On August 24, 2017, the New York State Division of Tax Appeals (“DTA”) issued a determination regarding the proper classification and sourcing of receipts from electronic litigation support services for apportionment purposes under Article 9-A of New York’s legacy corporate franchise tax regime (the “Tax”).1 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.2 Although the determination is not binding, it represents the third determination recently issued by the DTA reaching a similar conclusion.3
The taxpayer, Catalyst Repository Systems, Inc. (“Catalyst”) is a Colorado-based electronic data and document repository corporation that provides litigation support services to its clients. Catalyst provides its clients with the use of its system, which includes its proprietary software and the use of its technical personnel, in order to acquire, store, sort, filter, organize and ultimately find and retrieve the documents its clients require, typically in response to demands for discovery arising through litigation, governmental requests or regulatory inquiries. Catalyst maintains all of its servers and computer infrastructure in Colorado. The vast majority of its employees are also located in Colorado.
On its returns for tax years 2008 through 2010 (the “Audit Period”), Catalyst sourced its online litigation support service receipts entirely to Colorado, based on the location where the service was performed. The Department conducted an audit and assessed additional Tax against Catalyst for the Audit Period, based on the position that Catalyst’s litigation support service receipts should be reclassified as “other business receipts,” rather than as receipts from services, and sourced to New York-based on customer location.
The Department’s Position
The Department’s position was identical to the position that it had asserted in the Matter of CheckFree Services Corporation (“CheckFree”)4, and substantially similar to its position asserted in Matter of Expedia, Inc. (“Expedia”)5. The Department primarily argued that Catalyst’s litigation support service receipts were not receipts from the performance of services, because no employees, agents, subcontractors or other persons were involved in performing the transactions in question. Second, the Department argued that Catalyst’s receipts were generated as the result of the sale of access to and use of its software. Under both theories, the Department sought to classify Catalyst’s receipts as “other business receipts” that should be sourced based on customer location, because the receipts were “earned” at the location of the customers. The Department also argued that, even if the receipts were properly classified as service receipts, they should still be sourced based on customer location.
The Taxpayer’s Position
Catalyst contended that its electronic litigation support service receipts were properly classified as service receipts that should be sourced to the location of the servers and employees performing the work. Catalyst also asserted that even if the receipts were properly classified as “other business receipts,” the receipts should still be sourced to Colorado because the activities and work that generated the receipts were performed there, and not in New York, and therefore the receipts were earned in Colorado.
Determination of the Division of Tax Appeals
On appeal to the DTA, the Administrative Law Judge (“ALJ”) found for Catalyst in all of the issues discussed above.
Need for Human Involvement
As previously determined in Expedia and CheckFree, the ALJ again 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 that the Division’s attempt to treat automated services differently from other services was incorrect.
Sale of Access to and Use of an Intangible Asset
As was the case in CheckFree, the ALJ rejected the Department’s attempt to classify the receipts as derived from the granting of access to, or use of, Catalyst’s system, such that the receipts at issue could be characterized as resulting from licensing intangible assets. The ALJ noted that Catalyst’s clients utilize its services as a service provider, and that they do not simply pay Catalyst to host their documents on its servers, or to access its software.
Sourcing of Receipts from “Services”
The ALJ rejected the notion that, even if classified as service receipts, Catalyst’s receipts must be sourced based on customer location. The statute in effect for the Audit Period required service receipts to be sourced to the location where the services were performed. As the ALJ recognized, all of Catalyst’s services were performed in Colorado, where its servers and computer infrastructure, as well as the majority of its employees, were located.
Sourcing of “Other Business Receipts”
Finally, in a position that we find particularly interesting, the ALJ rejected the Department’s interpretation that the term “earned” is synonymous with market-based sourcing. Consistent with the determination issued in CheckFree, the ALJ stated that “even if the receipts in issue are properly classified as ‘other business receipts,’ the fees are not earned in New York simply because the client is in New York.”
The Catalyst determination is the third such win for taxpayers against the Department regarding the proper classification of electronically delivered service receipts. Despite the prior two taxpayer victories, the Department has continued to assert its position on audit, while arguing that each taxpayer’s facts are distinguishable, and that the prior determinations issued by the DTA were not binding. The Department has until September 23, 2017, to appeal the ALJ’s determination.6
Regardless of whether this decision is appealed, we believe that as the momentum continues to build against the Department, taxpayers should continue to fight the imposition of any additional Tax based on the “other business receipts” theory. The Department will have a difficult time ignoring three decisions issued by the DTA in which its position has been unambiguously rejected. Further, taxpayers that have classified receipts as “other business receipts” should consider the ALJ’s interpretation of “earned,” and whether a refund opportunity may exist.