In overturning the Commonwealth Court, the Pennsylvania Supreme Court recently held that royalty fees for certain intellectual property were not subject to Pennsylvania sales tax. See Downs Racing LP v. Commonwealth of Pennsylvania, Dkt. No. 70 MAP 2017 and 71 MAP 2017 (Pa. Oct. 25, 2018). The royalties at issue were payments between third parties for IP used in the operation of gaming machines (“Gaming IP”). The Commonwealth argued the Gaming IP was canned software, and thus taxable in Pennsylvania. The Commonwealth also argued, in the alternative, that sales tax was due on the full price paid for the gaming machines along with any ancillary items, such as the Gaming IP. In siding with the taxpayer, the court found the Gaming IP was not subject to sales tax because it did not constitute, nor was it ancillary to, tangible personal property.
In a clumsy effort to tax the Gaming IP, the Commonwealth sought to characterize it as canned software, which was found to be taxable in Dechert, LLP v. Commonwealth, 606 Pa. 334 (2010) (finding that canned software in the form of a copyright license was taxable). However, the Commonwealth’s position ignored the fact that the original purchase of the gaming machines included the operating software. The Gaming IP, in contrast, was a bundle of intangible legal rights distinct from the gaming machines and operating software. This fact was evidenced by a separate contract that governed the Gaming IP and the breakout of the Gaming IP royalty from the purchase price of the gaming machines.
The Commonwealth’s assertion that the Gaming IP was incidental to the gaming machines, and thus subject to sales tax, was equally flawed. Under Pennsylvania law, certain ancillary services to tangible personal property, such as processing and repairing, are subject to the sales tax. But for the reasons noted above, and because intellectual property is not identified in the Pennsylvania law as a taxable ancillary service, the court properly identified the Gaming IP as a separately purchased intangible right.
The conflation of canned software and intellectual property highlights the Commonwealth’s unmasked attempt to expand the Pennsylvania sales tax base. As the economy continues to shift to services and intangibles, states are pressed to look for creative ways to impose historic sales tax statutes, which were designed to tax tangible personal property and certain enumerated services, on new and different products and industries. The Commonwealth’s ambition was corralled in this case. However, it was not that long ago when Software as a Service (“SaaS”) was considered beyond the scope of a traditional sales tax statute. Now many states subject SaaS to tax, including Pennsylvania. While the taxability of SaaS remains contested in certain states, and the contours of the space continue to evolve (see “Exclusive Control Over Remotely Accessed Software Necessary for the Arizona Transaction Privilege Tax to Apply” ), the SaaS example is likely telling that states will continue to push for expansion of the tax base to new and different categories of property and services, including intellectual property.
From where we currently stand, the holding in this case is not surprising. However, for this issue — whether intellectual property is subject to sales tax — to reach the Pennsylvania Supreme Court for resolution is an important reminder of continued state overreach. While intellectual property remains exempt from sales tax in Pennsylvania for now, we expect states to continue to challenge this issue, particularly in those situations where the intellectual property is linked to the transfer of tangible personal property.