MEMORANDUM NO. 99-13
 

TO:	Chief Fiscal Officers/Vice Chancellor
FROM:	Edward Renfrow State Controller
SUBJECTS:	I. BACKUP WITHHOLDING OF FEDERAL INCOME TAX II. PARTIAL REPEAL OF THE STATE’s 4% NONRESIDENT WITHHOLDING TAX III. MAGNETIC AND ELECTRONIC REQUIREMENTS FOR YEAR 2000 INFORMATION RETURN REPORTING IV. PAYMENTS TO ATTORNEYS V. REPORTING QUALIFIED TUITION AND RELATED EXPENSES FOR 1999 IV. SALES TAX ON COMPUTER SOFTWARE

I. BACKUP WITHHOLDING OF FEDERAL INCOME TAX

In October, the IRS will issue CP2100 notices for 1099 information returns filed for tax year 1997. These CP2100 notices will detail vendors and TINs that are not in agreement with the information that is on file with either the IRS or the Social Security Administration. IRS procedure requires each agency to compare its records with the information furnished by the IRS. This comparison is a legal requirement; it is not subject to management discretion. The agency must obtain a certified TIN within 30 days of receipt of this notice. The certified TIN is obtained on a Form W-9. Vendors that appear on the CP2100 list for two out of three years must be subject to immediate backup withholding. Backup withholding must continue until the IRS notifies the agency to stop withholding. This notification is made on an IRS Letter 147C or SSA Form 7028.

Agencies that receive CP2100s will eventually receive IRS 972CG notices; usually in August of the following year. 972CG Notices are notices of proposed assessment. The IRS uses these notices to propose an assessment based on the number of mismatches that were reported on the magnetic tapes or paper 1099 forms. To avoid paying a penalty, the agency is required to show that due diligence was followed. The due diligence requirements along with a detailed discussion of backup withholding is found on the SIG at http://www.osc.state.nc.us/OSC/sigdocs/sig_docs/1099_withholding.html .

OSC personnel have compared vendors listed on the recently received 972CG notices with the vendor name and TIN combination on the NCAS. In many cases, vendors that were identified as mismatched, erroneous or incomplete on the IRS notices were still being carried in the statewide vendor file with the same incorrect information. Therefore, please have your staff review any IRS CP2100 notice that you receive in October and follow the procedures set forth at the above web site. Set to inactive or delete any vendor not corrected during your review or make that vendor subject to federal backup withholding if a certified W-9 is not received within the prescribed time period.

II. PARTIAL REPEAL OF THE STATE’s 4% NONRESIDENT WITHHOLDING TAX

The two Houses of the General Assembly have agreed on legislation (HB1318) that would repeal the 4% nonresident withholding tax to the extent it applies to construction contractors retroactive to January 1, 1998. G.S. 105-163.1(2), as amended, requires the withholding of 4% of any amount paid for personal services provided by a nonresident contractor in connection with a performance, an entertainment, an athletic event, a speech, or the creation of a film, radio, or television program. HB 1318 also changes the threshhold for the commencement of the withholding requirements. Subsection (a) now states that compensation of more than $1,500 during a calendar year paid to a nonresident contractor performing the above services shall be subject to the law.

Agencies and universities should have implemented this State legal requirement beginning January 1, 1998. All other definitions and requirements that were set out in the original legislation ratified by the 1997 General Assembly, have been retained in the law with the exception of raising the dollar limitation from $600 to $1,500 and exempting service in connection with the construction and repair of a building or highway.

Agencies that have withheld tax on payments that are no longer subject to the law may refund these payments to the contractors, provided the money has not already been remitted to Revenue. All tax withheld prior to June 30, 1998 should have already been remitted, so that we are only talking about tax withheld July 1 to the present. All vendors that had tax withheld from payments, and not subsequently refunded, should receive a Form 1099-MISC or a NC1099PS at year-end.

III. MAGNETIC AND ELECTRONIC REQUIREMENTS FOR YEAR 2000 INFORMATION RETURN REPORTING

In preparation for year 2000, the IRS has issued Announcement 98-5, I.R.B. 1998-5, 25. This announcement sets forth changes in the date fields for information returns that are magnetically or electronically filed to the Martinsburg Computing Center. Two-digit date fields (YY) will be expanded to four digits (YYYY), and six digit fields (MMDDYY) will be expanded to eight digits (MMDDYYYY). IRS Publication 1220 will incorporate these mandatory changes for the 1998 returns due to be filed February 28, 1999.

IV. PAYMENTS TO ATTORNEYS

Attorney fees of $600 or more paid in the course of your trade or business are reportable in box 7 of Form 1099-MISC (same as last year). However, for 1998 and later years, if you make a payment to an attorney in connection with legal services and the attorney’s fee cannot be determined, the total amount paid (gross proceeds) must be reported in block 13 with new code A. You are required to obtain the attorney’s TIN.

The exemption from reporting for payments made to corporations no longer applies to payments for legal services. Payments to legal corporations will be treated the same as individuals and partnerships.

Gross proceed payments made through the NCAS should be coded B1 in the 1099 field for reporting in block 13 of the Form 1099-MISC. For service payments, you should continue to use M7 in the 1099 field. The fields used on the 1099-MISC forms will be determined by the code used in the NCAS 1099 field. If the attorney’s SSN or EIN is not provided, backup withholding is applicable.

V. REPORTING QUALIFIED TUITION AND RELATED EXPENSES FOR 1999

IRS Notice 98-46, dated 8/20/98 has extended the provisions of IRS Notice 97-73 to information reporting required by institutions of higher learning to the 1999 calendar year reporting. As you remember, the Taxpayer Relief Act of 1997 added Code Section 6050S to the Internal Revenue Code. This section required the filing of information returns to assist taxpayers and the IRS in determining the Hope Scholarship credit and the Lifetime Learning credit that the taxpayer is allowed to claim.

