TWIST - This Week in State Tax

Welcome to TWIST for the week of September 19, 2022, featuring Sarah McGahan from the KPMG Washington National Tax state and local tax practice.

First up today we our covering two sales tax cases that were recently decided by state supreme courts. The Missouri Supreme Court held that a taxpayer did not qualify for sales and use tax manufacturing exemptions for purchases of computers and networking equipment used to generate vehicle history reports for customers. Creating the reports involved obtaining raw data, storing the data on a server in Missouri, and providing an automated data cleansing process to remove inconsistent entries. A report was extracted from the information in the database specific to a particular vehicle. The court noted that while this was a “close call,” the taxpayer was not manufacturing the reports. Based on the court’s previous determinations, “manufacturing” generally required a taxpayer’s output to have a separate and distinct use, identity, or value from the input. The court concluded that the taxpayer’s reports did not meet this distinct identity criteria.

In North Carolina, the Department of Revenue ruled that the provision of optional Helpdesk technical support was a taxable service contract. The Helpdesk services at issue obligated the taxpayer to maintain, repair, monitor and perform other services included in the definition of repair maintenance and installation services. As such, the taxpayer’s services fell within the definition of a taxable service contract.

The Pennsylvania Commonwealth court held that out-of-state sellers using Amazon's Fulfillment by Amazon program did not have the minimum contacts necessary under the Due Process Clause to be required to collect Pennsylvania sales tax for the tax years at issue. Notably, the FBA merchants did not place their merchandise in the stream of commerce with the expectation that the merchandise  would be purchased by consumers in Pennsylvania, and had not availed themselves of Pennsylvania’s protections, opportunities, and services.

Finally, in South Carolina, the state’s highest court concluded that membership fees that entitled bookstore customers to discounts on merchandise and free shipping were subject to sales and use tax.   All parties agreed the sales of memberships were not sales of tangible personal property. However, the Department asserted that the membership fees were taxable because they were part of the “gross proceeds of sales,” which is defined as the value proceeding or accruing from the sale, lease, or rental of tangible personal property. In the court’s view, because a member would eventually purchase tangible merchandise from the bookstore, the membership fee was taxable even if purchased prior to the purchase of merchandise.

Missouri: Equipment Not Purchased to Manufacture Vehicle History Reports

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Recently, the Missouri Supreme Court, overruling the Administrative Hearing Commission, held that a taxpayer did not qualify for the state’s manufacturing exemption for purchases of equipment used to generate vehicle history reports. The taxpayer at issue sold vehicle history reports (reports) to consumers and car dealers. The reports, which were generated for a specific vehicle, provided information about that vehicle’s history, such as ownership and title history, mileage information, accident history, previous maintenance and repairs, and manufacturer recall notices.  Creating the reports involved obtaining raw data, storing the data on a server in Missouri, and providing an automated data cleansing process to remove inconsistent entries. A report was extracted from the information in the database specific to a particular vehicle. The dispute at issue was whether the taxpayer was manufacturing the reports so that its purchases of servers, networking equipment, software, SAN drives, conferencing equipment, UPS devices, workstations, and related equipment were exempt from sales and use tax as machinery and equipment used directly in manufacturing or used in the manufacturing of any product. After the Commission ruled in the taxpayer’s favor, the Director appealed. 

At the outset, the court noted that the taxpayer owed sales and use tax on its purchases unless the equipment was used in “manufacturing” the reports. In the court’s view, the taxpayer did not “manufacture” reports as contemplated in the exemption statutes. Having spent a great deal of time attempting to define the outer reaches of the definition of “manufacturing” in the context of the manufacturing exemptions, the court observed that it had consistently rejected claims when the output involved did not have a separate and distinct use, identity, or value from the input. The taxpayer’s reports did not meet this distinct identity criteria. The reports might annotate or explain some of the data it collected but – in the end – the reports did not do anything other than present a customer with whatever information created by others concerning the vehicle the taxpayer had been able to obtain. In the court’s view, this did not create an “article with a use, identity, and value different from the use, identity, and value of the original” vehicle data that the taxpayer aggregated. The court did note that the case was a “close call,” and that this was often the situation in cases addressing whether an activity that could scarcely have been imagined when the manufacturing exemptions were enacted constituted manufacturing today. The court observed that the General Assembly could always change the law if it believes that the purchases at issue should be exempt. Please contact John Griesedieck with questions on Carfax, Inc. v. Dir. of Revenue.

North Carolina: Department Determines Helpdesk Services Taxable

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The North Carolina Department of Revenue recently concluded that the sale of optional Helpdesk technical support was a taxable service contract. Under North Carolina law, sales and use tax is imposed on sales of service contracts sourced to the state. The term “service contract” is defined as “[a] contract where the obligor under the contract agrees to maintain, monitor, inspect, repair, or provide another service included in the definition of repair, maintenance, and installation services to certain digital property, tangible personal property, or real property for a period of time or some other defined measure.” The term does not include a single service included in repair, maintenance, or installation services, but does include a contract where the obligor may provide a service included in the definition of repair, maintenance, and installation services as a condition of the contract. N.C. Gen. Stat. § 105-164.3(225) defines the term “repair, maintenance, and installation services” to include a number of specific activities, such as troubleshooting to identify the source of a problem for determining what is needed to restore property.

