United States

Michigan: Court of Appeals Holds that Cloud-Computing Transactions are not Subject to Use Tax

Nov 02, 2015
From KPMG TaxWatch

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In a recent decision that has been certified for publication, the Michigan Court of Appeals ruled that a taxpayer’s purchases of various cloud-computing services were not subject to Michigan use tax. The taxpayer at issue provided property and casualty insurance services to customers in 26 states. The taxpayer contracted with numerous third-party service providers to purchase remote access to their computer networks, servers, data storage, and software applications, which were used by the taxpayer to service insurance clients and independent agents. Tasks performed using the remotely accessed tools included retrieving data, processing billing and payments, and acquiring information such as data reports, risk analysis, property valuations, and legal research. On audit, the Department of Treasury determined that these transactions amounted to the taxpayer’s “use” of tangible personal property—specifically prewritten computer software—in the state of Michigan. The Department assessed use tax on the taxpayer’s purchases. The taxpayer protested, and the matter went to the court of claims. The court of claims concluded that the taxpayer did not take “delivery” of any prewritten software because the software was not handed over, left, or transferred to the taxpayer. Additionally, because remote access to a third-party provider’s technology infrastructure was essentially unheard of in 2004 when Michigan’s statute addressing prewritten software was enacted, the court of claims declined to extend the scope of the term “delivery by any means” to include remote access to software. The court of claims also held that (1) the taxpayer did not make requisite “use” of the software (by exercising rights incident to ownership) to subject the transactions to use tax and (2) any use of the software was incidental to the provision of nontaxable services. The Department of Treasury subsequently appealed.

The appeals court first addressed whether the taxpayer used any prewritten computer software in Michigan. Under Michigan law, prewritten computer software “delivered by any means” is subject to sales and use tax. The court first determined that the court of claims had erred when it held that no “delivery” occurred because all the software remained on third-party servers. In fact, certain of the software (or at least pieces of software that enabled the customer to access certain hosted services) was transferred to the taxpayer’s computers. In the court’s view, the court of claims also erred when it narrowed the scope of the term “deliver” to preclude electronic delivery. However, the court of claims correctly ruled that the mere transfer of information and data that was processed using the third-party providers’ software did not in and of itself constitute delivery of prewritten computer software. The majority of the transactions did not involve the delivery of software and therefore there was no use of tangible personal property. In particular, certain software-as-a-service transactions in which the taxpayer would input data and receive information regarding value or underwriting risk fell into this category.

The court concluded, however, that in certain of the transactions, software was delivered and use incident to ownership occurred. This included certain software related to Webex conferencing, payment processing, and managing remote access to the taxpayer’s networks by its employees.

The appeals court then analyzed whether the transfer of the software related to these services was incidental to the rendering of services so that the transactions were not subject to use tax. The six factor, so-called “incidental to service test” developed under Michigan case law, looks objectively at an entire transaction to determine whether the transaction was principally a transfer of tangible personal property or the provision of a service. Applying the six factors to the transactions at issue, the court determined that the majority of the factors weighed in the taxpayer’s favor. Notably, it was clear to the court that in all but one case, the taxpayer sought to purchase the service, not the underlying software. Furthermore, all of the third-party providers were service providers and there was no indication that the taxpayer could have purchased the software or other tangible personal property transferred separate and apart from purchasing the underlying services. Accordingly, the court concluded that the transactions were not subject to use tax. For more information on Auto-Owners Insurance Company v. Department of Treasury please contact Jill Nielsen at 312-665-2794.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.