In Matter of American Multi-Cinema, Inc. and RKO Century Warner Theaters, Inc., DTA Nos. 823589, 823590 and 823646 (N.Y.S. Div. of Tax App., Jun. 21, 2012), an Administrative Law Judge held that payments to motion picture distributors for licenses to exhibit motion pictures delivered in digital format via hard drives are not subject to sales tax.

Each of the petitioners operated several theatres in New York State where motion pictures were exhibited to the public. Petitioners did not own the motion pictures they exhibited, but instead received the motion pictures from motion picture distribution companies (“distributors”) pursuant to licenses to exhibit the motion pictures.

Petitioners received the motion pictures either in tangible form on 35mm celluloid film (“35mm Film Model”) or in digital form (“Digital Model”). Petitioners paid sales tax to the distributors on the license payments, and sought a refund of sales tax paid only with respect to payments to distributors for motion pictures delivered in digital form.

The decision describes in detail the differences between the 35mm Film Model and the Digital Model for delivering motion pictures. In particular, to exhibit a motion picture delivered under the 35mm Film Model, petitioners required a physical copy of the motion picture for each screen on which the motion picture was to be exhibited. The physical copy was delivered to petitioners on metal shipping reels. Five or six shipping reels together held an average-length motion picture. In order to exhibit a motion picture, petitioners removed the 35mm film from the shipping reels, made adjustments such as inserting trailers, and assembled the separate segments of the motion picture prior to loading the 35mm film onto a projector for exhibition. When the exhibition period for a given motion picture ended, petitioners returned the motion pictures on their original shipping reels to the distributors in the original shipping cases.

Under the Digital Model, motion picture images and sounds were recorded in the form of compressed data that was stored on computer servers and exhibited through digital projectors. Digital motion pictures were delivered by distributors in several different ways, including via a portable computer hard drive on which the data file was saved, as a download transmitted via a network, or via a satellite transmission. All of the receipts at issue related to digital motion pictures delivered via portable hard drives.

Each portable hard drive contained one or two digital motion pictures and digital trailers, and was shipped to petitioners in a case about the size of a child’s lunch box. Upon receipt of a portable hard drive, petitioners copied or uploaded the digital motion pictures onto a “digital media block” or computer server that was part of a digital motion picture projection system. The original data files remained on the hard drive after uploading. The copied files were stored on the media block or server, and were available for exhibition until the digital motion picture was no longer being exhibited, at which time petitioners deleted the files. Petitioners uploaded the files containing a digital motion picture onto multiple media blocks or servers using the same hard drive received from the distributor.

For security reasons most digital motion pictures were encrypted and required a separate digital key known as a “KDM” to unlock the files and exhibit the digital motion picture. Distributors transmitted the KDM to petitioners via email. Each KDM was set to be active for a particular period of time, at the end of which period the KDM was typically programmed to expire, causing petitioners to lose access to the digital motion picture so that the content could no longer be exhibited. Once the exhibition period for a particular motion picture was complete, petitioners deleted the digital motion picture data file from their servers. Petitioners also returned the hard drive to the distributor in its shipping package. The distributors did not separately charge petitioners for the use of the hard drives, which remained the distributors’ property.

The parties did not dispute that license payments for the exhibition of a digital motion picture are not subject to sales tax when the motion picture is transferred to the exhibitor electronically, for example by satellite or network download, with no accompanying transfer of tangible personal property. Likewise, the parties did not dispute that license payments for the exhibition of a motion picture under the 35mm Film Model are subject to sales tax.

Petitioners contended that the Digital Model transactions distributed by hard drive did not constitute taxable sales of tangible personal property, because under the Digital Model the distributors did not transfer title or permanent possession of the hard drives, no separate consideration was paid for the hard drives, and the temporary transfer of the hard drives from the distributors was insufficient to support imposition of the tax. The Department disagreed, arguing that the licenses to exhibit the digital motion pictures were inseparable from the hard drives on which the digital motion pictures were delivered, and that petitioners’ possession of the hard drives was a sufficient transfer of tangible personal property to constitute a taxable sale.

The ALJ held for the petitioners based upon two findings: (1) unlike content on 35mm film, content in digital form does not become an inseparable part of the tangible personal property (the hard drives), and (2) in the Digital Model the tangible personal property is not necessary to exercise the license and exhibit the content. According to the ALJ, the “primary purpose, in the 35mm film context . . . cannot be achieved without the continuous possession and use of the physical film during the exhibition.” That is, in the 35mm Film Model the license is valueless without physical possession and use of the tangible personal property. On the other hand, under the Digital Model, the ALJ found that tangible property is not employed in carrying out the primary purpose of the transaction. The ALJ characterized the hard drives as mere containers or vessels used “to accomplish delivery of the desired content to its place of exhibition in an orderly fashion” but not “necessary to carry out the licensed use of the content.”

Additional Insights. The Department acknowledged in American Multi-Cinema that digital motion pictures delivered purely electronically, with no accompanying transfer of tangible personal property, are not subject to sales tax. In general, the Department has taken the position that charges for digital products transferred purely electronically, such as videos, music, audio recordings, artwork, e-books, ringtones, and “wallpaper,” are not for sales of tangible personal property and thus are not subject to sales tax. Advisory Opinion, TSB-A-11(20)S (Jul. 8, 2007); Advisory Opinion, TSB-A-08(63)S (Nov. 24, 2008); Google Inc., TSB-A-08(22)S (May 2, 2008); Spiritual Compass, LLC, TSB-A-07(16)S (Jun. 22, 2007); Apple Computer, Inc., TSB-A-07(14)S (May 17, 2007); Universal Music Group, TSB-A-01(15)S (Apr. 18, 2001). However, the Department argued that that the transfer of the same digital data on hard drives—rather than electronically—pushes it over the line to make the transaction taxable, and has so ruled in response to taxpayer inquiry. See Advisory Opinion, TSB-A-12(10)S (May 14, 2012). That position has now been rejected by the ALJ, although the decision is subject to appeal to the Tax Appeals Tribunal, and the time to file an exception to the ALJ’s decision has been extended until August 22, 2012.