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Michigan Backs Off Cloud Tax, Refund Opportunities Available

After refusing to back down on the issue for years, the Michigan Department of Treasury (Department) issued guidance last week to taxpayers announcing a change in its policy on the sales and use taxation of remotely accessed prewritten computer software.  This comes after years of litigating the issue in the Michigan courts, most recently with the precedential taxpayer victory in Auto-Owners Ins. Co. v. Dep’t of Treasury, No. 321505 (Mich. Ct. App. Oct. 27, 2015), in which the Michigan Court of Appeals held that remote access to software did not constitute delivery of tangible personal property.  See our prior coverage here.  The Department has announced it will apply Auto-Owners (and the numerous other favorable decisions) retroactively and thus allow for refunds for all open tax years.  This is a huge victory for taxpayers; however, those that paid the tax (both purchasers and providers alike) must act promptly to coordinate and request a refund prior to the period of limitations expiring.

Implications

In issuing this guidance, the Department specifically adopts the Michigan Court of Appeals interpretation of “delivered by any means” (as required to be considered taxable prewritten computer software).  Going forward, the “mere transfer of information and data that was processed using the software of the third-party businesses does not constitute ‘delivery by any means’” and is not prewritten software subject to sales and use tax.  See Auto-Owners, at 7.  Not only has the Department admitted defeat with respect to the delivery definition, but it also appears to have acquiesced to taxpayers’ arguments with respect to the true object test (or “incidental to services” test in Michigan).  This test was first announced by the Michigan Supreme Court in Catalina Marketing, and provides that a court must objectively analyze the entire transaction using six factors and determine whether the transaction is “principally” the transfer of tangible personal property or the transfer of services with a transfer of tangible personal property that is incidental to the service.[1]  In last week’s guidance, the Department states that if only a portion of a software program is electronically delivered to a customer, the “incidental to service” test will be applied to determine whether the transaction constitutes the rendition of a nontaxable service rather than the sale of tangible personal property.  However, if a software program is electronically downloaded in its entirety, it remains taxable.  This guidance comes in the wake of Department and the taxpayer in Thomson Reuters, Inc. v. Dep’t of Treasury stipulating to the dismissal of a Supreme Court case involving the same issues that had been appealed by the Department.  In light of these developments, it appears that the Department has given up all ongoing litigation over cloud services.

Immediate Action Required for Refunds

Taxpayers who paid sales or use tax on cloud based services are entitled to receive a refund for all open periods.  In Michigan, the period of limitations for filing a refund [...]

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Precedential Cloud Victory in Michigan Court of Appeals

On Tuesday, a three-judge panel sitting for the Michigan Court of Appeals unanimously affirmed a lower court decision finding that the use of cloud-based services in Michigan is not subject to use tax in Auto-Owners Ins. Co. v. Dep’t of Treasury, No. 321505 (Mich. Ct. App. Oct. 27, 2015). While there have been a number of cloud-based use tax victories in the Michigan courts over the past year and a half, this decision marks the first published Court of Appeals opinion (i.e., it has precedential effect under the rule of stare decisis). See Mich. Ct. R. 7.215(C)(2). Therefore, the trial courts and Michigan Court of Appeals are obligated to follow the holdings in this case when presented with similar facts, until the Michigan Supreme Court or Court of Appeals say otherwise. While the ultimate outcome (i.e., not taxable) of the lower court decision was affirmed, the analysis used by the Court of Appeals to get there was slightly different and the court took the time to analyze over a dozen different contracts, as discussed below. Given the fact that a petition for review is currently pending in another Court of Appeals case (Thomson Reuters) decided on similar issues in 2014, it will be interesting to see if this development increases the Michigan Supreme Court’s appetite to hear a use tax case on cloud-based services. The Department of Treasury (Department) has approximately 40 days to request that the Auto-Owners decision be reviewed by the Michigan Supreme Court.

Facts

Auto-Owners is an insurance company based out of Michigan that entered into a variety of contracts with third-parties to provide cloud-based services. These contracts were grouped into six basic categories for purposes of this case: (1) insurance industry specific contracts, (2) technology and communications contracts, (3) online research contracts, (4) payment remittance and processing support contracts, (5) equipment maintenance and software customer support contracts and (6) marketing and advertising contracts.  The contracts all involved, at some level, software accessed through the internet. Michigan audited Auto-Owners and ultimately issued a use tax deficiency assessment based on the cloud-based service contracts it utilized.  In doing so, the Department cited the Michigan use tax statute, which like many states, provides that tax is imposed on the privilege of using tangible personal property in the state. See generally Mich. Comp. Laws Ann. § 205.93. The Department took the position that the software used in Michigan by Auto-Owners was “tangible personal property,” which is defined to include prewritten, non-custom, software that is “delivered by any means” under Michigan law. See Mich. Comp. Laws Ann. § 205.92b(o). The taxpayer paid the tax under protest and filed a refund claim, which was the focus of the Court of Claims decision being appealed.