The taxpayer at issue provided Information Technology as a Service (ITaaS) services to businesses. Customers could opt to purchase “helpdesk services” to assist users resolve service interruptions to the taxpayer’s ITaaS platform. The ruling noted that the Helpdesk feature was not intended to monitor, repair, or maintain customer's routers or customer-owned devices. Nevertheless, the Department determined that the taxpayer was performing a service contract. Notably, the taxpayer may at times be obligated to troubleshoot its customer’s network infrastructure by power cycling a customer’s router to reestablish a connection with the taxpayer’s ITaaS services. The diagnostic procedure of power cycling in certain instances will reload a router’s operating system and other software, clear the router’s memory, reinitialize the router’s configuration, and may resolve issues with dynamic IP address conflicts. Based on these and other facts, the Department ruled that the Helpdesk services obligated taxpayer to maintain, repair, monitor and perform other services included in the definition of repair maintenance and installation services. Please contact Nicole Umpleby with questions on SUPLR 2022-0004.

Pennsylvania: Inventory Present in State Did not Create Nexus for Seller

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The Pennsylvania Commonwealth Court recently concluded that out-of-state sellers using Amazon's Fulfillment by Amazon (FBA) program did not have the minimum contacts necessary to be required to collect Pennsylvania sales tax for the tax years at issue. Under the FBA program, participating merchants shipped inventory to a location designated by Amazon. Thereafter, the merchants had no further control over their inventory (e.g., it could be moved without the merchants’ knowledge). The Pennsylvania Department of Revenue, seeking information as to whether the FBA merchants had a physical presence in the Commonwealth, sought to compel the merchants to complete a Business Activities Request Questionnaire. Merchants were directed to respond within 15 days and the Questionnaire stated that failure to provide the requested information would result in “additional enforcement actions.” Through the Online Merchants Guild, the FBA merchants challenged the Department’s actions. The key question before the court was whether the FBA merchants would be required to collect Pennsylvania sales tax (or be liable for personal income tax) because Amazon stored the merchants’ inventory in warehouses located in the Commonwealth. The Guild argued that the FBA merchants lacked meaningful contacts with Pennsylvania under the Due Process Clause. The court agreed, finding that the FBA merchants did not place their merchandise in the stream of commerce with the expectation that it would be purchased by consumers in Pennsylvania. Further, the FBA merchants had not availed themselves of Pennsylvania’s protections, opportunities, and services. The court concluded that the Department had failed to provide sufficient evidence that the FBA merchants had sufficient contacts with the Commonwealth such that they could be required to collect and remit sales tax or pay personal income tax.  It remains to be seen whether this decision will be appealed. Please stay tuned to TWIST for future nexus updates.

South Carolina: Sales of Book Club Memberships were Taxable

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The South Carolina Supreme Court recently concluded that the Court of Appeals did not err when it ruled that so-called “millionaire’s club” membership fees were included in the sales tax base. A bookstore chain offered its customers a membership for $25 that entitled members to discounts on merchandise and free shipping.   All parties agreed the sales of memberships were not sales of tangible personal property. However, the Department asserted that the membership fees were taxable because they were part of the “gross proceeds of sales,” which is defined as the value proceeding or accruing from the sale, lease, or rental of tangible personal property. In the Department’s view, because the member would eventually purchase tangible merchandise, the membership fee was taxable even if purchased prior to the purchase of merchandise. The bookstore argued that sales tax did not apply because the $25 value from the sale of a membership could not possibly proceed or accrue from a sale of merchandise that had not yet occurred. Relying largely on the definition of “proceeding,” the court concluded that for a monetary value to proceed from something, the value must come from it. Here, the value of the club memberships originated from the sale of taxable goods because the only benefit to buying the club membership was to get the discount on taxable transactions.

Interestingly, the court noted that the taxpayer’s counsel had argued that other “big box” stores were not being taxed on their membership fees. The court was not persuaded by this argument and noted that, when pressed, the taxpayer failed to offer a specific legal theory as to how the disparate treatment would affect the outcome of the case.  The court also made clear that its holding was based on statutory interpretation, not based on any deference to the Department, and that it would leave the taxability of these other entities for another day. There were two dissents in the case. One dissent focused on the fact that the majority did not address the taxpayer’s position that other retailers were not required to collect tax on their membership fees. “Given the importance of ensuring that all similarly situated taxpayers are treated equally, I would prefer this Court not allow the Department to dodge such an important challenge. The charge of disparate treatment of similarly situated taxpayers is squarely before the Court, and I would insist upon a resolution of this challenge.” Please contact Nicole Umpleby with questions on Books-A-Million, Inc. v. South Carolina Department of Revenue.