A recent case in Michigan has created an unexpected twist in the brave new world of taxing software and services online.

The Michigan Court of Appeals has decided against the Michigan Department of Treasury in a case involving the taxation of the sales or use of services provided over the Internet. The case itself has broad application to a number of states that are weighing the taxation of Software-as-a-Service without changing their law to say that they are specifically taxing a service, according to June Haas, tax partner at Honigman Miller Schwartz and Cohn LLP.

The Court of Appeals, in Auto-Owner’s v. Department of Treasury, held that a variety of services provided via the Internet are not subject to sales or use tax. The department had asserted that such services involved the “use” of prewritten, canned software on the basis that the taxpayer was accessing the functionality of the software on the third-party service provider’s network through computers and the Internet, and that such use was taxable. The services included, among other things, data analysis services, information services, secure data transmission, electronic research services, hardware and software maintenance, and Web conferencing.

The Court of Appeals found that the majority of services at issue did not involve the delivery of any prewritten, canned software, Haas indicated. “The case was watched nationally because many states impose sales and use tax only on tangible personal property,” she said. “They have not updated their laws to cover electronic and digital delivery of software. Michigan was trying to tax accessing the functionality of software. They wanted to say that if you access the functionality, then it’s the same thing as buying the software. It transforms Software-as-a-Service into the purchase of tangible personal property that is taxable.”

“In a number of the transactions, the taxpayer merely electronically transmitted data and received back analyzed data. In others, the taxpayer electronically transmitted data to be securely transmitted to a third party,” she said. “In each of these cases, the court held that the taxpayer never had access to any of the third-party vendors’ computer codes, and thus there was no use of prewritten computer software.” The court also rejected the department’s argument that “accessing the functionality” of software constitutes delivery of prewritten software and a taxable use. The court held that sending requests into another’s system does not constitute an exercise of a right or power of control of the vendor’s software incident to ownership of the software that constitutes a taxable use. Thus, the delivery of the results of electronic research services or electronic analysis services that used the software to perform the service was not an exercise of control over the software. Accessing a Web site is not the use of software. 

The Court of Appeals held that the evidence proved that the maintenance contracts at issue did not include delivery of prewritten software. In addition, when the taxpayer purchased software and separately purchased software maintenance in transactions where the cost for the maintenance and support were separately stated, the maintenance fees were nontaxable fees for services.

Finally, the court also held that for the transactions where property was delivered, the “incidental to the services” test set forth in the Michigan Supreme Court’s decision in Catalina Marketing must be applied. Under these tests, the court held that these were service transactions and not sales of tangible personal property.



“The taxation of SaaS is a very hot area right now,” said Peter Stathopoulos, lead partner at the state and local tax practice at Atlanta-based Bennett Thrasher. “For a long time, states have struggled with how to treat SaaS, because state tax laws typically lag behind technology,” he said. “In the late 1970s and in the 1980s, state sales tax codes were designed for the most part to deal with tangible property. When software came along, the question was whether it was tangible property or was it a service. The states decided back then that because software was encoded on a tangible medium, it was tangible personal property.”

“So they had this idea that software is the same as any other piece of tangible personal property because you got it on a disk,” he said. “When technology moved along and people started to download software instead of buying it on a disk, the states split. Some decided if it was not on a floppy disk there was no property, so there was no sales tax. Others went the other way, and decided to do away with the distinction of how the software is delivered. So in the 1990s, if you downloaded from a computer they would treat it as the sale of property. Now that the software stays on the vendor’s computer, states are being asked if there’s really a transfer of tangible personal property.”

A number of states have addressed this issue, according to Stathopoulos: “The Michigan court said there is no transfer of property here. The software stayed on the vendor’s computer, and the user never got to control it like an owner or lessee. Since they had access to the software but never had the right to control it, there was never any taxable sale or use of the software in question.”

Other states have gone a different way, Stathopoulos said: “New York has issued a letter ruling saying that when you get on the Internet, you are getting constructive use of the software. It’s the same as leasing the software, and in New York the sale or lease of software is a taxable transaction.”

“That it the great divide now,” he said. “States will have to decide when there is hosted software or SaaS and it comes as part of a broader service offering, is it being leased to customers. Some will say there is no sale or lease of tangible personal property, while others like New York will say the ability to access the software from a computer is a form of constructive possession, so there is a sale or lease of tangible personal property.”

“Only a handful of states have addressed this,” he said. “Other states are watching. The Michigan decision will probably have a chilling effect on state departments of revenue that are trying to tax these kinds of SaaS transactions.”

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