The Arizona Department of Revenue (“Department”) recently made public Letter Ruling 16-011 (“Ruling”), which concluded that a taxpayer’s gross income from electronic transaction processing services that involved the use of software was not taxable for Arizona transaction privilege tax (“TPT”) purposes. The Department opined that the electronic transaction processing services were not taxable as a rental of tangible personal property because the taxpayer’s customers did not have the “exclusive control” over the software required for a taxable rental. This Ruling is significant because the Department, like revenue departments in several other states (including New York), has historically concluded that online services involving the remote access or use of software were subject to the TPT as a rental of tangible personal property, without analyzing the degree of control the customer had over the software.
The taxpayer at issue was a subscription billing and reoccurring payment provider that worked with third-party payment processors to process electronic payment transactions for its clients’ sales. The taxpayer received the transaction data from its clients through its cloud-based Application Program Interface (“API”). The API securely transmitted the clients’ transaction data over the Internet to the taxpayer’s servers for processing. The clients were able to access this data on the taxpayer’s servers and make any necessary changes to the data through a web-based portal (“Portal”). The taxpayer’s fees varied based on the size and scope of the work, but were generally based on the dollar amount of successful billing transactions in a particular timeframe.
The Department concluded that both the API and Portal were software and thus tangible personal property for TPT purposes. The Department then analyzed whether the taxpayer was “selling” or “renting” the API or Portal software or engaging in a non-taxable activity.
The Department first disposed of the selling inquiry. It concluded that the taxpayer was not subject to TPT under the retail classification because the taxpayer’s clients did not get perpetual rights to the software (i.e., the transfer of the software was not a “sale”).
With respect to the renting analysis, the Department explained that “the critical question is whether [the taxpayer’s] customers gain sufficient control and use of its software (the API and Portal) to constitute the rental of tangible personal property” and that “the granting or non-granting of a software license is not definitive of that question.” The Department then cited to Arizona cases addressing whether a particular activity is considered a rental of tangible personal property, including a case in which the Arizona Supreme Court concluded that a customer must have “exclusive control” over the property at issue to come within the meaning of the term “renting” for TPT purposes. According to the Department, no such “exclusive control” over the software existed in the present matter. Thus, the Department concluded that the electronic transaction processing services did not constitute a taxable rental of tangible personal property. In particular, the Department noted: (1) the taxpayer’s continued interaction with and use of the software, which demonstrated the clients’ lack of “exclusive control” over the software; and (2) the taxpayer’s compensation structure, which was based on the dollar amount of successful payments generated, rather than being fixed or usage-based.
This Ruling is a welcomed change from Arizona’s prior application of the TPT to online services involving remotely accessed software. In prior rulings the Department had generally concluded that the mere use of software (for example, by typing information into word processing software or entering search parameters into database software) was subject to the TPT as a rental of tangible personal property. See, e.g., Arizona Letter Ruling 15-005 (May 14, 2015). The Department’s recognition and application of the “exclusive control” standard in this Ruling should give taxpayers that provide or use similar online services involving remotely accessed software in Arizona helpful guidance when dealing with this issue in audit or litigation.