United States: Michigan Court Of Appeals Holds Certain Cloud Computing Not Subject To Use Tax

On October 27, 2015, the Michigan Court of Appeals held in a published decision that the purchase and use of certain cloud computing services by a Michigan insurer were not subject to Michigan use tax.¹ Specifically, transfers of data to a company resulting from the third-party use of prewritten computer software were not subject to use tax because there was no delivery of software to the company. Several additional transactions that involved the delivery of prewritten computer software or other tangible personal property were exempt from use tax because they were incidental to the rendering of professional services.

Background

A large insurance company that was headquartered in Michigan and had independent agents in 26 states entered into a variety of electronic technology contracts during the relevant period of December 1, 2006 to December 31, 2010. Many of these contracts used complex computing arrangements between the company and third-party providers, which resulted in litigation concerning whether these contracts were subject to Michigan use tax. The six main categories of contracts included: (i) insurance industry-specific contracts; (ii) technology and communications contracts; (iii) online research contracts; (iv) payment remittance and processing support contracts; (v) equipment maintenance and software customer support contracts; and (vi) marketing and advertising contracts.

The Michigan Department of Treasury conducted a use tax audit of the company and determined two bases for use tax liability: (i) fixed asset purchase; and (ii) expense items by looking at purchases. After the Department issued a use tax deficiency, the company paid the amount due, as well as additional interest, under protest. The company subsequently filed a complaint in the Michigan Court of Claims, seeking a refund of use tax paid to the Department based on the following arguments: (i) the products were not prewritten computer software; (ii) any software involved was incidental to the services the products provided; (iii) the Department unlawfully assessed use tax on transactions subject to sales tax; and (iv) the Department used improper audit methods. After discovery was conducted, the company moved for summary disposition.

In granting the company's motion for summary disposition, the Court of Claims held that the transactions were not subject to use tax because the software was not "delivered by any means." ² Furthermore, the Court held that even if the prewritten computer software was "delivered" to the company, the assessment would still be invalid because the company did not exercise the necessary "use" to subject the software to use tax. Finally, the Court held that even if the prewritten software was delivered to and used by the company, the use was incidental to the services rendered by the third-party providers and would not subject the overall transactions to use tax. The Court accordingly entered a final order for the refund of taxes. The Department appealed this decision to the Michigan Court of Appeals.

Taxation of Prewritten Computer Software

The Michigan use tax is designed to cover transactions that are not subject to sales tax and is levied "for the privilege of using, storing, or consuming tangible personal property" in Michigan. ³ "Use" is defined by Michigan law as "the exercise of a right or power over tangible personal property incident to the ownership of that property including transfer of the property in a transaction where possession is given." ⁴ Michigan law does not explain what a right or power incident to ownership of tangible personal property entails, but the Michigan Court of Appeals has held that the key determination is whether the party had some control over the property. ⁵ Under Michigan law, "tangible personal property" includes prewritten computer software. ⁶ Thus, prewritten computer software generally is subject to use tax. The Michigan use tax statute defines "prewritten computer software" 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." ⁷ However, the use tax statute does not define "deliver." Michigan law defines "computer software" as "a set of coded instructions designed to cause a computer or automatic data processing equipment to perform a task." ⁸

No Delivery of Prewritten Computer Software

The Court of Appeals held that most of the transactions in this case were not subject to use tax because they did not involve the delivery of prewritten computer software by any means. Because Michigan use tax law does not define "deliver," the Court adopted the dictionary definition of the term as "hand over" or "convey." Based on this definition and the statutes discussed above, the Court explained that the transactions in this case were subject to use tax if the company exercised control over a set of coded instructions that was conveyed or handed over by any means and was not designed and developed by the author or other creator to the specifications of a specific purchaser.

In reaching its decision that most of the transactions were not taxable, the Court of Appeals explained that despite coming to the correct conclusion regarding taxability under the use tax, the Court of Claims had incorrectly determined that all software remained on a third-party server. The Court of Claims held that no software was "delivered" because all software remained on the third-party servers and the only transfer involved information that had been processed using the third-party's software, hardware and infrastructure. However, because a desktop agent was installed on each of the company's computers with regard to one of the services, and another service used software that ran locally on the company's computers, the Court of Appeals disagreed that all software was located on third-party servers. According to the Court of Appeals, the Court of Claims also improperly narrowed the scope of "deliver" to preclude electronic delivery. However, the Court of Claims correctly determined that the mere transfer of information and data that was processed using the software of the third-party businesses did not constitute delivery by any means of prewritten computer software. In this situation, only data resulting from third-party use of software is delivered.

