For years, both the New York State Department of Taxation and Finance (the “Department”) and the New York City Department of Finance have aggressively sought to classify receipts generated by electronic or online service providers as “other business receipts,” rather than as services for corporate income tax apportionment purposes. The state’s and city’s position has been premised on the notion that there must be human involvement in the rendition of the service at the moment of the sale to meet the definition of a “service.” In Matter of Expedia, Inc., DTA Docket Nos. 825025 & 825026 (02/05/2015), the Department made that exact argument in seeking to recharacterize Expedia’s receipts from its travel reservation facilitation business as “other business receipts,” and to source those receipts based on customer location rather than on cost-of-performance. The Division of Tax Appeals has determined, in a determination authored by Administrative Law Judge Herbert Friedman, that the Department’s position is incorrect and has no basis in New York state tax law.
The Division of Tax Appeals determination begins by looking to the dictionary definition of a “service” in order to give effect to the plain meaning of the words used in the statute. According to Black’s Law Dictionary, a “service” is the “performance of labor for benefit of another, or at another’s command.” According to Judge Friedman, compiling information, facilitating arrangements, providing customer assistance, maintaining records and operating a rewards system – all for the purpose of acting as a travel intermediary – “leads to the inexorable conclusion” that the receipts at issue were from the performance of service.
Judge Friedman went on to state that there is no requirement in the statute (or, as the Department claimed, its regulations) that a service must include human interaction at the point of sale in order to meet the definition of a service. Calling the Department’s reading of its regulations “stretched,” Judge Friedman held that the Department’s argument represents an inaccurate interpretation of Tax Law regulation 20 NYCRR 4-4.3 and an “impermissible expansion” of Tax Law section 210(3)(a)(2)(B). Moreover, he noted that even if a “service” must contain human involvement, Expedia met the requirement. Expedia employs nearly 6,600 employees engaged in the creation of software, negotiation of agreements, compilation of information, programming and operation of servers, creation and maintenance of a website, and customer service. Thus, it would be incorrect to assert that there is no human involvement in the performance of Expedia’s service.
Finally, the determination confirms that a service is not performed at the location of the customer at the exact moment of sale, but rather, at the location where the activities that facilitate and generate the completion of the sale are conducted. Reflecting a position we have long advocated on behalf of clients, Judge Friedman even suggested that, under Matter of Siemens Corp. v. Tax Appeals Tribunal, 89 N.Y.2d 1020 (1997), a cost-of-performance analysis would apply regardless of whether the receipts are classified as being derived from “services” or “other business receipts.”
With the issuance of this determination, the Division of Tax Appeals has weighed in for the first time on what has long been a highly contentious and adversarial audit issue in New York state and New York City, especially for electronic and online service providers. While the determination is not binding, and will likely be appealed, the holding in the determination follows and supports the exact arguments that taxpayers have been making for years, which is that electronic and online service receipts are receipts from “services” that should be sourced based on cost-of-performance principles.
Taxpayers that have been filing New York State and City corporate income tax returns in accordance with the state and city’s erroneous position should consider filing refund claims for all open periods. Should the New York State Tax Appeals Tribunal uphold the administrative law judge’s determination, the decision would become binding on New York State (and effectively the city), and the refund claims would likely have to be granted. In the interim, taxpayers will be on stronger grounds to appeal any refund claim denials before the Bureau of Conciliation and Mediation Services or the Division of Tax Appeals. The determination will have similar consequences for ongoing audits and appeals. Although it is unlikely that the Department will immediately change its position, based on Reed Smith’s experience in representing numerous clients with this exact issue, the issuance of this determination is already having an impact by providing taxpayers with additional leverage in negotiated settlements. In addition, given New York’s corporate tax reform which went into affect on January 1, 2015, taxpayers may be in a favorable position to get certainty as to their filing position for all years prior to the change in law.