United States

Michigan court rules cloud computing is a nontaxable service

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On March 20, 2014, the Michigan Court of Claims issued its ruling in Auto-Owners Insurance Company v. Michigan Dep't. of Treasury, holding that accessing the computer systems of third-party providers via the Internet, commonly referred to as cloud computing, is not subject to sales and use tax because cloud computing is a nontaxable sale of a service and not, as the Michigan Department of Treasury contended, the taxable sale of tangible personal property. The court's ruling opens up the opportunity for taxpayers to seek refunds of sales or use tax paid on cloud computing services and may provide purchasers substantial ongoing tax savings.

Auto-Owners is a Michigan corporation in the business of providing various types of insurance through independent agents located in 26 states. To accomplish the tasks necessary to serve its clients and independent agents, Auto-Owners engaged third parties to provide cloud computing services, which the court generally described as follows:

[…] complex technology that involves a consumer's remote access to a third party's technology infrastructure, including its service as well as its networks, servers, data storage, and applications not physically located on the user's computer . . . . These tasks include, for example, the retrieval of data, the processing of billing and payments, and the acquisition of information such as data reports, risk analyses, property valuations, and legal research.

At no point, however, was any software transferred into the hands of Auto-Owners.

In deciding that software involved in the transactions at issue was not tangible personal property, the court looked to the state's rules in relation to the sales and use tax treatment of prewritten computer software, which define non-customized software delivered by any means as tangible personal property. The court, after looking to the plain and ordinary meaning of the term "deliver," noted that no software was "handed over, left or transferred" to Auto-Owners. Rather, "[w]hat was transferred was information and data that had been processed using the third-party [providers'] software, hardware, and infrastructure."   Accordingly, the court found that the transactions were not subject to sales tax because no software was delivered, leaving the transaction outside of the express terms of the definition.

Although the court could have ended its analysis after finding that the transactions at issue did not constitute the transfer of prewritten computer software, it considered whether Auto-Owners "used" the software as defined by the Michigan Use Tax Act (UTA), assuming that it was in fact prewritten computer software that could be properly subject to tax. For purposes of the UTA, "use" does not require the transfer of actual possession; however, a taxpayer must exercise some level of control over the property in question before use tax can be applied. The court noted that computer software was involved in most of the transactions at issue, but Auto-Owners' control was limited to controlling outcomes by inputting certain data to be analyzed rather than control of the software. Therefore, Auto-Owners did not have control of, and did not "use," the underlying software.

Finally, the court, continuing the assumption that the software in question was prewritten computer software and layering on the assumption that Auto-Owners used the software, analyzed whether such use was incidental to the services provided. In determining whether a transaction that involves services and the transfer of tangible personal property is a service or tangible property transaction, the court looked to the six factors of the "incidental to services test" espoused by the Michigan Supreme Court in Catalina Mktg. Sales Corp. v. Michigan Dep't of Treasury. After analyzing the transactions at issue and applying the Catalina six-factor test, the court found that "the transactions in question are ... in essence services with incidental transfers of tangible personal property, or no transfer of tangible personal property at all."  Thus, even if the transactions involved the transfer of tangible personal property, such transfer was incidental to the services and the transactions are, therefore, not taxable.

Interestingly, this is not the first time the Michigan Court of Claims has considered this issue. In 2012, the court issued its ruling in Thomson Reuters (Tax & Accounting) Inc. v. Michigan Dept. of Treas. and, in that instance, came to the conclusion that cloud computing services constituted a taxable sale of prewritten computer software. From a factual standpoint, the Thompson Reuters case is not substantially different from Auto-Owners; however, the judges in Thompson Reuters were persuaded that the cloud computing transactions in question were taxable because they could not have been provided without the software. This reasoning does not appear to comport with the structure of the law, which may explain the difference between the two decisions. Thompson Reuters is presently on appeal, and oral arguments were recently heard by the Michigan Court of Appeals.

Although it is likely that the Michigan Department of Treasury will appeal the Court of Claims decision in Auto-Owners, it is possible that the issue may be decided at the appellate level in Thomson Reuters before oral arguments are ever heard. In the meantime, purchasers of cloud computing services should review their purchases to determine whether sales and use tax was paid on such purchases in open tax periods and consider filing protective refund claims. Additionally, if Thompson Reuters is decided favorably on appeal and Auto-Owners stands, purchasers of cloud computing services should reevaluate whether sales and use tax is due.

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