On October 25, 2018, in Downs Racing, LP v. Commonwealth, a unanimous Pennsylvania Supreme Court partially reversed the Commonwealth Court and held that royalty fees for intellectual property are not subject to sales and use tax as charges for tangible personal property, thus entitling the taxpayer to a refund.
Downs Racing LP operated the Pocono Downs racetrack in Wilkes-Barre, Pennsylvania and an adjacent casino. It purchased video poker game machines that were located in the casino. Pursuant to a separate intellectual property agreement, Downs Racing paid royalty fees for intellectual property associated with the different poker games that would run on the machines. The company paid (and did not dispute) sales tax on its purchases of the machines. It also self-assessed and paid use tax on the royalty payments.
After being audited and issued a sales and use tax assessment for certain unrelated service fees, the company challenged the assessment and separately sought a refund of the use taxes that it had paid on the royalty fees (the “Refund Claim”). After the Department of Revenue (the “Department”) and the Board of Finance and Revenue upheld the assessment and denied the Refund Claim, the company appealed to the Commonwealth Court. The Commonwealth Court consolidated the appeals, reversed the assessment in part and upheld the denial of the Refund Claim. In denying the Refund Claim, the Commonwealth Court found that the intellectual property constituted “tangible personal property” and stated that “just because the [statute] does not expressly mention ‘intellectual property’ in its definition of ‘tangible personal property’ does not mean that [intellectual property] does not constitute tangible personal property.”
The Pennsylvania Supreme Court reversed the Commonwealth Court with respect to the Refund Claim and upheld the remaining assessment (the Department did not appeal the Commonwealth Court’s partial reversal of the assessment). In rejecting the Commonwealth Court’s conclusion that intellectual property is “tangible personal property,” the Pennsylvania Supreme Court noted that the statutory definition of “tangible personal property” is “[c]orporeal personal property” and that the statute identifies types of properties included in the definition of the term “not all of which are ‘tangible’ in the common sense of the word” – such as steam, telecommunications services and video or cable programming services – but the statute does not identify intellectual property as being included in the definition. The Court, therefore, found that it would be “tenuous” to suggest that intellectual property is included “by implication” within the definition of tangible personal property, particularly in consideration of the precept that taxing statutes are to be strictly construed against the taxing authority.
The Court also rejected the Commonwealth’s argument that the royalty fees should be taxable as part of the purchase price of the poker game machines. The Court found that Downs Racing had demonstrated that the royalty payments for the use of the intellectual property were distinct from the purchases of the machines and the software necessary to operate the machines. In particular, the Court noted that there was a separate contract for the intellectual property, the intellectual property was not necessary to the function of the machines and the company’s decisions about which intellectual property to purchase for each machine depended on events that occurred after the machines were in place and being used (the company could change the intellectual property being used on a machine depending on customer interest and revenue generation). Accordingly, the Court found that the Department should have granted the Refund Claim.
The Commonwealth Court is not the first court to attempt to expand the definition of “tangible personal property” beyond the plain language of the statute and the common sense meaning of the term. For example, the Michigan Court of Claims, in Thomson Reuters (Tax & Accounting) Inc. v. Department of Treasury, concluded that “information” was “tangible personal property.” Companies should take heart in the fact that in both Downs Racing and Thomson Reuters the decisions of the lower courts were reversed on appeal and the companies ultimately prevailed.