Surprise Inside

The software buried deep within business machines can be a tax saver.

As any collector of Patek Philippe watches or Shelby Cobras will tell you, when it comes to machines, it’s what’s inside that counts.

This is also true when it comes to the tax treatment of what’s inside machines.

These days, most industrial or office machines — even dishwashers, for that matter — come bundled with embedded software. In some cases, the firmware, which typically sits on single microprocessor boards, helps the machines perform dedicated tasks more efficiently (network routers, for example). In others, embedded operating systems actually control the devices (certain computers, ATMs).

Here’s where the story gets interesting for non-geeks. Most states treat capital equipment as property, and thus tax those assets at rates ranging from 1 percent to 8 percent. But in theory, a machine’s embedded software — like any other intangible property — should not be subject to the levy. And in fact, a number of states currently offer an exemption from property taxes on the programs that drive capital equipment (see “Tax Code?” at the end of this article). Since sophisticated software often makes up the lion’s share of a machine’s overall value, experts say the tax savings can be sizable — particularly for small-to-midsize businesses. Notes Tom Cottrell, a partner at BKD LLP, a regional accounting firm based in Springfield, Mo.: “People underestimate what a significant component software is to so much new equipment.”

That can be a costly oversight. Tax experts say some finance managers are simply unaware of the exemption for embedded software. Those who do know aren’t always sure what monetary value to place on the programs. The problem is compounded by equipment vendors, which rarely break out the worth of firmware in a sales receipt. As Cottrell notes: “The hitch [in taking the exemption] is figuring out a way to explicitly value the software.”

Hard to Figure

Managers at Indiana Ohio Heart can speak to that point. In the past year, the private physicians’ practice in Indiana purchased four ultrasound devices worth $1 million. Managers at the health-care provider wanted to exempt the value of the firmware from the total price of the equipment for property-tax purposes. But the manufacturer of the machines failed to state the worth of the software on its invoice, complicating the process.

In April, however, the Indiana state legislature passed a law permitting third-party valuation of embedded software for property-tax purposes. The physicians group immediately brought in Pellegrino and Associates, a valuation specialist started by a former finance chief at a software-development company. The firm appraised the value of the software within the new ultrasound equipment, significantly reducing the price of the equipment for tax purposes. Mike Pellegrino, founder of the eponymously named valuation firm, says embedded programs make up between 20 and 50 percent of the total purchase price of an ultrasound machine, depending on the model and its features.

Consultants like Pellegrino have been busy since Indiana passed the third-party valuation law. In the past year, Pellegrino has assessed the software housed within a host of different machines, including telephone systems, networking switches, DVD-manufacturing equipment, gasoline pumps, point-of-sale terminals, printing machines — even egg sorters. Firmware is amazingly ubiquitous — Pellegrino says Caterpillar tractors are candidates for his valuation service.

Such introspection can pay off. Assuming an 8 percent property tax, a company that purchases a $2 million piece of equipment can pare $80,000 from its tax bill — not exactly small potatoes for small businesses. “You’re paying $80,000 a year in property tax that you don’t have to,” asserts Pellegrino.

Nevertheless, a lot of companies seem willing to take the hit. Admittedly, claiming the software exemption can be a tricky business. Complications abound. Of the 21 states that permit the tax break, each has a different approach for valuing embedded software. In a number of tax jurisdictions, it’s not entirely clear if a third-party appraisal is acceptable evidence of value, because no precedent has been established.

Moreover, some states exempt software applications but not operating systems. And several states follow the federal government’s position on the subject: that is, they grant the exemption only if a machine’s manufacturer demonstrates the embedded software value in an invoice. Says one valuation expert: “The laws are all over the place.”

Can’t — or Won’t?

Getting manufacturers to document the value of embedded software, consultants contend, would solve many of the problems. Getting manufacturers to donate 50 percent of their net profits to Save-the-Kittens would also be swell, but, like the first scenario, it’s not likely to happen anytime soon.

The reality is, many equipment makers don’t want anyone — most notably, competitors — to know the value of the firmware in their products. And plenty of manufacturers don’t rightly know the value of the software, or greatly undervalue it for their own tax purposes. One consultant recalls a recent conversation with a project manager at a European-based manufacturer of fuel-dispensing equipment. During the talks, the manager stated that the company values the software within its systems based on the cost of the microchip the program sits on. In other words, about a buck. Says the consultant: “That’s ridiculous when you consider the $15 million development effort behind the software.”

Russ Banham is a contributing editor of CFO and author of The Ford Century.

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