United States: MoFo New York Tax Insights, Vol 10, Issue 9

After three non-precedential Administrative Law Judge decisions—and well after the statute in question has been replaced by new apportionment rules—the New York State Tax Appeals Tribunal has issued a precedential decision holding that revenue earned by an online business is properly sourced to the location where the revenue-generating activity was performed, in this case entirely outside New York. Matter of Catalyst Repository Systems, Inc., DTA No. 826545 (N.Y.S. Tax App. Trib., July 24, 2019). While it did not agree with the Administrative Law Judge's determination that the receipts were from services, finding that they were instead "other business receipts," the Tribunal nonetheless rejected the Department of Taxation and Finance's argument that, under the facts in this case, "other business receipts" should be sourced to the location of customers for years prior to New York's adoption of market sourcing for all businesses.

Facts. Catalyst Repository Systems, Inc. ("Catalyst") is a Colorado-based electronic data and document management company that provides litigation support services, including the use of proprietary software and technical personnel to acquire, store, sort, filter, and organize documents, generally used by clients needing to respond to discovery requests in litigation or regulatory proceedings. Catalyst licenses the use of its system to clients, for a designated case, on a month-to-month basis. The clients provide data to be hosted by Catalyst and then use the Internet to access Catalyst's system to search, review, and retrieve their own data. Catalyst organizes the data at its Colorado headquarters, where it maintains computer servers and storage facilities and where its employees develop, monitor, and maintain the necessary technology. Catalyst employs a large staff to keep the system operating and secure, assist clients in using the system, and build and maintain routers, servers, and other equipment. It charges its clients various forms of hosting fees, including monthly access fees, variable license fees, and base license fees.

The Issue. Catalyst treated its receipts as "service receipts" under Tax Law former § 210(3)(a)(2)(B) and sourced the receipts to the location where it maintained that the services were performed, outside of New York State. As an alternative, Catalyst argued that even if its receipts are classified as "other business receipts," under Tax Law former § 210(3)(a) (2)(D), they should still be sourced to Colorado because the activities and work that generated the receipts were performed there and not in New York.

The Tribunal . . . cited Siemens Corp. v. Tax Appeals Trib., . . . in which the Court of Appeals held that other business receipts [were] earned in and properly sourced to the location of the work that resulted in the income.

The Department argued that Catalyst's receipts should be classified as payments for intangible assets and treated as other business receipts, as opposed to receipts derived from the performance of services, relying on the language in Catalyst's agreements with its customers that referred to the right to access and use Catalyst's software system, and also contending that "services" must be performed by humans and may not be wholly automated. Under Tax Law former § 210(3)(a)(2)(D), other business receipts are sourced to the location where they are earned, which the Department argued, relying in part on its own Advisory Opinions issued in cases involving what it claimed were analogous facts, is the location of the devices on which Catalyst's customers access the system.

ALJ Determination. An ALJ agreed with Catalyst that the receipts arose from services and found that, even though no employees or agents of Catalyst were involved in performing the transactions at the moment of sale, the company was performing a litigation support service, through extensive personnel and facilities. The ALJ then determined that the services were performed in Colorado where Catalyst's servers and computer infrastructure, as well as the majority of its employees, were located.

Tribunal Decision. While it upheld the ALJ's ultimate decision that the receipts were not properly sourced to New York, the Tribunal did so on a different theory. First, it agreed with the Department that the receipts were not properly characterized as from services, finding that Catalyst's agreements with its customers granted the customers a license to use, and access to, its system. The Tribunal found that the employees who operated and maintained the system provided those services to Catalyst and not to its customers and that any services provided by Catalyst's employees to customers were not part of the licensing revenue at issue. Therefore, the Tribunal found that the receipts were for the license of "the use of a technologically advanced tool" and were properly classified as "other business receipts."

The Tribunal then considered the provision in Tax Law former § 210(3)(a)(2)(D) requiring other business receipts to be sourced to the location where they were earned. It cited Siemens Corp. v. Tax Appeals Trib., 89 N.Y.2d 1020, rearg. denied, 90 N.Y.2d 845 (1997), in which the Court of Appeals held that interest income, classified as other business receipts, was earned in and properly sourced to the location of the work that resulted in the income. Here, because virtually all of the work resulting in the receipts at issue—the development, monitoring, and maintenance of the system—occurred in Colorado, the receipts were not earned in, and could not be sourced to, New York.

The Tribunal acknowledged that the Department had issued four Advisory Opinions regarding the sourcing of receipts from digital transactions, including opinions dealing with digital access to data, digital sales of gift certificates and related products, and digital access to information, and that the Department has ruled that other business receipts should be sourced to the location of the purchasers' devices. However, as the Department conceded, Advisory Opinions are at most persuasive but are not precedential, and the Tribunal found that these Opinions are not persuasive, because they "offer no statutory or regulatory justification" for their conclusions; "they simply assert it." In the absence of authority for the position taken in the Advisory Opinions, the Tribunal rejected their conclusion and followed the Court of Appeals' holding in Siemens.

The Tribunal also noted, as had the ALJ below, that corporate tax reform, effective for taxable years beginning on or after January 1, 2015, provides for customer sourcing of other business receipts, and it is presumed that the amendments made a material change in the law. While the Department attempted to rebut this presumption by arguing that the "long-standing purpose" of the receipts factor had been to require customer-based sourcing, which tax reform was merely adopting, the Tribunal rejected this argument and found that the memorandum in support of tax reform actually reflected the contrary position, describing the modern shift to a service-based economy and expressly stating the new law would source a business's receipts to the location of its customers, thus removing "a previous disincentive to locating in New York."

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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