On September 29, 2020, the Ohio Supreme Court issued its opinion in Defender Sec. Co. v. McClain, Slip Opinion No. 2020-Ohio-4594, reversing the Court of Appeals and ordering the Tax Commissioner to refund the Ohio Commercial Activity Tax (“CAT”) amounts requested. As you will recall from our earlier Buzz [Ohio CAT Situsing of Security Monitoring Service Contracts is Alarming, April 22, 2019], the issue was the proper situsing of the gross receipts received by Defender Security from the sale of alarm services contracts (“contracts”) with Ohio customers to ADT for purposes of the CAT. Defender Security collected the contracts at its headquarters in Indianapolis and forwarded them to ADT at its dealer-support office in Aurora, Colorado, where ADT decides whether to accept assignment of the contract.
Defender Security included the gross receipts in its CAT returns and subsequently filed refund claims. The Tax Commissioner denied the refund claims, finding that the gross receipts were properly sitused to Ohio because ADT realized the benefit of the contracts in Ohio. Defender Security appealed the Tax Commissioner’s Final Determination to the Board of Tax Appeals (“BTA”), which affirmed the Tax Commissioner’s conclusion that the gross receipts from the contracts were properly sitused to Ohio, citing to the Tax Commissioner’s rule for situsing services, Ohio Administrative Code (“OAC”) 5703-29-17(C).
Defender Security appealed the BTA’s decision to the Franklin County Court of Appeals, which affirmed the BTA. Defender Security then sought discretionary review from the Ohio Supreme Court, which was granted. Initially, the Tax Commissioner moved the Supreme Court to dismiss the appeal as improvidently granted because Defender Security had failed to present business records to prove what tax it paid on the contracts at issue. Defender Security had presented summary documents to the Tax Commissioner and presented testimony of its controller to verify the accuracy of the summary documents at the BTA hearing. Noting that the Tax Commissioner did not raise any issue regarding the sufficiency of the summary evidence in the Final Determination, the Supreme Court concluded that dismissal on evidentiary grounds would not be appropriate.
Turning to the substantive issue in the appeal, the proper situsing of the gross receipts from the sale of the contracts, the Supreme Court applied the situsing provision in R.C. 5751.033(I), which looks to the physical location where the purchaser ultimately uses or receives the benefit of what was purchased. The Supreme Court concluded that the physical locations at which ADT uses and receives the benefit of its contracts are ADT’s physical locations where it receives customer payments and performs services for Ohio customers—all of which were outside Ohio. The Court rejected the Tax Commissioner’s argument and the BTA’s holding that the gross receipts should be sitused to the location of the customers of ADT, many of whom were in Ohio. The BTA relied primarily on the rule for situsing services. However, the Supreme Court noted that what Defender Security sold to ADT were contracts, not services; therefore, the rule was not applicable. The Court also rejected the Tax Commissioner’s reliance on R.C. 5751.033(F), which directs how gross receipts from the sale of intellectual property are sitused, noting that Defender Security sold contracts, not intellectual property. Finally, the Supreme Court held that the Tax Commissioner erroneously looked to where the contracts were used rather than to where ADT received the benefit of the contracts, which is what R.C. 5751.033(I) requires.
A similar ruling was recently handed down under another state gross receipts tax, Washington’s Business and Occupation (“B&O”) Tax. In LendingTree, LLC v. Dept. of Rev., 460 P.3d 640 (Wash. App. 2020), Washington’s 1st District Court of Appeals examined the sourcing of the gross receipts of LendingTree. LendingTree operates an online marketplace that matches prospective borrowers with potential lenders. After analyzing a potential borrower’s data from a completed online form, LendingTree refers the borrower to as many as five potential lenders. As with the Ohio CAT, Washington’s B&O Tax sources services to the location “where the customer received the benefit of the taxpayer’s service.” The relevant regulation provides that “the benefit is received where the customer’s related business activities occur.” The court infers from this rule that “taxes are attributed to the state where the lenders conduct their business activity that most closely or directly relates to the services performed by LendingTree.” Thus, it is necessary to properly define the service being purchased as well as the customer’s business activity most directly related to that service. The Court of Appeals agreed with the taxpayer that the service was a referral of potential borrowers provided for a fee to the lenders, who receive the benefit of that service at their business locations where they receive and evaluate the referrals.
While the Defender Security decision notes that ADT purchased contract rights rather than services from Defender Security, this difference is less important than the fact that both courts refused to view the benefit of what was provided to the purchaser as being located at the purchaser’s customers’ location, even though that location continued to be relevant to the purchaser. In Defender Security, it did not matter that the households using the security service were located in Ohio because the purchaser of the contracts, ADT, was located in Colorado and would operate its security service from a physical location in that state. Similarly, in LendingTree, the lenders were the paying customers and they would evaluate the loan applications from their own locations, not where the referred borrowers were located, even though the lenders would later earn income, when successfully closing loans, from these borrowers’ locations. The LendingTree court’s reasoning is analogous to that found in Defender Security, providing support for the correctness of the approach of carefully evaluating what service or right is being paid for, what is the benefit, and where is the benefit actually realized by the customer.
ZHF Observation
Taxpayers that sell contracts or other intangibles should review how they sitused gross receipts from those sales for the CAT to determine if they properly sitused those gross receipts. Depending upon the location of the business operations of the taxpayers’ customers, those taxpayers may have refund opportunities or may have potential liabilities. The rationale by the Supreme Court in Defender Security may also apply to sales of certain types of services. If you would like to discuss how Defender Security might apply to your business, please contact Rich Farrin, John Trippier or any other ZHF professional.