The Arizona Court of Appeals, Division One, affirmed1 lower Arizona court rulings that sales of leased software in Arizona constitutes a sale of tangible personal property (TPP), which are subject to Arizona’s transaction privilege tax (TPT) requirements.
SaaS Background
Software-as-a-service (SaaS) is a software leasing model whereby the end customer receives the right to access cloud-hosted software applications over the Internet. The SaaS application remains under the control of the SaaS provider, and the customer does not receive any right to download, copy, and/or otherwise install the software on the customer’s systems. Common examples of popular SaaS applications include Microsoft Office 365, Salesforce, and Workday.
While SaaS providers can offer a number of benefits when compared to traditional software leasing models, SaaS providers must comply with a patchwork of complex and evolving state and local sales tax laws. At the outset, SaaS providers must determine which of their SaaS leasing models are subject to such state and local taxes, and then must establish systems to invoice, collect, and remit applicable taxes. Depending on the applicable state or local jurisdiction, a SaaS application may qualify as a specifically taxed service, tangible personal property, a digital good, and/or a rental. Thus, the SaaS provider must determine the SaaS application’s tax status for each applicable jurisdiction. Further complicating matters is the fact that many states and local governments have tax regimes which pre-date the Internet, alongside various state interpretations established by court or administrative rulings. Therefore, navigating the multi-jurisdictional sales tax rules applicable to SaaS applications will likely remain an ongoing challenge for the foreseeable future.
Arizona TPT Background
In Arizona, tangible personal property or TPP is broadly defined as “personal property that may be seen, weighed, measured, felt or touched or that is in any other manner perceptible to the senses.”2 Unlike many states’ sales tax regimes, Arizona’s transaction privilege tax (TPT) is a tax levied on the privilege of doing business in the state.3 Consequently, the TPT is the seller’s (SaaS provider’s) legal liability whether or not collected and remitted by the seller (SaaS provider) in connection with any lease or rental of TPP.
Arizona considers digital services to be “tangible personal property,” and digital services are taxable under the personal property rental classification. 4 Anything digital is “tangible” because it can be viewed on media in some form, and Arizona considers “accessing” digital services to be the same as renting or leasing tangible personal property. Importantly, software is only exempt from TPT if such software is uniquely created for customer.
Although SaaS is not expressly defined in Arizona’s TPT statutes or its Administrative Code, an Arizona Department of Revenue (ADOR) Private Letter Ruling (LR10-007)5 defines SaaS as a model of software delivery where the vendor hosts the software application, and customers pay on a subscription basis to access and use it over a network (i.e., the Internet using a web-based user interface). Under this Private Letter Ruling, leased and subscription-based software are subject to TPT.6
Arizona TPT tax nexus generally occurs where the business has a physical presence in the state or, where there is no physical presence in Arizona, the business derives $100,000 or more in gross proceeds of sales of TPP, or gross income derived from sales to customers in the state.
Case
By way of background, ADP contracted with Maricopa County, Arizona, to deliver its cloud-hosted Enterprise eTime SaaS application, which was used for timekeeping (eTime) and hosted on servers located outside the state of Arizona. ADOR, Maricopa County (through ADOR), and the City of Phoenix assessed and collected TPT in connection with eTime fees. ADP sought refunds of TPT payments by asserting that eTime was an intangible good that did not qualify as TPP. ADP also argued that the primary focus of its contract with Maricopa County was providing a timekeeping service, and that the eTime SaaS application was incidental or inconsequential to the transaction – and therefore should not be taxable TPP. Finally, ADP argued that subjecting eTime to Arizona’s TPT is a violation of the Internet Tax Freedom Act (ITFA)7 because it results in ADP’s online paycheck services being treated differently than it would services involving physical assets, the way ADP conducted business pre-internet.
In its ruling, the Arizona Court of Appeals sided with earlier findings from ADOR and City of Phoenix, as well as the ruling from Arizona Tax Court, by rebuffing all of ADP’s assertions. The Arizona Court of Appeals held that sales of SaaS applications in Arizona are rentals of tangible personal property and taxable under Arizona’s transaction privilege tax. In State v. Jones,8 the Arizona Supreme Court held that paying to play a record by a jukebox was "perceptible to the sense of hearing" and thus constituted tangible personal property. The Arizona Court of Appeals cited Jones as informing its conclusions, noting that, “Like the sound of the record in Jones, which was audibly perceptible to a jukebox patron’s senses, eTime is likewise perceptible because it can be viewed by the County’s users while accessing and using the program.”
The Arizona Court of Appeals also rejected the timekeeping services argument because ADP’s invoices have separate, individual charges for Hosting Services, ADP Enterprise eTime, Hardware Shipping and Handling, and Implementation Charges. In the court’s view, the separate charges for eTime as a SaaS application distinguish the leased software from actual services provided pursuant to the contract between the parties.
Finally, while the IFTA prohibits imposing multiple or discriminatory taxes on electronic commerce, the Arizona Court of Appeals rejected ADP’s IFTA argument. The Arizona Court of Appeals rejected this argument because it determined that the record established that ADP changed the nature of the transaction when it developed software to automate tasks that were previously performed by human employees. Thus, as the Arizona Court of Appeals determined, the change in tax status is entirely attributable to ADP’s automation of its work, not because of its internet use.
Petition to Arizona Supreme Court for Review
ADP has petitioned the Arizona Supreme Court to review the Arizona Court of Appeals' decision with respect to, among other things, each of the three arguments described above. On May 19, the Council On State Taxation (COST) filed an amicus brief arguing that upholding the Arizona Court of Appeals' decision, “makes Arizona an extreme outlier among states, authorizing improper administrative action to tax certain digital products without statutory authority.” 9 COST argues that there is no statutory authority to include eTime in the TPT tax abase as the lease or rental of TPP. COST also argues that taxing ADP’s eTime discriminates against electronic commerce in violation of the IFTA because the company’s services were not subject to the tax when they were non-digital.
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