The Court of Appeals held that a majority of transactions in this case were not subject to use tax because they did not involve the delivery of software by any means. After thoroughly examining the transactions, the Court determined that the company did not exercise an ownership-type right or power over the software under many of the contracts at issue. Also, the company did not have access to the computer codes that enabled the systems of the third-party providers. Furthermore, the Court noted that the company's contracts with software companies to provide maintenance and support services were not subject to use tax because they involved the provision of services rather than the delivery of prewritten computer software.

Delivery of Other Prewritten Computer Software Was Incidental to Service

According to the Court of Appeals, prewritten computer software or other tangible personal property was delivered to the company in several of the transactions at issue in the case. However, these transactions were not subject to use tax because they were incidental to rendering a professional service under the six-factor test provided by the Michigan Supreme Court in Catalina Marketing Sales Corp. v. Department of Treasury.⁹ The incidental to service test requires a review of whether a transaction is principally a transfer of tangible personal property or a service.

The Court of Appeals conducted a thorough analysis and determined that three of the contracts involved the delivery of prewritten computer software. For example, under one of the technology and communications contracts, the company purchased access to a network that was designed and used for Web conferencing. The company did not have access to the code, but the third party provided a support center that was downloaded onto several of the company's computers. In this situation, the company exercised an ownership-type right over the support center because the software was installed on the company's computers, and the company was able to control use of the software. Similarly, a contract for payment processing services involved the delivery of prewritten computer software. The company exercised an ownership-type right over the software by taking possession of the software, installing the software on its computers, and using the software as it wished. Finally, another contract that provided remote computer access to employees required a desktop agent constituting prewritten computer software to be installed on each computer. Also, the company received flash drives from the provider that were tangible personal property. Under this contract, the company exercised an ownership-type right over tangible personal property by taking possession of the property, installing the software on its computers, and controlling the use of the software and drives.

One of the online research service contracts did not involve the transfer of prewritten computer software, but the company received print materials from the provider which constituted tangible personal property. The company exercised a right over the print materials incidental to ownership because the company received the print materials from the provider, had possession over the print materials and was able to use them at will.

Even though the company exercised a right or power over tangible personal property for the contracts discussed above, the company was not taxed because these transfers of tangible personal property were incidental to the rendering of professional services. In Catalina, the Michigan Supreme Court adopted a six-factor test for determining whether a transfer of tangible personal property is incidental to the rendering of professional services: (i) what the buyer sought as the object of the transaction; (ii) what the seller or service provider is in the business of doing; (iii) whether the goods were provided as a retail enterprise with a profit-making motive; (iv) whether the tangible goods were available for sale without the service; (v) the extent to which intangible services have contributed to the value of the physical item that is transferred; and (vi) any other factors relevant to the particular transaction.

The Court applied the incidental to service test factors to each of the four contracts. ¹⁰ Considering all of the factors together, the tangible personal property was incidental to the services that the company received. The company contracted with the businesses in order to receive services, and the tangible personal property was merely incidental to the provision of services. There was no indication that the taxpayer could purchase the software or other tangible personal property independent of the services. Also, the services gave value to the software and other tangible personal property. The Court of Appeals concluded that use tax did not apply to the transactions and that the Court of Claims properly granted the company's motion for summary disposition.

Commentary

Auto-Owners is a published decision that can be cited as precedent and unless overturned by the Michigan Supreme Court, cannot be ignored by the Department based on the facts of similarly situated taxpayers. The Department has about 40 days to file application for leave to appeal with the Michigan Supreme Court.

The decision clarifies the application of use tax to cloud computing transactions in Michigan, which have substantially grown in use and scope since the tax periods at issue. The Court focused on the "delivered by any means" language in the statute that defines the "prewritten computer software" that is subject to tax. Under the Court's reasoning, prewritten computer software is only subject to use tax if the purchaser exercises control over a set of coded instructions that was conveyed or handed over by any means. Most of the transactions at issue were not taxable because the purchaser did not exercise an ownership-type right or power over the software and never had access to any of the computer code. The Court provided a thorough analysis and separately applied this test to a wide variety of different types of contracts. Thus, taxpayers with many different types of cloud computing contracts may use this decision to support an argument that the transaction is not subject to tax provided that the purchaser did not exercise control over the software or computer code.

