TWIST - This Week in State Tax

Arizona: Application Software Taxable as Tangible Personal Property

The Arizona Court of Appeals recently upheld a superior court’s order that a taxpayer was renting software subject to the state’s Transaction Privilege Tax (TPT). Since 2007, the taxpayer had licensed its Enterprise eTime application software to Maricopa County.  The software allowed County employees to login to the Internet from their computers and enter their time and other employment data. The taxpayer requested a refund of the state and City of Phoenix TPT collected on the monthly revenues from its contract with the County. After the TPT refund was denied and a trial court ruled in favor of the Department of Revenue and the City, the taxpayer appealed.

Under Arizona law, TPT applies to any lease or rental of tangible personal property. Tangible personal property in turn, is broadly defined as “personal property that may be seen, weighed, measured, felt or touched or that is in any other manner perceptible to the senses.” On appeal, the taxpayer argued that the software was intangible personal property that was not subject to TPT. The court, relying on the Arizona Supreme Court’s 1943 decision in State v. Jones, disagreed. In Jones, the court held that the placing of a coin in a slot to play a record was the sale of tangible personal property subject to TPT because the music was perceptible to the senses.  Similarly, the court concluded that the software at issue was “perceptible” to users who were able to view the program when it was accessed. The taxpayer argued that Jones was archaic, wrongly decided, and should not be followed. The court again rejected this assertion. Despite the significant technological advances that had transpired since the Jones decision, the definition of tangible personal property remained essentially the same and, in the Court’s view, Jones remained binding and relevant. As such, the Court concluded that the software at issue was tangible personal property.

The Court next addressed the taxpayer’s argument that it was not leasing the software but was providing human resources services. Under prior Arizona cases addressing the distinction between providing a service and renting property, the courts have held that the “use and control” exercised over the property is evidence as to whether a lease or rental of tangible personal property is occurring.  Here, the County’s use and control over the software established that it was renting the software from the taxpayer. The taxpayer also argued that imposing TPT on its charges violated the Internet Tax Freedom Act because pre-Internet, its services were not taxable. The Court disagreed. In its view, the taxpayer was renting software that automated tasks previously done by human employees. The change in taxation reflected the fact that the taxpayer had automated its services and did not, in the Court’s view, constitute a discriminatory tax on electronic commerce.

Finally, the Court concluded that the software was also subject to the TPT under the Phoenix City Code. Computer software, other than custom software, was expressly included in the City’s definition of tangible personal property. The Court determined that the eTime software, despite being modified for the County, was not custom software as the modifications were separately accounted for in the taxpayer’s agreement with the County. Please contact Stacey Matthew with questions on ADP, LLP v. ADOR and City of Phoenix. 

Michigan: Waste Hauler Does Not Qualify for Rolling Stock Exemption

The Michigan Tax Tribunal recently addressed whether a taxpayer, a provider of waste disposal services, such as trash collection, trash disposal, and recycling, was eligible for the rolling stock use tax exemption. Under Michigan law, the exemption applies to purchases of rolling stock (e.g., trucks, trailers and various parts affixed to trucks or trailers) used in interstate commerce and purchased, rented, or leased by an interstate fleet motor carrier. “‘Interstate fleet motor carrier” means a person engaged in the business of carrying persons or property, other than themselves, their employees, or their own property, for hire across state lines, whose fleet mileage was driven at least 10 percent outside of this state in the immediately preceding tax year. The taxpayer argued that it qualified for the exemption because it was hired to transport property (waste) and its commercial service agreements confirmed it never took title to the non-recyclable waste. Similarly, it did not take title to the recyclable waste until after it was processed by a third party. Because the taxpayer did not own the landfill or the recycling plant, it viewed itself as an interstate fleet motor carrier whose primary business purpose was transporting its customers’ waste across state lines. As such, the taxpayer asserted that the purchased trucks and equipment were “rolling stock” exempt from Michigan Use Tax.

