October 2, 2020
Ohio Supreme Court ruling provides first judicial guidance on Commercial Activity Tax sourcing rule for gross receipts for purchased contracts
In Defender Security Co. v. McClain,1 the Ohio Supreme Court (Court) ruled that the situs of a company's receipts from the sale of customer contracts is the out-of-state physical locations where the purchaser received the benefit of the purchased contracts. In so finding, the Court reversed the Ohio Department of Taxation's (Department) denial of the company's refund claim for Commercial Activity Tax (CAT). The Court remanded the case back to the Department to issue the refunds.
ADT Security Services, Inc. (ADT), based in Colorado, provides security services to residential and commercial customers. ADT enters into alarm-services contracts with its customers and provides remote alarm-monitoring services by receiving information from security equipment installed at customers' properties. The appellant, Defender Security Co. (Defender), based in Indiana, served as an authorized dealer of ADT. Pursuant to an agreement between the parties, Defender generated new leads for ADT through advertising, installed equipment for new residential customers in Ohio, and executed alarm-monitoring services contracts with customers in Ohio. Defender received new Ohio contracts at its Indiana headquarters and forwarded them to ADT's dealer support unit in Colorado for acceptance. If accepted, ADT would make a payment to Defender to purchase the alarm-services contract. ADT then provided alarm-monitoring services to the Ohio customers from one of six locations, all of which were located outside of Ohio. ADT interacted with both Defender and its Ohio customers from locations outside Ohio.
Defender paid CAT on ADT's payments for its purchase of the alarm-monitoring service contracts. Defender subsequently applied for a refund of CAT on those payments for 2011, 2012 and 2013. Defender's refund claim was supported by two spreadsheets showing the computation of what was paid on the original returns and the amount of refund claimed. The Department denied the refund, reasoning that because ADT realized the benefit of the alarm-services contracts in Ohio, to the extent customers on those contracts were located in Ohio the situs of the benefit from the sale of those underlying alarm monitoring-service contracts must also be in Ohio for CAT purposes. Notably, the Department's determination did not question the sufficiency of Defender's documentation in support of its refund claim.
Defender appealed the Department's denial of its refund claim to the Ohio Board of Tax Appeals (BTA), where Defender's controller presented testimony verifying the refund amount requests by reference to internal business records not provided as part of the original refund claim submission. The BTA affirmed the denial of the refunds on the ground that ADT received the benefit from the contracts it purchased from Defender in Ohio. Like the Department, the BTA did not question the sufficiency of the submitted documentation. Defender appealed to the Franklin County Court of Appeals, which affirmed the refund denial, and Defender then appealed to the Court.
Court grants refund, finds benefit of what was purchased received outside Ohio
The Court first addressed the Department's objection that the appeal was improvidently allowed on grounds that Defender never offered business records to support its refund claim. The Court concluded that the documentation and testimony presented were sufficient to allow it to consider the substantive issues, noting that " … we see no reason why the absence of primary documentation should deter us from reaching the legal issues when it did not deter the commissioner himself, in his final determination, from doing so without any suggestion of a defect in the evidence."
The Court then turned to its substantive analysis, focusing on Ohio Rev. Code Section 5751.033(I), a catch-all provision for "gross receipts not otherwise sitused" in the CAT statute. Under this provision, the situs of receipts are Ohio "in the proportion that the purchaser's benefit in [Ohio] with respect to what was purchased bears to the purchaser's benefit everywhere with respect to what was purchased." In determining the ratio, Ohio Rev. Code Section 5751.033(I) also provides that the "physical location where the purchaser ultimately uses or receives the benefit of what was purchased shall be paramount in determining the proportion of the benefit in [Ohio] to the benefit everywhere." In applying the statute, the Court reached three conclusions.
Situs of receipts is where purchaser received the benefit. The Court found that under Ohio Rev. Code Section 5751.033(I), the situs of the receipts from the alarm-monitoring services contracts were at ADT's physical locations, all of which were located outside of Ohio. The Court reasoned that the "paramount" consideration in determining where the Ohio benefit was received was the physical location where ADT received the benefit of what was purchased. The Court then contrasted the benefits received from property owners from ADT's performance of alarm-monitoring services and the benefit received by ADT from its purchase of the alarm-monitoring contracts from Defender. ADT's customers purchased security services with the benefit of those services being received at physical locations in Ohio. On the other hand, the physical location where ADT used and received the benefit of its intangible contract rights were its physical locations, all of which were outside of Ohio, where it received payments and performed services.
The term "benefit", as used in Ohio Rev. Code Section 5751.033(I) should be interpreted according to its common, ordinary meaning. The Department had argued that the term "benefit" had acquired a special meaning in US Supreme Court cases involving due process or commerce clause challenges to the imposition of state excise or income taxes. Citing Goldberg v. Sweet,2 the Department argued that "benefit" connotes "government services that make business possible and profitable, such as 'police and fire protection, the use of public roads and mass transit, and the other advantages of civilized society.'" The Court rejected the Department's argument, finding the term "benefit," as used in Ohio Rev. Code Section 5751.033(I), does not involve a judicially defined concept established by case law. Instead, the term bears an ordinary meaning — "something that guards, aids, or promotes well-being: advantage, good." Defender did not sell police or fire protection to ADT when it sold the service contracts. The availability of government services was not, in the Court's view, the benefit derived from the transaction.
Ohio Rev. Code Section 5751.033(I) established situs where ADT used or received the benefits of the contract rights, not where ADT used the contract rights themselves. The Court considered the South Carolina Supreme Court's decision in Geoffrey, Inc. v. S.C. Tax Comm'n.,3 noting that the taxpayer used trademarks in South Carolina but received the benefit of its license agreements for those trademarks in its home state of Delaware. Applied to the ADT contract rights, the Court concluded that Ohio Rev. Code Section 5751.033(I) established situs where ADT received the benefit of the contracts, not where ADT used the contracts.
The Court also rejected the Department's argument that Ohio Admin. Code 5703-29-17, its administrative rule governing the situs of services, applied because ADT purchased contracts from Defender, not services.
The Court's decision is significant as the first judicial guidance on how Ohio Rev. Code Section 5751.033(I) will be applied. The Court focused on the transaction at issue — the transfer of an intangible contract right — which the Department had conflated with the services performed pursuant to that contract. The Court's decision also highlights that the purchaser's physical location is paramount in sourcing such receipts. The Court's decision may have broader application to the sourcing of receipts from other services, for example, where the Department has applied a "look-through" approach in audits, the situs of services may be based on where the purchaser's customer is located instead of the location of the purchaser itself. Finally, the decision also may have implications on pass-through entity and individual income tax as the situs rules employed in those taxes are virtually identical to the CAT rules reviewed by the Court.
1 Slip Opinion No. 2020-Ohio-4594 (Sept. 29, 2020).
2 488 U.S. 252, 267 (1989).
3 437 S.E.2d 13 (1993).