N.W.2d 656, 658 (1978) is to the same effect ("[E]mbodied in the cards, tapes, and print-outs is the essence of the transaction ... the purchase of coded or processed data, an intangible.”). These courts seem to treat the machine readable form of the data as controlling intangibility. Neither opinion discusses the machine readable only, commercially purveyed, phonorecord or