Procedural History

At the trial court level, the Court of Claims determined that the application of use tax to the software used in Michigan by Auto-Owners would be improper. In doing so, the court issued three separate holdings—all in favor of the taxpayer. First, the court held that use tax [...]

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Three Strikes…Tax on Cloud Computing Out in Michigan?

If the Department of Treasury (Treasury) was hoping that the Michigan courts would simply overlook the previous two cloud computing losses this year in Thomson Reuters (previously covered here) and Auto-Owners (discussed here), they appear to have been mistaken.  Last Wednesday’s Court of Claims opinion in Rehmann Robson & Co. v. Department of Treasury marked the third Michigan decision this year to rule that cloud-based services are not subject to use tax in the state.  In Rehmann Robson, the Court of Claims found that the use of Checkpoint (a web-based tax and accounting research tool) by a large accounting firm was properly characterized as a non-taxable information service, despite Treasury’s continued effort to impose use tax and litigate similar cloud-based transactions.  This taxpayer victory comes just six months after the Michigan Court of Appeals in Thomson Reuters found that a subscription to Checkpoint was primarily the sale of a service under the Catalina Marketing test, Michigan’s version of the “true object” test, which looks to whether the use of tangible personal property was incidental to the provision of services when both are provided in the same transaction.  The Thomson Reuters decision reversed a 2013 Court of Claims opinion that granted summary disposition in favor of Treasury’s ability to tax the cloud-based service as “prewritten computer software.”

Analysis

While all three Michigan decisions issued this year reach the same conclusion, the most recent decision makes an explicit effort to affirmatively block any potential avenue Treasury may use to impose the use tax on cloud-based transactions.  For what it’s worth, the Rehmann Robson opinion was written by the same judge who wrote the Auto-Owners opinion released in March 2014, and contained an identical analysis.  Unlike the Thomson Reuters decision that found use of prewritten computer software in the state, but simply found it to be incidental to the nontaxable information services provided under Catalina Marketing, Auto-Owners (and now Rehmann Robson) both undercut the Treasury’s argument before it begins.

First, the court held that there was no tangible personal property transferred because the definition of “prewritten computer software” was not satisfied.  Like many other states, Michigan defines this term as software “delivered by any means.”  The court reasoned that because the accounting firm simply accessed information via the web that was processed via BNA and Thomson Reuter’s own software, hardware and infrastructure, there was no “delivery” under a conventional understanding of the word.  Absent delivery, there was no prewritten computer software for Treasury to impose tax upon.

Second, the Court of Claims went on to note that even if prewritten computer software was delivered, the accounting firm did not sufficiently “use” the software to impose the tax.  Because the accounting firm did not exercise a right or power over the software incident to ownership (other than the ability to control research outcomes by inputting research terms), there was no use.  The court explicitly turned down Treasury’s argument [...]

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Tennessee SaaS Ruling Highlights Telecommunications Concerns for SaaS Providers

The Tennessee Department of Revenue recently released Letter Ruling No. 14-05, in which it considered whether certain cloud collaboration services are subject to the state’s sales tax.  At a high level, the provider’s services are provided in a typical Software as a Service (SaaS) form:  (1) the provider owns the hardware and software used to provide the services; (2) the software is installed on the provider’s servers; (3) the provider’s employees monitor and maintain the hardware and software; (4) the provider charges a customer a monthly user fee; and (5) customers remotely access the software (i.e., no software is ever downloaded by a customer).  Of additional note, the provider does not license any of its software to the customers.

As the Tennessee Department has done in the past, it correctly determined that the SaaS arrangement does not constitute a retail sale of computer software because the provider “does not transfer title, possession, or control of any tangible personal property or software to a customer.”  Instead, the provider “ultimately uses and consumes both hardware and software as a means of providing its services.”

However, the Tennessee Department found that the cloud collaboration services are subject to the state’s sales tax as telecommunications services or ancillary services to telecommunications.  The cloud collaboration services instruct a customer’s telecommunications equipment as to how to process and route calls, “augment[ing] a customer’s voice, video, messaging, presence, audio/web conferencing, and mobile capabilities.”  As such, Letter Ruling No. 14-05 highlights a major concern for SaaS providers:  that their services will be considered taxable telecommunications or ancillary services.  While the cloud collaboration services are perhaps more clearly telecommunications or ancillary services than others, many SaaS offerings include an element of telecommunications by the very nature of remotely accessed software.

