March 23, 2022
Ohio Supreme Court clarifies 'true-object test' for bundled transactions and sales tax on automated services
In Cincinnati Federal Savings & Loan Co.1 the Supreme Court of Ohio (Court) affirmed a decision by the Ohio Board of Tax Appeals (BTA) that sales and use tax applies to transactions involving data processing services, but vacated the BTA's ruling that charges relating to customized software are taxable. The Court remanded the case to the BTA for further analysis.
Facts and BTA decision
The taxpayer (a bank) entered into an agreement with a service provider for "account processing services." The service provider received transactional data from the taxpayer and its customers, processed that data and maintained the taxpayer's general ledger. The services were automated and performed electronically. The service provider also provided software customization services by creating an electronic general ledger that was specific to the taxpayer and not usable by any other business. The taxpayer requested a refund of the sales and use taxes paid on the service provider's account processing services, arguing that Ohio law considered those services to be nontaxable accounting services or, alternatively, nontaxable customized software. The Ohio Department of Taxation (Department) denied the taxpayer's refund claim.
The BTA separated the charges for software customization and account processing services. Regarding the taxpayer's argument on software customization, the BTA construed the tax exemption strictly against the taxpayer. The BTA noted "that 'software customization is a spectrum' that ranges from a vendor selling 'prewritten software with no modifications specific to a purchaser' to a vendor who 'creates an entirely new software system from scratch'." The BTA observed that the services provided were "in the middle" of that spectrum and concluded that the taxpayer's claim must be denied because it is doubtful that the services are exempt. Regarding the account processing services, the BTA affirmed the Department's denial of the taxpayer's refund claim, concluding that they were taxable data processing services.
Statutes at issue
Ohio Rev. Code (ORC) 5739.01(B)(3)(e) taxes "automatic data processing services" when "the true object of the transaction is the receipt by the consumer of automatic data processing … rather than the receipt of personal or professional services to which automatic data processing … [is] incidental" (the true-object test). ORC 5739.01(Y)(1)(a) defines "automatic data processing services" as the "processing of others' data … or providing access to computer equipment for the purpose of processing data." ORC 5739.01(Y)(2) identifies "personal and professional services" as not subject to tax and delineates a non-exhaustive list of services that fall under this nontaxable category of services. Included in this list are accounting and legal services, including situations where the service provider receives data or information and studies, alters, analyzes, interprets or adjusts that data. See ORC 5739.01(Y)(2)(a).
The Court took issue with the BTA's analysis of software customization, specifically that the taxpayer based its refund claim on an exemption that should be strictly construed2 in favor of taxability. The Court disagreed with the BTA's analysis that ORC 5739.01(Y)(2)(e) created an exemption for an existing taxable service (in this case, automatic data processing). Instead, the Court found that ORC 5739.01(Y)(2) defined specific services as taxable while specifying that personal and professional services are not taxable. The Court said that the statutes at issue were crafted in anticipation of situations "in which different services could be bundled in one transaction," and conditioned taxability of the whole transaction based upon its true object. Concluding that the BTA should have applied the true-object test, the Court vacated the BTA's ruling on the treatment of the services as software customization, remanding that issue back to the BTA to apply the true-object test to determine taxability.
Regarding the tax treatment of "account processing services," the Court affirmed the BTA's conclusion that the services were taxable. The Court rejected the taxpayer's argument that the services were nontaxable accounting services under ORC 5739.01(Y)(2)(a). The Court reasoned that the statutory provision cited by the taxpayer described specific services that are performed by individuals, may be bundled with automatic data processing services and may be nontaxable. The Court observed that the account processing services did not involve any accounting services that required a professional license or services performed by individuals. In so finding, the Court rejected the taxpayer's argument that the account processing services allowed the taxpayer to replace a portion of its accounting personnel with automated accounting services. Because there was no bundled transaction, the Court concluded that the true-object test did not apply.
While the Court remanded the issue of the taxability of the customized software back to the BTA, its decision on applicability of the true-object test is still instructive in cases where separable personal or professional services are bundled with otherwise taxable automatic data processing or electronic information services. Likewise, the Court's decision on the taxability of the taxpayer's account processing services helps to clarify that the automation of services formerly provided by individuals will be taxable unless individuals are performing personal services that are not taxable, such as analysis and interpretation, in conjunction with those services.
1 Cincinnati Federal Savings & Loan Co. v. McClain, Slip Opinion No. 2022-Ohio-725 (Ohio S.Ct. March 15, 2022).
2 In a concurring opinion, Justice DeWine noted that the majority's opinion requires taxpayers claiming an exemption to meet an "especially high burden." In Justice DeWine's view, there was "no justification for a judge-made rule that puts a thumb on the scale in favor of the government and against the taxpayer when a tax exemption is at issue." Instead, Justice DeWine argued that tax statutes "should be read through a clear lens, not one favoring tax collection."