The Tribunal agreed with the Department of Treasury that the taxpayer was not an “interstate fleet motor carrier” and therefore did not qualify for the exemption.  In the Tribunal’s view, the taxpayer was not in the primary business of carrying property other than their own property for hire across state lines. Rather, the taxpayer’s primary business purpose was providing garbage and recycling disposal services and the taxpayer’s transportation of the waste and garbage was incidental to its disposal. The Tribunal also determined that although the taxpayer’s contracts stated that the waste remained the property of the owner, the reality was that when a customer hired the taxpayer to haul away garbage or waste, they were relinquishing control over that waste.  Looking at the business as a whole, the Tribunal concluded that the taxpayer was hired to dispose of waste, and not merely transport it to a second location. As such, the taxpayer was not an interstate fleet motor carrier and was ineligible to claim the rolling stock exemption.  Please contact Ryan Hohenthaner with questions on Michiana Recycling & Disposal Services, Inc. v. Michigan Dep’t of Treasury. 

Texas: Comptroller Amends Local Sales Tax Sourcing Rule

In the Texas Register issued on January 27, 2023, the Comptroller formally adopted revised 34 TAC §3.334, which governs Local Sales and Use Taxes. The process of amending this rule has been a lengthy and somewhat controversial endeavor. Recall, amendments to the rule were previously adopted in May 2020, but several cities subsequently challenged the Comptroller’s interpretation of the statute. Ultimately a district court concluded that the Comptroller had not complied with the procedural notice requirements necessary to amend the rule.  As such, the Comptroller once again published notice of his intent to amend the rule and a public hearing was held on October 17, 2022. The adopted rule, which is somewhat different than the May 2020 adopted version, is effective January 30, 2023. It should be noted that the litigation over whether the amended rule aligns with the statute is ongoing and will now move forward on the merits.

There are over ten pages of text in the Texas Register explaining the procedural background, summarizing the comments received on the proposed amendments, and responding to those comments and requests for changes to the rule. Many of the comments relate to a change in the definition of “place of business,” which is relevant in determining where a local sale is consummated. Historically, 34 TAC § 3.334(h)(3)(C), provided that when an order was placed over the internet and the seller fulfilled that order at a location that was a “place of business in Texas,” the sale was considered to be consummated at that place of business where the order was fulfilled. Accordingly, local sales tax was sourced to the fulfillment location. As revised, 34 TAC § 3.334(b)(5), provides that “a facility without sales personnel is not usually a place of business of the seller.” Further, “a computer that operates an automated shopping cart software program is not an established outlet, office, or location," and does not constitute a "place of business of the seller.”  When an order is received at a location that is not a place of business of the seller in Texas and is fulfilled from a location in Texas that is not a place of business of the seller, the sale is consummated at the location in Texas to which the order is shipped or delivered, or at which the purchaser of the item takes possession. What this means is that local sales taxes from Internet orders fulfilled at warehouses or distribution centers in Texas (assuming those locations are not places of business of a seller) will be sourced to the delivery location. Many localities have economic development agreement with retailers that have established fulfillment centers and localities are concerned about local sales tax revenue loss due to this change.  Previously, under an agreed to temporary injunction, the Comptroller agreed not to enforce the provision relating to orders not received by sales personnel while the rule’s validity was being challenged in district court. Thus, although the rule has been formally adopted, it appears the Comptroller will not enforce it pending the outcome of the litigation. Please contact Karey Barton with questions on the revised rule. 

Wisconsin: DOR Bulletin Addresses Lack of Conformity to IRC section 174

The Wisconsin Department of Revenue recently issued its January 2023 Tax Bulletin. In the Bulletin, the Department addresses the state’s conformity (or lack thereof) to IRC section 174, as amended by the Tax Cuts and Jobs Act. Recall, for taxable years beginning on or after January 1, 2022, section 13206 of the Tax Cuts and Jobs Act amended IRC section 174 to require taxpayers to amortize research and experimental expenditures, as opposed to deducting the expenses in the year incurred.  Because Wisconsin did not adopt section 13206 of the TCJA, Wisconsin has not adopted the federal changes to IRC section 174. Per the Bulletin, for Wisconsin tax purposes, taxpayers with R&E expenses have the following options: 1. Elect to deduct the expenses in the year paid or incurred, 2. Elect to defer the expenses and deduct ratably over at least 60 months, or 3. Elect to treat the expenses as capital expenditures amortizable over a useful life, if determinable. Please stay tuned to TWIST for additional state updates on IRC section 174.