Fortunately, there are strong arguments in many states for most SaaS offerings to be excluded from the definition of telecommunications or ancillary services.  Streamlined Sales and Use Tax Agreement (SSUTA) member states (Tennessee is an associate member) are required to exclude “data processing and information services that allow data to be generated, acquired, stored, processed, or retrieved and delivered by an electronic transmission to a purchaser where such purchaser’s primary purpose for the underlying transaction is the processed data or information” from the definition of “telecommunications services.”  Therefore, where a provider can demonstrate that the true object of its offering is data processing or information services—and that any telecommunications services are merely incidental to those services—the offering should not constitute taxable telecommunications services.  In fact, demonstrating that the telecommunications component of any SaaS offering is merely incidental to the true object of the service should be effective in almost all states, SSUTA members or not.  Therefore, to adequately defend against the concern that a SaaS offering will be considered taxable telecommunications or ancillary services, providers should ensure that the true object of their offering is apparent and that it is clear that any telecommunications component is provided solely to facilitate that true object.




The Vermont Department of Taxes Begins to Take a Close Look at Cloud Computing

On June 30, 2013, the Vermont sales tax moratorium on remote access to software expired.  At that time, the Vermont Department of Taxes (Department) reverted to its prior position that interpreted, without any analysis, the Vermont sales tax to apply to prewritten software that was “licensed for use and available from a remote server.”  Recently, the Department released draft regulatory language relating to the taxation of remotely accessed software and is currently seeking comments on the draft (due by October 1, 2014).

The draft regulations provide a great deal of guidance, some good and some bad.  On the positive side, the regulations recognize that a sale cannot occur unless “use or control [is] given [to] the purchaser with respect to the software” such that “the purchaser is able to use the software to independently perform tasks.”  This language comports with established legal authorities in the state regarding when sales occur, rather than simply stating that a sale has occurred when software is remotely accessed.  See, e.g., In re Merrill Theatre Corp., 415 A.2d 1327 (Vt. 1980) (finding no sale where “[the patron] never comes into possession of [the tangible property], and exerts no control over it” because the vendor was the one with “actual possession” of the property).

The draft regulations also contain a non-exhaustive list of nontaxable transactions, which provide much needed clarity in the area of cloud computing.  These include:  (1) a transaction whose true object is the purchase of a service (to which any transfer of software is merely incidental), (2) sales of data processing and information services, (3) a transaction where the seller processes the purchaser’s data on the seller’s software and (4) a transaction where the customer runs its own software on the seller’s hardware in a cloud computing environment (such arrangements are commonly referred to as Infrastructure as a Service (IaaS), and the draft regulations refer to them as such).  This list is particularly helpful and positive because it recognizes:  (1) the importance of the true object test in determining taxability rather than simply relying on licensing or other language in a contract, (2) that many cloud computing transactions are properly characterized as data processing services performed by the vendor rather than the transfer of software and (3) that IaaS is different in nature than Software as a Service (SaaS) and should be analyzed differently.  The IaaS discussion is particularly significant as many states have not directly addressed the subject.

The draft regulations are less successful when they attempt to provide factors for determining whether a taxable transfer of software has occurred.  These factors include whether:  (1) “[t]he purchaser can use the prewritten software with little or no intervention by the seller other than ‘help desk’ assistance;” and (2) “[t]he purchaser can use an organizational tool or function that is a function of seller’s software.”  The proposed factors are troublesome because of the lack of clarity regarding what it means to “use” the software or the functions of the software, which [...]

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Does the Massachusetts Department of Revenue Still Believe SaaS is Subject to Sales Tax?

As noted in an earlier blog post, “[a] trend is developing in response to aggressive Department of Revenue/Treasury policy-making regarding cloud computing.”  This trend has not been friendly to aggressive Departments, and it appears that the Massachusetts Department of Revenue (Massachusetts Department) may be subtly moving away from its own aggressive position regarding one type of cloud computing transaction, software as a service (SaaS).

Following in the footsteps of the New York Department of Taxation and Finance, the Massachusetts Department has been one of the more aggressive departments in the current debate over the taxability of SaaS (see, e.g., Mass. Regs. Code 64H.1.3(3)(a); Mass. Letter Ruling 13-5 (June 4, 2013); Mass. Letter Ruling 12-13 (Nov. 09, 2012); Mass. Letter Ruling 12-10 (Sept. 25, 2012); Mass. Letter Ruling 12-6 (May 21, 2012)).  In its various letter rulings on the subject, the Massachusetts Department has routinely stated its position as follows:

Charges for prewritten software, whether it is electronically downloaded to the customer or accessed by the customer on the seller’s server (including the “Software as a Service” business model), are generally taxable. However, the marketing description of a product as “software -as-a-service” does not determine taxability of a product, nor does the fact that customers do not download software  or otherwise install software on their own computers or other devices.

