Arizona Court of Appeals Rules that ADP’s Software License Subscriptions are Taxable
March 30, 2023
At a glance
- The main takeaway: An Arizona court concluded that licensing software to customers in Arizona on a subscription basis is subject to the state’s Transaction Privilege Tax as a rental of tangible personal property.
- Assess the impact: This case is an important reminder that depending on the state and the type of tax, software can be viewed as either tangible or intangible personal property and that there are exceptions where federal, state, and/or local governments may be subject to sales/use tax.
- Take the next step: Aprio’s State and Local Tax (SALT) team can assist you in identifying and analyzing business transactions to ensure your business complies with its sales and use tax obligations.
Schedule a free consultation today to learn more!
The full story:
Arizona’s Court of Appeals recently upheld the Arizona Department of Revenue’s (AZDOR) determination that ADP’s contracts, which granted access to ADP’s eTime software on a subscription basis, constituted as taxable rentals of tangible personal property (TPP) for purposes of Arizona’s Transaction Privilege Tax (TPT).1
Historically, ADP’s employees manually performed HR services for clients. However, these functions are now largely automated by licensing its eTime software application, so that customers can use it to enter their time and other employment data. ADP has contracts with Maricopa County which grants access to the eTime software. County employees would log into the remotely hosted software to enter the information that ADP’s software uses to process and generate employee paychecks.
The ruling explained
Arizona’s TPT, which is functionally similar to other states’ sales taxes, is imposed on businesses engaged in a wide variety of transactions, one of which is “leasing or renting tangible personal property for consideration.”2 The Court’s analyzed ADP’s eTime software transactions under this business classification.
First, under Arizona’s TPT, TPP is defined as “personal property that may be seen, weighed, measured, felt or touched or that is in any other manner perceptible to the senses.”3 The Court considered the software to be TPP because the software can be viewed by the County’s users while accessing and using the application. It reasoned that this treatment was similar to a prior case law which determined that revenues from jukeboxes were taxable TPP because, “the playing of the record is perceptible to the sense of hearing.”4 The Court was not convinced with ADPs’ arguments that (i) the older jukebox ruling did not apply simply because it predated computers and software as we now know them or (ii) that the software should instead be considered intangible personal property based on case law in the context of ad valorem taxes.
Second, after determining that the eTime software was TPP, the Court focused on ADP’s business of renting such TPP for the County’s use. While there is no rule that defines “rental,” prior case law focused on whether the customer had “exclusive use . . . and exclusive control of all manual operations necessary” to use the TPP.5 ADP argued that none of its customers had exclusive use of eTime since all customers access the same “copy” of the remotely hosted software. However, the Court clarified that the County’s contract is not for access to ADP’s out-of-state servers where the software resides, but instead the contracts are for the use of the eTime program.
From this perspective, the County’s use of eTime is exclusive in that (a) each customer’s access is configured to fit their particular needs, and (b) only those authorized by the County can use it. Since the County’s use and control of the software are sufficiently exclusive with respect to the end user’s level of interaction, the Court concluded that the contracts with the County constituted a rental of eTime for TPT purposes.
ADP further argued that it is in the business of providing HR services and that such services were the primary object of these transactions. Furthermore, ADP argued that any property (e.g., eTime) was an incidental or inconsequential element of the service. However, the Court rejected this contention by pointing to ADP’s invoices to the County which separately stated eTime charges from other service-related charges.
In addition to the Court’s conclusion, this case highlights two important points.
- First, while many states view software as tangible personal property for sales tax purposes, software may be viewed as intangible property for other tax purposes (e.g., property taxes, income taxes, etc.).
- Second, the customer in this case is Maricopa County. Most states consider federal, state, and/or local governments to be exempt for sales/use tax purposes, but this case reminds us that there are exceptions.
The bottom line
Aprio’s SALT team has experience identifying and analyzing business transactions to determine if they are subject to sales tax, and if so, whether your business has an obligation to collect the tax. We can assist your business to ensure that it complies with its sales and use tax obligations so that it does not incur unexpected tax liabilities and penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
1 ADP, LLC v. Arizona Dept. of Revenue, Ariz. Ct. App., No. 1 CA-TX-21-0009, 01/31/2023.
2 Az. Rev. Stat. § 42-5071(A).
3 Az. Rev. Stat. § 42-5001(21).
4 State v. Jones, 60 Ariz. 412, 415 (1943).
5 State Tax Comm’n v. Peck, 106 Ariz. 390, 396 (1970)
About the Author
Jess Johannesen, Senior Tax Manager at Aprio, is a state and local tax advisor with expertise in sales/use tax and state income tax matters, state tax credits and incentives, and state and local tax M&A due diligence. Known for quick response times and technical expertise, Jess helps business leaders and decision makers in an array of industries maximize state tax benefits, and minimize risks and exposures while keeping in compliance. Defined by kindness and passion for Georgia sports, Jess is a thoughtful, curious and detail-oriented advisor.