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The Ohio Supreme Court recently determined that gross receipts received for the sale of security monitoring services contracts should be sourced outside of Ohio for Commercial Activity Tax (CAT) purposes.1
The Court determined that the receipts should be sitused to the location where the purchaser realizes the benefit from purchasing the intangible contract rights, rather than where the purchaser’s customers receive the benefit of the services ultimately provided.
The CAT is a privilege tax which generally applies to taxable gross receipts in Ohio received on and after July 1, 2005.2
The base of the CAT is gross receipts, defined as the total amount realized, without deduction for the cost of goods sold or other expenses incurred, from activities that contribute to the production of gross income.3
Several statutory exemptions are available.4
Notably, imposition of the tax requires consideration of how to properly allocate receipts to Ohio. Specifically, taxable gross receipts include only “gross receipts sitused to this state.”5
The statutes provide general situsing rules for certain receipts, including proceeds from the sales of real property, tangible personal property, and delineated services.6
For receipts not otherwise addressed, sourcing is based on 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.7
The taxpayer, Defender Security Co. (Defender), is an Indiana-based company with several Ohio offices, whose business consists solely of serving as an authorized dealer of ADT home security products and services under a master agreement. Pursuant to the master agreement in effect for the tax periods at issue, Defender was not an agent of ADT, but operated on an exclusive basis with ADT under the agreement. ADT entered into alarm-services contracts with its customers located throughout the country to provide remote monitoring services using information transmitted from security equipment installed at their locations, and provided security services to customers.
Under the terms of the master agreement, Defender generated leads for new ADT customers through advertising, installed equipment at customer locations, and concurrent with installation, signed an alarm-services contract with customers under which ADT provided security-monitoring services. While Defender had several Ohio branch locations, all executive and administrative office work was performed from its Indiana headquarters. To service a new Ohio customer, Defender installed the requested equipment at the customer’s Ohio location, collected the related new alarm-services contract at its Indiana headquarters and forwarded it to ADT, which then decided whether to accept the assignment. When ADT accepted the assignment of a customer contract, it paid Defender a specified fee. In a small number of cases, ADT rejected the assignment and the ultimate customer paid Defender directly for the security-monitoring services that were still provided by ADT.
Accordingly, Defender generally received three types of receipts related to Ohio customers: (i) payments made by Ohio customers to Defender for the initial installation of alarm-services equipment; (ii) payments made by Ohio customers to Defender under the alarm-services contracts not accepted by ADT; and (iii) payments from ADT under the master agreement as consideration for its purchase of the alarm-services contracts for Ohio residents.
Defender initially paid Ohio CAT with respect to all of its gross receipts associated with Ohio customers. For the quarterly tax periods during 2011-2013, Defender filed a CAT refund claim for the gross receipts from ADT for payments related to the sale of the alarm-services contracts.8
The tax commissioner denied the refund, concluding that ADT (the purchaser of Defender’s contract) realized the benefit of the Ohio-based alarm services contracts in Ohio. On appeal, the Board of Tax Appeals agreed, concluding that “(i)t belies logic to argue that the purchaser (ADT) receives no benefit in Ohio from the contracts it purchases from Defender.”9
Defender appealed to the Franklin County Court of Appeals, which affirmed and held further that the imposition of the tax did not violate the Commerce Clause of the U.S. Constitution.10
Defender appealed this decision to the Ohio Supreme Court.
Ohio Supreme Court decision interprets location of ‘benefit’
Defender and the Tax Commissioner agreed that the primary issue under consideration was the proper application of Ohio Rev. Code Ann. Sec. 5751.033(I) to the gross receipts at issue. Specifically, the Court considered how to situs Defender’s receipts from the sale to ADT of the alarm-services contracts for Ohio customers.
According to the statute, identifying the physical location where the purchaser ultimately uses or receives the benefit of what was purchased is key in determining the proportion of benefit attributed to Ohio for the type of sale at issue in this case. Defender asserted that the payments from ADT were for intangible contract rights used at ADT’s physical locations outside of Ohio. Thus, the benefit of the purchase was received entirely outside Ohio. The Court agreed, noting that the Tax Commissioner, the BTA and the Court of Appeals had all failed to properly distinguish between the benefit Ohio consumers received from ADT and the benefit ADT received from the purchase of customer contracts from Defender.
