In a curious decision out of Arizona, an Administrative Law Judge (ALJ) found an out-of-state provider of online research services was properly assessed transaction privilege tax (TPT, Arizona’s substitute for a sales tax) based on the logic that the provider was renting tangible personal property to in-state customers.  The Office of Administrative Hearings (OAH) decision, No. 14C-201400197S-REV, should be unsettling for all remote providers of subscription-based services with customers in Arizona.  This decision offers an example of the continued push by states to administratively expand the tax base to include nontaxable digital services.  Many states, like Arizona, do so by considering remote access to digital goods and services to be tangible personal property, as defined by statutes that are decades old.

Facts

The taxpayer was an out-of-state IT research firm offering internally-produced proprietary research and data compilation content remotely.  The taxpayer’s headquarters, offices, servers and platform were all located outside Arizona.  Customers accessed the research material via usernames and passwords received as part of a subscription.  The Arizona Department of Revenue (the Department) determined that the subscription income was subject to the TPT because it was income from the leasing of tangible personal property.  The taxpayer filed a protest with the Department, arguing that the online research services provided make it a service provider—not a lessor of tangible personal property.  The taxpayer noted “at most, [they are] providing clients with a simultaneous license to use.”

Department’s Argument

The Department argued that the taxpayer was leasing tangible personal property (research and data content) through the subscriptions they provide to customers.  Because they had exclusive access and use to the digital content (via username and password), the customers were able to perceive tangible personal property through their sense of sight. Therefore, the taxpayer’s receipts from subscriptions to its research and data content are taxable rental activities subject to the personal property rental classification.

Holding

The ALJ held the taxpayer did not meet its burden of proof of showing the Department misapplied the tax laws.  The decision dismissed all of the taxpayer’s arguments that it is not engaged in leasing tangible personal property.  At the outset, the ALJ found that the inability to control or modify the digital content was not enough to consider the customers to be lacking “exclusive control.”  This is important because the Arizona Supreme Court has made it clear that the scope and application of the personal property rental classification (and its predecessor) hinges on the degree of control over the property in question that is ceded to its putative “lessee” or “renter.” In sum, because the access and use of the proprietary research and data content was offered for a periodic subscription (consideration), such activity is the leasing of tangible personal property, and the assessment by the Department was appropriate.

Analysis

As a threshold matter, it is unclear whether the Department has authority to consider remote access to digital content to be tangible property merely because the content may be viewed on a computer or mobile device.  For purposes of this statute, the definition of tangible personal property was enacted in 1989.  See Taxation—Corrections Bill, 1989 Ariz. Legis. Serv. 132.  The Internet as we know it today did not exist, with the World Wide Web not even established until 1991.  By interpreting the definition as such, the Department is imposing a new tax—something that is the province of the legislature.  The proprietary research and data available electronically is more properly characterized as an intangible or service.  By purchasing a subscription, customers are really paying for access to the proprietary data and research, the creation of which is unquestionably a service.  This information service is the “true object” of the subscription transaction, and any tangible personal property (i.e., the ability to access it via the Internet) is a mere inconsequential element.

Second, even if the classification as tangible personal property is proper, we seriously doubt whether the exclusive use and control requirement is met in this case.  In State Tax Commission v. Peck, 106 Ariz. 394, 476 P.2d 849 (1970), the court determined that customers of a coin-operated laundry “have an exclusive use of the equipment for a fixed period of time and for payment of a fixed amount of money . . . [and] exclusively control all manual operations necessary to run the machines.” Id. at 396, 476 P.2d at 851.  Over 30 years later, the Arizona Court of Appeals found customers at a tanning salon do not “themselves exclusively control all manual operations necessary to run” the tanning beds in question. The court held that while customers could select within a five-minute window when the tanning session begins and terminate it early, the question of whether a tanning session may be commenced at all, and how long it could last, were exclusively controlled by the taxpayer’s tanning technician.  Further, the question of the appropriate tanning device was also significantly within the technician’s control. In sum, the “exclusive use and control by the customer that Peck determined to be the essence of “renting” taxing statute [was] not present” in the tanning salon context.  See Energy Squared, Inc. v. Arizona Dep’t of Revenue, 203 Ariz. 507, 510, 56 P.3d 686, 689 (Ct. App. 2002).

Here, like the tanning salon in Energy Squared, the taxpayer’s customers do not have “exclusive use or control” of the research and data.  The ability to open and access the content is limited by the subscription level, and customers are only permitted one copy (limitations that someone with exclusive use or control would not receive).  Because the information is proprietary in nature, customers are further restricted by the fact that they may not use the research as their own and may only summarize, excerpt or quote it.  Further (and perhaps most importantly), the content is at all times housed on the server of the taxpayer, who may add or subtract to the content available to customers at any time.  Because the property in question (however it may be classified) is ultimately controlled by the taxpayer, it is not exclusively used or controlled by the customer.  This common law requirement is a prerequisite to the application of the TPT personal property rental classification, upon which the Department and ALJ decision relies.

Beyond Arizona

The Arizona Department is not the first revenue department to proffer this logic to tax subscriptions to digital services.  Within the past year, the authors are aware of two other state tax agencies that have attempted to tax remote providers—both resulting in legislative action opposing the agency’s actions.

• Alabama: On February 28, 2015, the Alabama Department of Revenue proposed an amended regulation that sought to impose rental tax on remote providers of streamed music and video to in-state customers.  Similar to Arizona’s tactic here, the proposed regulation would have imposed tax by considering streamed music and movies to be tangible personal property.  After significant feedback from industry representatives, the Joint Legislative Council (composed of the state legislative leaders from both chambers) wrote the Commissioner requesting the proposed regulation be withdrawn.  The letter cited to the fact that the proposal was overly expansive and would in effect be the imposition of a new tax, a determination that rests with the legislature.

• Idaho: In October 2014, the Idaho State Tax Commission issued a notice of proposed rulemaking for a regulation that would have taxed the sale, lease or rental of digital products (defined as tangible personal property under Idaho law) if the user had the right to stream or download them.  See Idaho State Tax Comm’n, Notice of Proposed Rulemaking Dkt. 35-0102-1401 (Oct. 2014).  In response, the legislature passed a bill in March 2015 that modifies the statute to require digital products be purchased with a permanent right to use to be taxable as tangible personal property, effective April 1, 2015.  Notably, the bill states that a permanent right to use does not exist when the right to use is conditioned upon continued payment.

Practice Note:  While the OAH decision is appealable, the 30-day period to request review has run.  It is unclear whether the taxpayer in this case has requested review, appealed directly to the Board of Tax Appeals or accepted defeat.  Taxpayers providing subscriptions to digital goods and services (including streaming audio and video) should be aware of the Arizona decision and be prepared to defend their service offerings from the states apparent position.

Eric Carstens is co-author of this article.