The Arizona Supreme Court declined without comment to hear arguments from ADP, LLC (ADP) regarding its requested transaction privilege tax refunds from the Arizona Department of Revenue (Department) and the City of Phoenix for revenue from its contracts with Maricopa County.
“ADP’s contract providing eTime to Maricopa County unambiguously falls into the category of business activity subject to TPT by Phoenix City Code ...”
AdP software
ADP is a human resource service provider of online payroll, HR, tax and compliance services. Historically, these functions were performed manually but are now provided mainly by use of automated software known as “eTime.” More specifically, eTime is an application software that allows ADP’s customers and their employees to login from their own computers and enter their time and other employment data. eTime collects and processes the data, and ADP generates the company’s paychecks. The software is maintained on ADP’s servers outside of Arizona.
transaction privilege tax
In the lower court, ADP argued that Arizona’s wide-reaching transaction privilege tax does not apply to eTime because eTime is not tangible personal property (TPP). However, the Arizona Court of Appeals refuted this argument, citing the Arizona Supreme Court case State v. Jones (1943).
In Jones, the defendant failed to pay sales tax on revenue received from jukeboxes he placed in various stores and restaurants in Maricopa County. The court held that placing a coin in the slot and playing the record was a sale of TPP because “the playing of the record is perceptible to the sense of hearing, and hence, constitutes what the statute terms tangible personal property.”
Although Jones was decided in 1943, the Arizona Court of Appeals likened the “sound of the record in Jones, which was audibly perceptible to a jukebox patron’s senses,” to eTime, which it claimed is perceptible because it can be viewed by users while accessing the program.
Understandably, ADP argued that the Jones case was an “archaic” example and claimed it was wrongly decided. ADP asserted that jukeboxes and computers are distinguishable items, and pointedly mentions that modern computer software was unknown to the public at the time the Jones ruling was handed down.
Despite these assertions, the Court of Appeals adhered to the Jones ruling stating that even though modern software and computers as we know them today did not exist in 1943, the use of machines to automate a process in a way that is perceptible to the senses did. The Court analogized a jukebox playing a song for patrons to hear to modern computers that run programs for users to view, thus enabling them to use the software and perform specific tasks. Consistent with the decision in Jones, the Court held that the sales were of tangible personal property in Arizona.
ADP rental V service
Although the jukebox analogy is perhaps the most interesting argument , ADP made a number of other claims that were also struck down by the Court of Appeals. One such claim was that ADP offers a service providing access to its servers not a “rental”, as the Department had claimed.
In an effort to show ADP’s contracts were for the purpose of renting eTime for their customer’s use, the Court of Appeals relied on another timeworn example, State Tax Comm’m v. Peck. In Peck, the Arizona Supreme Court held that coin-operated laundromats and car-washing machines were subject to Arizona’s transaction privilege tax as a “rental”. The reasoning was that the customers themselves “perform all the manual activities necessary” to use the machine, a degree of use and control that comes within the state’s statutory definition of rental.
Here, the Court states the use of eTime by ADP’s customers is similar to the use of laundry machines in Peck. While laundromat customers pay for the use of laundry machines, ADP’s customers pay fees for the use of a configured version of eTime. ADP’s customers “perform all the manual activities necessary” to use eTime. Further, the Court stated ADP’s customers pay for the use of eTime, not for access to ADP’s servers.
sales tax implications
ADP’s case is a reminder that state sales tax laws related to computer software, data processing, computer access and computer-related activities are still catching up to modern technological developments.
Critics of the case suggested that the Arizona Court of Appeals, and now the Arizona Supreme Court, are turning a blind eye to important sales tax implications involving advancements in technology. As computer software advances, states will need to address new taxability considerations such as “access” versus “use” and Software as a Service, none of which were undertaken in this case.
Taxability determinations are difficult, even for experienced and well-versed justices. Having an additional experienced tax professional on your team just makes sense.