Specifically, ADT’s customers acquired the benefit of ADT’s security services in relation to their Ohio properties, and the corresponding payments to ADT were taxable Ohio CAT receipts. In contrast, Defender’s receipts from ADT were for intangible contract rights. ADT’s benefit from the purchase arose from receiving payments from Ohio customers in consideration for providing monitoring services from its locations outside Ohio. The difference between where ADT received benefits (outside Ohio) and ADT’s customers received benefits (Ohio) from the same contracts was stark. Because ADT used and received the benefit of the contracts purchased from Defender outside Ohio, the Court concluded that the receipts at issue were sitused outside Ohio pursuant to Ohio Rev. Code Ann. Sec. 5751.033(I).
Next, the Court considered whether Ohio Admin. Code 5703-29-17 might provide relevant guidance for situsing the receipts at issue. The BTA had applied this rule, which addresses how to source receipts from sales of services (including relevant definitions and examples),11
in its decision for the Tax Commissioner.12
Specifically, the BTA applied examples demonstrating the proper treatment of receipts by property appraisers, architects and engineers for services related to Ohio property to Defender’s situation.13
According to the rule, fees received by those professionals related to Ohio property were taxable Ohio CAT receipts. In finding the guidance inapplicable to the current situation, the Court observed that the transactions at issue constituted sales of intangible assets in the form of contracts, rather than receipts from enumerated services. ADT did not pay Defender for performing security or other specific services in relation to Ohio property. Instead, when Defender installed alarm systems at Ohio properties that result in ADT’s ability to perform security-monitoring services for those properties, the Ohio customer paid Defender, who paid CAT with respect to these receipts.
The Court then considered whether the term “benefit” in Ohio Rev. Code Ann. Sec. 5751.033(I) should be accorded its common meaning. The Tax Commissioner argued that the term has acquired a special meaning in U.S. Supreme Court cases involving due process or commerce clause challenges, in that it connotes “government services that make business possible and profitable, such as ‘police and fire protection’, …”14
Rejecting the argument, the Court accorded the term its ordinary meaning, finding that Defender did not sell police and fire service protection to ADT when it sold the service contracts.
Finally, the Tax Commissioner asserted that ADT “used or received” the intangible contract rights in Ohio to generate income for itself, pointing to Ohio Rev. Code Ann. Sec. 5733.033(F), which “allows Ohio to tax the ‘right to use’ a trademark in Ohio.” Under the plain language of the statute at issue, the Court focused on where ADT “used or received” the benefit of the contracts rights it purchased from Defender, rather than where ADT “used or received” the contract rights themselves. Since the receipts at issue were not license fees for intellectual property, the Court determined situs by the location where ADT used or received the benefit of
the contract rights, not the actual location where it received the contract rights itself. Having rejected all of the Tax Commissioner’s arguments, the Court did not need to consider Defender’s claim that the tax violated the federal Commerce Clause, and remanded to the Tax Commissioner with instructions to issue applicable refunds and interest.
This Ohio Supreme Court decision provides crucial guidance for taxpayers seeking to situs certain receipts for CAT purposes, especially receipts that fall under what is considered the “catch-all situsing provision” at issue in this case. Although the CAT has been in effect for 15 years, there have been few decisions to date detailing how to apply its situsing provisions.
Since the adoption of the CAT, many other states adopted general market-based sourcing provisions for sales of other than tangible personal property under corporate income tax statutes. Some of these states have adhered to a purchaser benefit sourcing rule for sales of certain services. Therefore, the Defender
decision could provide some clues as to how a court might interpret these types of market-based sourcing provisions. In particular, the decision provides some guidance for relatively common three-party transactions when the presence of a seller, an intermediary and an ultimate customer make it challenging to determine how to source receipts from such arrangements. This is particularly important when the identity or location of the intermediary differs from the location of the identity or location of the ultimate beneficiary of the service. As demonstrated in the Defender
case, this happened when the benefit of a service was received in one state by a direct customer (like ADT) and in another state by ADT’s commercial or residential customer receiving the security services (the Ohio property owners). With no specific statutory guidance available, taxpayers have typically been left to interpret the proper sourcing of these types of receipts. Although precedent from the Ohio Supreme Court decision is not dispositive in other states for purposes of interpreting market-based sourcing, the Court’s analysis provides taxpayers with a potential starting point to consider in interpreting similar language.
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