In a curious decision out of Arizona, an Administrative Law Judge (ALJ) found an out-of-state provider of online research services was properly assessed transaction privilege tax (TPT, Arizona’s substitute for a sales tax) based on the logic that the provider was renting tangible personal property to in-state customers.  The Office of Administrative Hearings (OAH) decision, No. 14C-201400197S-REV, available here, should be unsettling for all remote providers of subscription-based services with customers in Arizona.  This decision offers an example of the continued push by states to administratively expand the tax base to include nontaxable digital services.  Many states, like Arizona, do so by considering remote access to digital goods and services to be tangible personal property, as defined by statutes that are decades old.

Facts

The taxpayer was an out-of-state IT research firm offering internally-produced proprietary research and data compilation content remotely.  The taxpayer’s headquarters, offices, servers and platform were all located outside Arizona.  Customers accessed the research material via usernames and passwords received as part of a subscription.  The Arizona Department of Revenue (the Department) determined that the subscription income was subject to the TPT because it was income from the leasing of tangible personal property.  The taxpayer filed a protest with the Department, arguing that the online research services provided make it a service provider—not a lessor of tangible personal property.  The taxpayer noted “at most, [they are] providing clients with a simultaneous license to use.”

Department’s Argument

The Department argued that the taxpayer was leasing tangible personal property (research and data content) through the subscriptions they provide to customers.  Because they had exclusive access and use to the digital content (via username and password), the customers were able to perceive tangible personal property through their sense of sight. Therefore, the taxpayer’s receipts from subscriptions to its research and data content are taxable rental activities subject to the personal property rental classification.

Holding

The ALJ held the taxpayer did not meet its burden of proof of showing the Department misapplied the tax laws.  The decision dismissed all of the taxpayer’s arguments that it is not engaged in leasing tangible personal property.  At the outset, the ALJ found that the inability to control or modify the digital content was not enough to consider the customers to be lacking “exclusive control.”  This is important because the Arizona Supreme Court has made it clear that the scope and application of the personal property rental classification (and its predecessor) hinges on the degree of control over the property in question that is ceded to its putative “lessee” or “renter.” In sum, because the access and use of the proprietary research and data content was offered for a periodic subscription (consideration), such activity is the leasing of tangible personal property, and the assessment by the Department was appropriate.

Analysis

As a threshold matter, it is unclear whether the Department has authority to consider remote access to digital content to be tangible property merely because the content may be viewed on [...]

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