On February 28, 2019, the Ohio Court of Appeals for the 10th appellate district (appeals court) issued another decision¹ addressing the sourcing rules for purposes of the Commercial Activity Tax (CAT), this time for the sale of customer contracts. In its latest decision, the appeals court in Defender Security Company, dba Defender Direct v. Testa,² upheld the denial of the taxpayer's refund claim, finding that the taxpayer's receipts from the sale of customer contracts are properly sitused to Ohio based on the location where the asset originated (i.e., the location of the customer) and not to the location where the asset was received and utilized (i.e., the purchaser's out-of-state locations). The appeals court reasoned that "[t]he contracts would not exist without property in Ohio to be monitored and equipment located within such property in Ohio by which the monitoring is performed."

Defender Security Company (doing business as Defender Direct) (Defender Direct) is an authorized dealer of residential security monitoring services provided by ADT. Defender Direct markets ADT residential monitoring services via the Internet, direct pay and print advertisements. A potential customer will contact Defender Direct at one of its call centers in Indianapolis or Kentucky. If the customer purchases the services, a Defender Direct security advisor is sent to the customer's home to install the equipment and obtain the customer's signature on an alarm services contract. This contract is an ADT form that obligates the customer to purchase the services for three years and informs the customer that the contract will be assigned to ADT. After review and processing in Indianapolis, Defender Direct sends the contract to ADT in Colorado. If ADT accepts the contract, Defender Direct sells the contract to ADT. ADT then provides the monitoring services to the customer from one of its operations centers (none of which are in Ohio). In exchange for the contract, Defender Direct receives a fee based upon the level of service purchased and other criteria.

Defender Direct had paid CAT on the receipts from the sale of contracts to the extent they related to an Ohio end-customer. Defender Direct applied for a refund for a three-year period arguing that the receipts from the sales of the contracts should have been sourced to ADT's headquarters in Colorado based on the Ohio statute that sources such sales based on where the customer receives the benefit of what is provided. The Ohio Department of Taxation (Department) denied the refund claim and the Ohio Board of Tax Appeals (BTA) affirmed the denial.

On appeal, Defender Direct presented two arguments. First, Defender Direct argued that the Department erred in sourcing the receipts to the location where the asset originated (i.e., the location of the customer). Instead, the Defender Direct argued the receipts should have been sourced to the location where the asset was received and utilized (i.e., ADT's locations), none of which were located in Ohio. Defender Direct asserted that Ohio Admin. Code Section  5703-29-17(C)(4) should apply. That rule addresses the sourcing of certain agency services that would have operated to source the receipts to the purchaser's principal place of business. The appeals court rejected Defender Direct's arguments in deference to the Department's findings upon audit that the rule cited by Defender Direct did not apply. Instead, the appeals court concluded that the "catch all" provision of Ohio Rev. Code Section 5751.033(I), which sources receipts not otherwise covered in the sourcing rule based upon where the purchaser ultimately uses or receives the benefit of what was purchased, applied to the receipts at issue. Ultimately, the appeals court determined that the contract sales³ were properly sourced to Ohio.

Defender Direct also argued that the Department's sourcing rule created a substantial likelihood of double taxation in violation of the Commerce Clause and the Due Process Clause.⁴ The appeals court applied the rational basis standard of review, leaving Defender Direct with a heavy burden to support its contention. The appeals court then applied both the internal and external consistency tests, concluding that the sourcing rule is (i) internally consistent because the receipts from alarm contract sales would be sourced only to one state if every other state employed the same rule; and (2) externally consistent because of the sufficiency of the connections between the specific gross receipts at issue and Defender Direct's Ohio activities.

Implications

Defender Direct has the right to appeal this decision to the Ohio Supreme Court, but the review is not as of right. Rather, it is discretionary. It is unknown as of the date of this Alert whether Defender Direct will appeal this decision.

This case is one of the first cases relating to the sourcing of receipts from the sale of other than tangible personal property to come through the Ohio courts. The Department's "look-through" approach — sourcing the receipts from Defender Direct's sale to a contract into which its customer entered — is consistent with observed audit practices in other areas, such as the sale of services. What remains unclear is whether, as a matter of statutory construction, the term "purchaser" should be limited to the direct buyer in any application of Ohio Rev. Code Section  5751.033 or whether differing constructions of the term are appropriate depending on the character of the receipts at issue. Another issue in applying the sourcing statutes is whether, like the reasoning employed in Corrigan, a distinction should be made between a service contract, an intangible, and the service to be provided under that contract.

———————————————

———————————————
ENDNOTES

¹ The prior decision was reported in our earlier Tax Alert on the appeals court's ruling in Greenscapes Home and Garden Products, Inc. v. Testa, No. 17-AP-593 (Ohio Ct. App., 10th App. Dist., Feb. 7, 2019), see Tax Alert 2019-0430.

²Defender Security Company, dba Defender Direct v. Testa, No. 18-AP-238 (Ohio Ct. App., 10th App. Dist., Feb. 28, 2019).

³ The appeals court dismissed the taxpayer's argument that there should be a distinction between the service Defender Direct provided to ADT (i.e., obtaining the customer contract), and the service ADT provides to Ohio customers (i.e., the security monitoring services). This argument may have been supported in the reasoning of the Ohio Supreme Court (Court) in Corrigan v. Testa, Slip Opinion No. 2016-Ohio-2805 in which the application of a sourcing statute to a nonresident's gain on his sale of an interest in a pass-through entity was reviewed. In Corrigan, the Court distinguished between two types of income received by the taxpayer: the distributive share income received from the pass-through entity's operations and the ownership interest in the pass-through entity itself. However, the appeals court deferred to the Department's conclusion that conflated the service being provided by Defender Direct with those provided by ADT on the theory that the contract could not exist without property in Ohio to be monitored making the Department's "look-through" to ADT's customer appropriate.

⁴ Specifically, Defender Direct contended that the Department inconsistently applied the sourcing rules of Ohio Rev. Code §5751.033, when the Department applied destination-based sourcing in many circumstances but applied origin-based sourcing in others. Defender Direct further contended that the Department narrowly interpreted the term "purchaser" for some sales, while expanding its interpretation of the term for other sales to include the "ultimate" purchaser. Defender Direct's argument may have some merit considering the Department's final determination in Lexmark International, Inc. (July 15, 2014). In that determination, the Department concluded that the term "purchaser" as used in the rule for sourcing sales of tangible personal property (Ohio Rev. Code §5751.033(E)), referred to the direct buyer and could not be informed by the location of the buyer's customer. In the present case, the Department concluded that the application of the term "purchaser" in Ohio Rev. Code §5751.033(I) was informed by ADT's customer location. In any event, whether these distinctions are invalid may be more a matter of statutory construction rather than constitutional law.