When computers take over and make everything taxable: Tales from the Cincinnati Federal Decision

By Derek K. Heyman, PhD, JD, CPA, Zaino, Hall & Farrin

In Cincinnati Federal Savings & Loan Co. v. McClain, 2022-Ohio-725, issued March 15, 2022, which involved a sales tax refund claim filed by a financial institution, the Ohio Supreme Court held that the Board of Tax Appeals’ analysis of transactions involving a combination of software customization and automatic data processing or electronic information services was erroneous because it did not perform the true-object test required by Ohio Revised Code (“R.C.”) 5739.01(B)(3) (e) The court remanded the case to the board to apply the true-object test to the mixed transactions.

Cincinnati Federal Savings & Loan Co. (“Cincinnati Federal”) had engaged Fiserv Solutions, Inc. (“Fiserv”) to provide services, including automated processing of banking transactions to maintain Cincinnati Federal’s general ledger and subsidiary account ledgers, which Cincinnati Federal argued was a nontaxable accounting service. Cincinnati Federal paid Ohio sales tax to Fiserv when it was invoiced for services and submitted a refund claim to the Ohio Department of Taxation for services it claimed were not automatic data processing or electronic information services (“ADP/EIS”) but rather personal and professional services, customization of software, and accounting services, which are not subject to tax in Ohio.

Tax Commissioner and board’s view of customization

As discussed by the court, when the General Assembly amended the taxing statute in 1993, it worded the law to tax ADP/EIS when: provided for use in business when the true object of the transaction is the receipt by the consumer of [ADP], computer services, or [EIS] rather than the receipt of personal or professional services to which [ADP], computer services, or [EIS] are incidental or supplemental.

The Ohio Tax Commissioner had denied the refund claim, finding, among other things, that there was no customization of software among the services for which tax was collected. In affirming the Commissioner’s denial of the refund claim, however, the board accepted new evidence and noted that customization may have been included. The board noted that “software customization is a spectrum” ranging from prewritten software with zero modification (taxable as a product) to an entirely new software system created from scratch (nontaxable as a personal/professional service). The board found that “the services Fiserv provides are in the middle” of the spectrum because Fiserv did not start the software from scratch but “made some modifications to account for Cincinnati Federal’s needs.” However, the board declined to “draw the line on that spectrum” and reasoned that customized software is an exemption created by the legislature and “in all doubtful cases the exemption is denied.” The board concluded, “Because the exemption is ‘doubtful’ we reject [Cincinnati Federal’s] argument.”

Personal and Professional in R.C. 5739.01(Y)(2)(e) not an exemption for determining burden

In reviewing this rejection, the court scrutinized the board’s reasoning, and held that the board erred when it viewed R.C. 5739.01(Y)(2)(e) as a tax exemption and that the board’s erroneous “application of the stringent test for tax exemptions distracted it from applying the true-object test as required by statute.” The court reasoned that none of the R.C. 5739.01(Y) (2) services are “exemptions” carved from the taxable ADP and EIS. Rather, the legislature “defined and carved out those computer-related services as taxable while leaving personal and professional services outside the ambit of the tax.” Personal and professional services, moreover, are qualitatively different from ADP and EIS in that they are performed by people rather than "primarily by computer systems.”

The statutorily required method of analyzing a mixed transaction is to use the true-object test of R.C. 5739.01(B) (3)(e) to determine what the customer was primarily paying for, the taxable or non-taxable element. Therefore, the court remanded the case to the board to perform this analysis on those transactions that might include a nontaxable service.

Use of software vs. Purchase of software

In addition to clarifying Ohio sales tax law regarding the relationship between personal and professional services and ADP/EIS, the court in Cincinnati Federal clarifies two other points that may be helpful to taxpayers:

1. The court found that the assistance provided by Fiserv might have “included some of those service types listed in R.C. 5739.01(Y)(2)(e) in adapting the preexisting software to Cincinnati Federal’s particular needs.” Thus, “software customization” may include the vendor’s choosing from among pre-existing software modules as long as that choice involves “determining how data should be summarized, sequenced, formatted, processed, controlled, and reported.”

2. The court stated that R.C. 5739.01(Y)(2)(e) “encompasses ‘designing ... custom software for collecting business information’ without regard to whether that software as a product is sold to the consumer or is used by the designer itself to provide service to the consumer.” In other words, the software need not be transferred to the consumer for the customization to be exempt.

Both holdings may be helpful to taxpayers.

Non-taxable accounting services

On the other hand, the court, in rejecting Cincinnati Federal’s argument that Fiserv performed nontaxable accounting services, held that for a service to qualify as a nontaxable personal or professional service, an individual must perform the service. Specifically addressing the argument that Fiserv was performing accounting services as listed under R.C. 5739.01(Y)(2)(a), the court noted that a professional service is one performed by an individual licensed to perform the service. Because Fiserv lacked the legal authority to provide accounting services requiring licensure, the court held that the services, even had they been performed by an individual, could not qualify as nontaxable professional services, and because Fiserv’s services were not performed by an individual, they did not qualify as nontaxable personal services, even though the services related directly to accounting.

Conclusion

The taxpayer in this decision, Cincinnati Federal, did not achieve a clear victory; in fact, they may lose on remand, depending on whether the board finds that the invoices in the refund claim include billing for the customization that the court said may have been provided. Moreover, Cincinnati Federal lost on its assertion that the software, when functioning, provides the taxpayer with non-taxable “accounting services.” Once set up, the Fiserv system is fully automated and, without the involvement of a live person, the services are taxable ADP/EIS.

The Cincinnati Federal decision should provide clarity to the Commissioner, the board, and taxpayers regarding the proper way to analyze mixed transactions involving ADP/ EIS and personal or professional services. The decision may be instructive where an outsourced function has become automated in whole or in part. Based on the decision, a fully automated process is likely taxable. Yet these remain complex issues in Ohio sales tax. For instance, the court did not specify exactly how much human involvement is needed for a partially automated process to qualify as a personal or professional service.

Further, even if an individual is involved, it may be necessary to determine whether the individual has a license. The court is clear that there is no presumption of taxability where personal and professional services are concerned. The true object test is neutral regarding taxability but, with its reference to “the purchaser’s overriding purpose” or “the essential reason the buyer enters the transaction,” it contains an element of subjectivity that must be inferred from the objective facts. It is often difficult to apply when the purchase consists of both tangible personal property and a service, the application is no easier when the purchase consists of a service provided in part by automation and in part by individuals.

Derek K. Heyman, PhD, JD, CPA is an attorney at Zaino, Hall & Farrin with 10 years of experience in state and local tax. He assists clients in a variety of state and local tax areas, including economic development and tax incentives, refund claims, audit defense, and appeals.