In an unpublished opinion, the Michigan Court of Appeals held that subscriptions to the taxpayer's online research product were not subject to use tax because the taxpayer primarily provided a service, rather than the transfer of tangible personal property.1 In reversing the Michigan Court of Claims, the Court of Appeals concluded that the taxpayer was in the distinct business of selling a nontaxable information service. Any prewritten computer software that was transferred as part of the service was incidental and did not change the nature of the transaction.
Background
The taxpayer was a Texas corporation that sold numerous information products, including CD-ROM computer software and online research products and tools. This case concerned a product, Checkpoint, which is an online tax and accounting research program that provides subscribers with access to a wide collection of information. Checkpoint subscribers are able to search and retrieve multiple updated sources, browse compiled information regarding a particular topic and use links between sources. The Michigan Department of Treasury assessed use tax after determining that the taxpayer's sale of Checkpoint subscriptions constituted the sale of taxable prewritten computer software.
At an informal conference, the taxpayer unsuccessfully argued that the sale of Checkpoint subscriptions was the sale of a nontaxable information service. The taxpayer subsequently paid the tax under protest and filed a complaint in the Court of Claims alleging: (i) Checkpoint was not taxable prewritten computer software; (ii) any software was incidental to the sale of a nontaxable information service; and (iii) the final assessment violated the Due Process and Commerce Clauses. In granting the Department's motion for summary disposition, the Court of Claims explained that the case involved an evolution of services. Because the product was taxable when it was in book or CD format, the online version of the product similarly was taxable. Also, the Court of Claims concluded that the primary object in selling the subscriptions was the sale of tangible personal property because the information that the customers purchased constituted tangible personal property. Finally, the Court of Claims dismissed the taxpayer's constitutional claims after determining that they were without merit. The taxpayer appealed to the Michigan Court of Appeals.
Michigan Use Tax
In Michigan, use tax generally is imposed on the privilege of "using, storing, or consuming tangible personal property."2 In general, use tax applies to tangible personal property, but does not apply to services.3 The definition of "tangible personal property" includes prewritten computer software.4 If a transaction involves the transfer of both tangible personal property and services, the Michigan Supreme Court has adopted an "incidental to service test" that "looks objectively at the entire transaction to determine whether the transaction is principally a transfer of tangible personal property or a provision of a service."5
Any Transfer of Tangible Personal Property Incidental to Service
The Court of Appeals reversed the Court of Claims and held that any transfer of tangible personal property was incidental to the information service provided by the taxpayer. The taxpayer's customers sought the expert knowledge of Checkpoint's content creators in organizing the information and making research more efficient. There was no evidence that any small amount of software transferred was the object of the transaction or that the customers sought to own the prewritten computer software.6 This conclusion was supported by the license agreement that entitled the customers to use the Checkpoint program.
The taxpayer sold taxable print and software products, but also was in the business of selling the distinct Checkpoint information service. Furthermore, the taxpayer's business model was to profit from providing a service rather than the sale of any prewritten computer software. Any transfer of prewritten computer software was an insignificant part of the overall transaction aimed at providing a service. The taxpayer did not market or separately sell the software related to the Checkpoint platform. Finally, the intangible services greatly contributed to the value of the physical item transferred.
The Court of Appeals disagreed with the lower court's reason for granting the Department's motion for summary disposition. Although prior versions of the product constituted prewritten computer software subject to use tax, the taxpayer changed the nature of the product. The lower court's reasoning that a product is taxable in its current form because it evolved from a taxable product was not a valid basis for granting summary disposition. Since the Court agreed with the taxpayer that the tax imposed was improper, the Court did not need to consider the taxpayer's Due Process and Commerce Clause arguments. The Court concluded that summary disposition should be granted in favor of the taxpayer.
Commentary
This decision is favorable for businesses that provide online information services that involve an incidental transfer of prewritten computer software to their customers as part of the service.
In reversing the lower court, the Court of Appeals rejected the notion that sales and use tax determinations relating to new products should automatically be treated in the same manner as former versions of these products. The change in the product format from book / CD to an online provision of information mattered to the Court of Appeals. As a nontaxable provision of an information service, taxpayers in Michigan that sell a similar type of information service should consider filing protective refund claims, which likely will be held by the Department pending a possible appeal to the Michigan Supreme Court.
The imposition of sales and use tax on information services varies widely among states, and continues to change in light of newly available technologies, revised interpretations of existing laws, and the enactment of new legislation that specifically addresses the taxability of information services. This case would appear to be relevant to taxpayers that sell this type of service in states that have use tax statutes similar to those enacted by Michigan, broadly exempt information services from tax, and follow the "incidental to service" test for mixed transactions.
It should be noted that the Court declined to address the taxpayer's argument that it did not have a taxable use of software in Michigan because the incidental to service test was dispositive to the Court's holding. However, the case also provides support for the position that software has to be transferred to a user in Michigan to be considered delivered and therefore taxable. The Court referenced the expert testimony that JavaScript software was actually transferred to users in Michigan. Because access to software is not sufficient, any software to be taxable must be transferred to the user like the JavaScript software that was transferred to customers. The Court did not suggest or hold that any other software that resided on the taxpayer's servers outside Michigan was also transferred to customers in Michigan.
Finally, corrective legislation has previously been introduced, S.B. 142 and S.B. 143, to clarify that software residing on another's server is not taxable prewritten software. The legislation is still under consideration and has not been enacted.
Footnotes
1 Thomson Reuters Inc. v. Department of Treasury, Michigan Court of Appeals, No. 313825, May 13, 2014 (unpublished).
2 General Motors Corp. v. Department of Treasury, 644 N.W.2d 734 (Mich. 2002), quoting MICH. COMP. LAWS § 205.93(1). Note that a limited number of services are taxed under the Use Tax Act in the same manner as tangible personal property such as telecommunications, lodging, industrial laundering, and the transmission and distribution of electricity. MICH. COMP. LAWS §§ 205.93(1); 205.93a; 205.93b.
3 Fisher & Co. v. Department of Treasury, 769 N.W.2d 740 (Mich. Ct. App. 2009). See the preceding footnote regarding a limited number of services that are taxed in the same manner as tangible personal property.
4 MICH. COMP. LAWS § 205.92(k). Note that "prewritten computer software" is defined as "computer software, including prewritten upgrades, that is delivered by any means and that is not designed and developed by the author or other creator to the specifications of a specific purchaser." MICH. COMP. LAWS § 205.92b(o). "Computer software," in turn, is defined as "a set of coded instructions designed to cause a computer or automatic data processing equipment to perform a task." MICH. COMP. LAWS § 205.92b(c).
5 Catalina Marketing Sales Corp. v. Department of Treasury, 678 N.W.2d 619 (Mich. 2004).
6 The Court acknowledged in footnote 1 of the case the expert testimony that there was a transfer of JavaScript software from the taxpayer's server to its customer's computer and the Court noted that even though the software represented less than one percent of the transaction, the software could be taxable but for the incidental to service test of Catalina. The Court did not suggest or hold that any other software that resided on the taxpayer's servers outside Michigan was also transferred to customers in Michigan.
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