The decision also provides guidance on the use tax treatment of contracts that involved the delivery of prewritten computer software. The Court applied the incidental to service test used in the Catalina sales tax case to a use tax context. Last year, the Michigan Court of Appeals considered a similar issue in Thomson Reuters Inc. v. Department of Treasury.¹¹ In reversing the Court of Claims, the Court of Appeals held that an online tax and accounting research program that provided subscribers access to a wide collection of information was not subject to use tax under Catalina because the transaction was primarily the provision of a service rather than transfer of tangible personal property. Thomson Reuters was an unpublished decision that the Department filed for leave to appeal with the Michigan Supreme Court. Leave to appeal has not yet been granted by the Michigan Supreme Court.

Interestingly, and no doubt with a view that cloud computing contracts are becoming more widely used, the Department released an update in the days prior to the decision that provides guidance on the imposition of sales and use tax on cloud computing. ¹² The guidance explains that "cloud computing" is a generic phrase that refers to a variety of delivery models over the Internet, ranging from the storage of data to the outsourcing of a customer's information technology department. The term includes the delivery of software to customers by electronic download or remote access. The Department's position regarding whether a software transaction is subject to sales and use tax depends on the facts and circumstances of each transaction.

The guidance notes the distinction between custom software and prewritten computer software. Custom software is designed for the exclusive use and special needs of a single purchaser and is exempt from sales and use tax, but prewritten computer software is subject to tax. The Department emphasized its position that it is not relevant how prewritten computer software is delivered, or whether it is accessed remotely or downloaded. If services and the right to use software are integrated or combined into one transaction, the Department will apply the incidental to service test from Catalina. The Department noted that the taxability of certain forms of cloud computing is being litigated, with no precedential decisions to date. The Department referenced Thomson Reuters, which was not considered to be precedential because it was an unpublished decision, as well as the Auto-Owners decision, which was issued for publication following issuance of the Department's update.

Footnotes

1 Auto-Owners Insurance Co. v. Department of Treasury, Michigan Court of Appeals, No. 321505, Oct. 27, 2015.

2 Auto-Owners Insurance Co. v. Department of Treasury, Michigan Court of Claims, No. 12-000082-MT, March 20, 2014.

3 MICH. COMP. LAWS § 205.93(l).

4 MICH. COMP. LAWS § 205.92(b).

5 WPGP1, Inc. v. Department of Treasury, 612 N.W.2d 432 (Mich. Ct. App. 2000).

6 MICH. COMP. LAWS § 205.92(k).

7 MICH. COMP. LAWS § 205.92b(o) (emphasis added).

8 MICH. COMP. LAWS § 205.92b(c).

9 678 N.W.2d 619 (Mich. 2004). The Court of Appeals noted that the Michigan Supreme Court articulated the incidental to service test in the context of a challenge to the sales tax rather than the use tax. However, neither party challenged whether the test also applied to the use tax. In its prior analysis, the Michigan Supreme Court did not limit the test to transactions under the sales tax.

10 The Court noted that it did not apply the sixth element relating to "any other relevant factors" since the first five factors encompassed the main features of the transactions.

11 Michigan Court of Appeals, No. 313825, May 13, 2014 (unpublished).

12 Treasury Update, "Cloud Computing: A Clearer Horizon," Michigan Department of Treasury, Nov. 2015 (released Oct. 23, 2015). The Department's guidance also addressed the tax treatment of virtual currency. As explained by the Department, convertible virtual currency, such as Bitcoin, is a digital representation of value that has equivalent value in real currency or acts as a substitute for real currency. Under Michigan law, taxpayers are required to remit sales and use tax liabilities based on the dollar value of the consideration exchanged for taxable property. If the consideration is not in U.S. dollars, the taxpayer must convert the value of the consideration to dollars as of the date and at the time of the transaction. This requirement includes convertible currency exchanged for taxable property. The taxpayer accepting virtual currency must convert the value to dollars and maintain documentation indicating the value of the virtual currency on the day and at the exact time of the transaction. However, because virtual currency is not tangible personal property, purchases of virtual currency are not subject to sales and use tax. Treasury Update, "Virtual Currency," Michigan Department of Treasury, Nov. 2015 (released Oct. 23, 2015).

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