IRS Notice 97-73 requires the Form 1098-T, Tuition Payments for calendar year 1998 to include the following:

1. the name, address, and TIN of the eligible educational institution,
2. the name, address, and TIN of the student,
3. an indication of whether the student was enrolled for at least half the full-time academic workload during any academic period commencing in 1998, and
4. an indication as to whether the student was enrolled exclusively in a program or programs leading to a graduate degree, graduate level certificate, or other recognized graduate level educational credential.

1. aggregate amount of qualified tuition and related expenses (not including certain expenses related to sports, games or hobbies, or nonacademic fees). The qualified tuition and related expenses should be reported without adjustments for nontaxable grant aid or scholarships.
2. grant amounts received for payment of cost of attendance that was processed through the institution. The institution is not required to report on grant aid paid directly to student and not processed through institution.
3. the aggregate amount of refunds and reimbursements paid through the institution.

The OSC has received several inquiries as to the sales tax treatment of custom computer software following changes enacted by the 1997 session of the General Assembly. These changes are effective for purchases made on or after October 1, 1997. The following is a brief explanation of application of the sales tax rules to computer hardware, software, and maintenance agreements.

The sale of computer hardware is taxable as a sale of tangible personal property. This term includes computer software delivered on a storage medium such as a CD-ROM, disk or tape. Basic operating programs are subject to the sales and use tax.

Custom computer software is exempt from sales and use tax. "Custom software" means software written in accordance with the specifications of a specific customer, including a user manual or other documentation that accompanies the sale of the software. Canned software that has its source code modified will meet the definition of custom software, depending on the timing of the transaction.

The sales and use tax is a transaction tax and any modification to the software’s source code must occur prior to the sale or exchange in order to be exempt from sales and use tax. There is no percentage amount specified in the law for the amount of source code that must be changed in order to be exempt from tax. Therefore, any change to source code prior to the sale or exchange will exempt the transaction from the sales and use tax. The term source code does not include changes to configure hardware.

There is no prohibition in the law that prevents a transaction from being structured to avoid sales and use tax. If the vendor is engaged to modify the software after the sale, he could also be engaged to modify prior to the sale, thus exempting the sale from sales tax.

Canned Computer software is prewritten software that can be installed and executed with no changes to the software’s source code other than changes made to configure hardware or software. Canned computer software is subject to the sales and use tax.

Access Charges are separately stated charges for access to a computer program or database and are exempt from the sales and use tax.

Sale or Lease of Computer Hardware:
Optional computer maintenance agreement is one that the purchaser is not required to purchase from the seller or lessor and he is free to contract with whomever he chooses. Optional computer maintenance agreements providing for the furnishing of parts, labor, and materials to maintain hardware are not subject to sale and use tax. The repairer and not the customer must pay tax on the parts used to repair the hardware. If the repairer bills the customer for parts not included in the maintenance agreement, then the repairer must collect the tax from the customer and remit to Revenue.

Mandatory computer maintenance agreement is one the purchaser is required to buy as a condition of the sale or lease of the hardware. Mandatory computer maintenance agreements are subject to the sales and use tax. It does not matter if the maintenance agreement is a separate agreement or part of sale or lease of the hardware.

Sale or Lease of Computer Software:
Optional software maintenance agreement that provides only for the maintenance of the software being sold, leased or licensed is a sale of service and is not subject to the sales and use tax. The agreement may include support services such as consultants. The seller is liable for sales tax on the price of any software enhancement or update used in fulfilling the maintenance agreement.

Mandatory software maintenance agreements are subject to sales and use tax, even if the charge for the maintenance agreement is separately stated on the invoice.

Warranty Contracts:
Manufacturer’s Warranty is an explicit warranty the manufacturer extends to the purchaser as part of the purchase price of the new property. If the manufacturer uses a part to make a repair under a manufacturer’s warranty contract and the customer is not charged for the part, then the customer is not liable for the sales and use tax. Warranty deductibles also are not subject to the sales and use tax.

Dealer’s Warranty (a contract that extends beyond the manufacturer’s warranty period) is not subject to tax, but the dealer must pay sales and use tax on parts used in fulfilling the warranty contract. When the part is given without cost to the customer, the dealer must pay tax when it is withdrawn from inventory.

Revenue has not yet issued administrative rules covering the new sales tax law. However, they have provided the following responses to questions raised by the State Information Processing Center. These questions and answers are provided for your guidance in verifying that the software vendors are correctly charging the sales and use tax on software to your agency.
 

Question 1:	If the purchase of software is received electronically, with no physical carrier involved, is there are basis for applying sales tax to this purchase?
Answer 1:	No; since the software is not delivered on an article of tangible personal property such as a disk or CD ROM, a sale of tangible personal property does not occur. There is no specific levy on the sales and use tax laws imposing tax on information downloaded electronically.
Question 2:	Does this change if a second copy is sent on a physical carrier?
Answer 2:	Yes; since the computer software is delivered on a type of storage medium, it constitutes tangible personal property. The charges for the software would be taxable unless the software constituted custom computer software.
Question 3:	How is the sales and use tax applied to software contracts entered into before October 1, 1997, for which payment is spread over multiple years beyond October 1, 1997?
Answer 3:	It depends on the terms of the contract. If the software was exempt under pre October 1, 1997 law and no changes and modifications have been made and the payment constitutes no more than a renewal, then the software is generally exempt. Any change or acquision of a new or modified product will be taxed based upon the law in existance at the time of the acquisition or modification.

 
Should you have questions concerning the above, please call Randy Thomas at (919)981-5488. Thank you for your attention to this matter.