The Massachusetts Department applies a “true object of the transaction” test to distinguish between situations where a transaction is for taxable software as opposed to a non-taxable service, noting in its guidance that “[w]here use of a software application is bundled with substantial non-taxable personal or professional services or non-taxable services such as database access or data processing, the object of the transaction may be the non-taxable service rather than a sale of software.”

Though the Massachusetts Department has continued to assert that charges for SaaS are generally subject to tax—both in its published guidance and during taxpayer audits—it has been over a year since the Massachusetts Department has published guidance finding that a specific SaaS offering was subject to tax (see Mass. Letter Ruling 13-5 (June 4, 2013)).  During that year, the Massachusetts Department has issued two new letter rulings, Mass. Letter Ruling 14-4 (May 29, 2014) and Mass. Letter Ruling 14-1 (Feb. 10, 2014), and revised one, Mass. Letter Ruling 12-8 (Revised Nov. 8, 2013), all of which have relied on the “object of the transaction” test to conclude that the offerings at issue were not taxable transfers of prewritten software.

In Mass. Letter Ruling 14-4, the Massachusetts Department considered the requestor’s SaaS offering through which it provided customers with remote access to interactive training programs hosted on its servers, seemingly a ripe fact pattern for finding that the true object of the transaction was prewritten software, especially in light of the Massachusetts Department’s position in other letter rulings (see, e.g., Mass. Letter Ruling 12-10, finding the true object of a SaaS transaction to be the underlying software, noting that “the customer must interact with the software in [...]

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Revise Your Tax Matrix: Remote Access of Software Exempt in Michigan and Idaho

A trend is developing in response to aggressive Department of Revenue/Treasury policymaking regarding cloud computing.  The courts and legislatures are addressing the issue and concluding that the remote access to software should not be taxed.  Here are two recent developments that illustrate the trend:

Michigan – Auto-Owners Insurance Company v. Department of Treasury

On March 20, 2014, the Michigan Court of Claims held in Auto-Owners Insurance Company v. Department of Treasury that certain cloud transactions were not subject to use tax because the transactions were nontaxable services.  The State has appealed this decision.

Auto-Owners engaged in transactions with numerous vendors to provide services and products that Auto-Owners used to conduct its business.  The court grouped Auto-Owners’ transactions into transactions with six categories of providers: (1) Insurance industry providers; (2) Marketing and advertising providers; (3) Technology and communications providers; (4) Information providers; (5) Payment remittance and processing support providers; and (6) Technology providers.  The transactions all involved, on some level, Auto-Owners accessing software through the Internet.  No software was downloaded by Auto-Owners.

The Michigan use tax is imposed on the privilege of using tangible personal property in the state.  Tangible personal property includes prewritten, non-custom, software that is “delivered by any means.”  Mich. Comp. Laws § 205.92b(o).  The court held that the transactions were not subject to use tax under the plain language of Michigan’s statute.

First, the court held that use tax did not apply because the court interpreted the “delivered by any means” language from Michigan’s statute to apply to the electronic and physical delivery of software, not the remote access of a third-party provider’s technology infrastructure.  Second, the court held that the software was not “used” by Auto-Owners.  Auto-Owners did not have control over the software as it only had the “ability to control outcomes by inputting certain data to be analyzed.”  Third, the court held that even if prewritten computer software was delivered and used, the use was “merely incidental to the services rendered by the third-party providers and would not subject the overall transactions to use tax.”  Michigan case law provides that if a transaction includes the transfer of tangible personal property and non-taxable services, the transaction is not taxable if the transfer of property is incidental to the services.

Practice Note:  This decision is encouraging in that the court said that the Department was ignoring the plain meaning of the statute and overreaching, and determined that the legislature must provide specific language extending the sales and use tax for such transactions to be taxable.  It is important to note that the Michigan statute uses the phrase “delivered by any means,” and the court focused on the definition of deliver in reaching its decision.  This decision will likely have implications for other streamlined sales tax (SST) member states.  Auto-Owners Ins. Co. v. Dep’t of Treas., No. 12-000082-MT (Mich. Ct. Cl. Mar. 20, 2014).

Idaho – H.B. 598

On April 4, 2014, Governor Butch Otter signed into law Idaho [...]

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