Washington: Court of Appeals upholds imposition of tax on digital automated services

The Washington State Court of Appeals recently upheld a $3.1 million assessment of retailing Business & Occupation (B&O) tax and retail sales tax on an information technology firm.  The taxpayer provided proprietary technology-related information and services, including various subscription based research service packages that were the subject of the assessment.  The main service included in the packages was the provision of online access to proprietary research documents in the taxpayer’s research library.  Customers accessed these documents through a client specific portal after logging on to the taxpayer’s website. The Department argued that the provision of access to the research library constituted a digital automated service, which is subject to retail sales tax and retailing B&O. Under Washington law, a “digital automated service” is defined as “any service transferred electronically that uses one or more software applications.” “Transferred electronically” means “obtained by the purchaser by means other than tangible storage media.”  A service or product that is transferred electronically but “primarily involves the application of human effort by the seller, and the human effort originated after the customer requested the service” is not classified as a digital automated service and is not subject to retail sales tax.

In challenging the assessment, the taxpayer countered that it was providing professional services subject to service B&O tax, but not subject to retail sales tax.  In support of this argument, the taxpayer noted that due to its constant updating of research content, the “application of human effort” was involved and, as such, it was not selling a digital automated service.  The taxpayer also explained that because its customers often purchased add-on services for access to human research analysts, the true object of a customer purchasing access was to obtain a professional service (e.g., the assistance of the research analyst).  Additionally, the taxpayer argued that the imposition of retailing sales tax conflicted with the Internet Tax Freedom Act’s ban on discriminatory taxes on electronic commerce.  After a trial court ruled in the Department’s favor, the assessment was appealed to the Washington State Court of Appeals.

In rebutting the taxpayer’s arguments, the Court found that despite the capabilities of the various tools used to access and customize the research results to the individual customer, the research offering fell clearly within the definition and examples of digital automated services contained in the Department’s regulations. The court next disagreed that the taxpayer’s research service met the human effort exclusion from the definition of digital automated services.  Developing the content for the research library involved human effort, but that effort occurred prior to a customer purchasing access to the research library. After the fact, the taxpayer did not allow customers to request any specific research be included in the library. The taxpayer next contended that the “true object” test applied because a single product was being sold that could be classified as subject to either service or retail tax. The court disagreed, holding instead that it was a “bundled transaction” in which there were two or more distinct and identifiable products sold for one non-itemized price instead of a single product with two or more components that cannot be separated, as evidenced by the fact that a customer could purchase access to the research tool without purchasing any direct interaction with human analysts. In the court’s view, the true object test was inapplicable and the taxpayer was selling bundled transactions that included a digital automated service.  Further, although certain customers purchased enhanced packages that included help from human analysts that fact was not relevant to analyzing whether the service of providing access to the research library involved human effort that originated after the customer requested the service.  The court also disagreed that the imposition of retail sales tax and retailing B&O on the service violated the Internet Tax Freedom Act. It explained that due to offering its research library via a software application with various search capacities, the taxpayer was offering an additional service that was not equivalent to the service of simply distributing content using e-mail or other methods.   Please contact Michele Baisler at 206-913-4117 for more information on Gartner, Inc. v. State of Washington, Department of Revenue.