The New York State Division of Tax Appeals has issued a determination regarding the proper methodology for sourcing electronic service receipts under Article 9-A of the pre-reform Tax Law. The taxpayer prevailed in overcoming the Department’s attempt to impose market-based sourcing and was vindicated in sourcing its service receipts to the location where the services were performed.
On January 5, 2017, the New York State Division of Tax Appeals (“DTA”) issued a determination regarding the proper classification and sourcing of electronic service receipts for apportionment purposes under Article 9-A of New York’s legacy corporate franchise tax regime. In a taxpayer win, the DTA rejected the “other business receipts” market-based sourcing approach of the New York State Department of Taxation and Finance (the “Department”), and found that place of performance was the proper sourcing methodology.
The taxpayer, CheckFree Services Corporation (hereinafter “CheckFree”), is a provider of electronic bill payment and presentment services. CheckFree’s services allow financial institutions, credit unions, and community banks across the United States to outsource the service of providing electronic bill payment and presentment, allowing customers to initiate payments electronically, and allowing merchants and vendors to present bills electronically. CheckFree’s core business functions, including its data center, call center, and other support facilities, were located entirely outside of New York.
CheckFree timely reported and paid tax for the period July 1, 2004 through December 31, 2009 (the “Audit Period”). On its returns, CheckFree applied a cost of performance methodology to source its electronic bill payment and presentment service receipts. The Department conducted an audit and assessed additional tax against CheckFree for the Audit Period, based on the position that CheckFree’s electronic bill payment and presentment receipts should be reclassified as other business receipts and sourced to New York based on customer location.
B. Department’s Position
The Department sought to source CheckFree’s bill payment and presentment receipts based on the location of CheckFree’s customers. The Department’s primary argument was that CheckFree’s receipts were not from the performance of services because there was no direct human involvement in the performance of the services. The Department also argued that the receipts were generated as the result of the sale of access to and use of an intangible asset. Under both theories, the Department sought to classify CheckFree’s receipts as “other business receipts” and, therefore, source them based on customer location. The Department also argued that, even if the receipts were properly classified as service receipts, they should still be sourced based on customer location.
C. Taxpayer’s Position
CheckFree asserted that its bill payment and presentment receipts were properly classified as service receipts. CheckFree argued that the Tax Law and corresponding regulations contain no requirement for human involvement in order to properly classify receipts as service receipts and that, even if such a requirement existed, the performance of CheckFree’s services included significant human involvement. CheckFree also asserted that, even if the receipts were properly classified as “other business receipts,” the receipts were “earned” at the location where the work that generated the receipts was performed by CheckFree and, therefore, would still be sourced outside of New York. Lastly, CheckFree asserted that the Tax Law does not permit service receipts to be sourced based on customer location, which is evidenced by the Legislature’s recent adoption of a market-based sourcing regime that applies only on a prospective basis.
D. Determination of the Division of Tax Appeals
On appeal to the DTA, the Administrative Law Judge (“ALJ”) found for CheckFree with respect to all of the issues discussed above.
1. Need for Human Involvement
The ALJ determined that the term “services” may be properly defined as “useful labor that does not produce a tangible commodity” or “performance of labor for benefit of another, or at another’s command.” The ALJ determined that there is no requirement – in the statute or regulations – for human involvement in an activity in order to properly classify receipts from the activity as service receipts.
In regard to the Department’s attempt to classify receipts from electronically delivered services as “other business receipts,” the ALJ stated:
It is of no moment that the ultimate fulfillment of the desired service is… accomplished electronically. In this respect, and due to the advance of technology, the computers, services, data centers and secure electronic connections (i.e. the portions of the overall service petitioner provides that have been automated) are simply the tools used by petitioner (and its employees) to perform and provide its… services.
Thus, the ALJ recognized that the Department’s attempt to treat electronic services as other business receipts would serve to eliminate any consideration of technological advances, and the practical expansion of the means by which service activities may be performed. In sum, the ALJ determined that the use of electronic means as a tool to perform a service cannot be said to reclassify the service itself.
Moreover, the ALJ found that even if there was a requirement for human involvement, the work performed by CheckFree’s approximately 3,000 to 4,000 employees during the Audit Period undoubtedly fulfilled that requirement.
2. Sale of Access to and Use of an Intangible Asset
The ALJ rejected the Department’s attempt to classify the receipts as derived from the sale of granting access to or use of an intangible asset. The determination reinforced the rule that, in classifying receipts for corporate income tax purposes, a taxpayer is required to ascertain the primary purpose, or true nature of the business activities that generate the receipts. While CheckFree’s service contracts may have involved access to and use of CheckFree’s online platform, such access was merely a component part of the means by which CheckFree performed its overall services.
The ALJ found that when looked at in its entirety and from the perspective of its customers, CheckFree’s business was providing customers with electronic bill payment and presentment services. Any rights granted to access and use its systems represented a necessary incident or aspect of the means by which CheckFree provides such service. Notably, the existence of “right to access and use” terms in CheckFree’s service contracts – language the Department often points to on audit for support of its position – did not reclassify the service.
3. Sourcing of “Services”
The ALJ rejected the notion that, even if classified as service receipts, CheckFree’s receipts must be sourced based on customer location. The statute requires service receipts to be allocated to the location where the services are performed. As the ALJ recognized, the services performed consisted of much more than an instantaneous, fully automated transaction rendered at the moment a customer clicked on his or her keyboard. Rather, the services were performed over a period of time (payments were sometimes scheduled for up to a year in advance) by hundreds of CheckFree employees working at facilities and locations entirely outside of New York.
The determination also noted that New York’s recently enacted corporate tax reform3 supports the fact that the Department’s attempt to use a market-based sourcing approach contradicts the statutory scheme in place during the years at issue. The ALJ determined that the rules of statutory construction make clear that it is presumed that changes to law are made to affect some purpose and to make some change in the existing law. Accordingly, if a market-based sourcing regime had been contemplated by the prior statute, portions of the new law would have been unnecessary.
4. Sourcing of an “Other Business Receipt”
Finally, the determination concluded that even if the receipts at issue were other business receipts, the receipts were “earned” at the location where the work that generated the receipts was performed. Contrary to the Department’s view, the location where a receipt is earned is not necessarily the same as customer location. In this case, the work done to complete the bill payment and presentment services was rendered at CheckFree’s data center and facilities located entirely outside of New York.
The Department has until February 5, 2017, to appeal the ALJ’s determination.
To a large degree, these sourcing issues are fact-specific. However, taxpayers in electronic service industries should pay particular attention to the CheckFree determination.