Michigan: Department Clarifies Its Policy on Taxability of Cloud Computing Services in Light of Auto-Owners Case

Given a recent Michigan Court of Appeals ruling and the subsequent administrative guidance released by the Department regarding the change in the Department’s policy concerning the taxability of cloud services, Michigan businesses may be entitled to refunds of sales/use tax that was erroneously paid under audit, collected by vendors or self-assessed and remitted on its own returns. Due to changes in the delivery of technology, many consumers are shifting to a hosted service model where, rather than buying software and running it on their own equipment, they buy software as a service (SaaS) from a vendor and pay a monthly subscription fee. Typically, the service is provided with little or no software being transferred to the consumer and the equipment is owned and maintained by the service provider. Many states have aggressively applied their existing tax laws, which typically are geared towards the traditional technology delivery model where software was transferred to the customer, to attempt to tax this new model of service delivery. Such was the case in Auto-Owners Insurance Co. v. Michigan Department of Treasury where the Department assessed tax, interest and penalty on hosted computer services as part of a routine use-tax audit of Auto-Owners.

The Department has historically taken the position that the transfer of prewritten software, delivered by any means, was subject to tax as a sale or use of tangible personal property. The definition of use included the exercise of a right or power over tangible personal property including transfer of the property in a transaction where possession is given. The Department broadly construed that definition to include charges for software that was delivered via remote access in a hosted environment. 

Auto-Owners successfully challenged in the Michigan Tax Court the Department’s policy on the taxation of certain prewritten computer software delivered electronically, a decision that was subsequently appealed by the Department. The Court of Appeals found in favor of the taxpayer, reaffirming the lower court decision that the Department had wrongfully assessed tax on charges for non-taxable professional services rather than a sale or use of tangible personal property. 

Issues in Auto-Owners Case

In Auto-Owners, the issue was whether certain products were subject to the imposition of use tax on prewritten computer software delivered in any manner under Michigan law. In its review, the Court of Appeals found that there were essentially two different categories of products at issue in the case:

• The first category consisted of products that did not include the delivery of code that enabled the vendor's system to operate. The court found these products did not satisfy the requirement that prewritten computer software must be delivered, in any manner, because there was no proof that code was electronically delivered to the taxpayer, or that the taxpayer exercised any incidents of ownership over the vendor's code.
• The second category consisted of products where the court found that some prewritten computer software was electronically delivered to the taxpayers. The court found that the electronic delivery of a local client or desktop agent was sufficient to constitute an ownership type right over the product. However, the court found that although some software had been delivered in the second category, the court determined that under the incidental to service test of the Catalina Marketing Sales Corp. case, the software was merely incidental to the vendor's rendering of professional services.

As a result, the Court of Appeals concluded that the trial court properly determined that the transactions were not subject to taxation under the Michigan Use Tax Act.

Change in Department Policy

In light of the Court of Appeals decision in Auto-Owners, the Department has recently issued a release announcing a change in its policy on the taxation of certain prewritten computer software delivered electronically. The Department has agreed to give judicial decisions full retroactive effect and Auto-Owners will be applied to all open tax years.

Consequently, those portions of prior Michigan guidance that suggest that access to software over the internet without also the delivery of either the code that enables the program to operate or a desk top client are inconsistent with the Auto-Owners decision and no longer represent the Department's policy. When only a portion of a software program is electronically delivered to a customer, the incidental to service test will be applied to determine whether the transaction constitutes the rendition of a nontaxable service rather than the sale of tangible personal property. If a software program is electronically downloaded in its entirety, it will be taxable sale of tangible personal property.

The Takeaway for Businesses Located in Michigan

Generally, the statute of limitations for refunds is four years from the date set for filing the original return. The Department has specific procedures that must be followed in order to obtain a refund.