Michigan sales tax does not apply to property sold incidental to a service.

As the economy is transformed from one in which sales in goods becomes less predominant and the rendering of services proliferates, a recent decision by the Michigan Supreme Court deserves the attention to today's tax ex ecutive. With increasing frequency, transactions between a business and its customers involves both a service component and the transfer of tangible personal property. The courts have grappled with a standard by which to determine whether the transaction should be considered a sale of personal property or the rendition of the service. The consequence of this determination is that, if a sale of personal property is involved, the transaction may be subject to a state sales or use tax. If, on the other hand, the transaction involves a rendition of the service, unless that service has been specifically subjected to sales or use tax by the individual state, the transaction is free of sales or use tax. The method for making this determination in Michigan has been clarified by a recent decision of its highest court.

The Michigan Supreme Court issued a decision on May 5, 2004, in Catalina Marketing Corporation v Michigan Department of Treasury in which the court adopted for Michigan the "incidental to service" test for determining the taxability of a business relationship that involves both the provision of services and the transfer of tangible personal property as a taxable or non-taxable sale. In so doing, the court overruled lower court decisions of the Michigan Tax Tribunal and the Court of Appeals, which had employed the competing "real object" test. A Revenue Administrative Bulletin published by the Michigan Department of Treasury in 1995 had administratively imposed the real object test without legislative action or adherence to the State's Administrative Procedures Act.

The Nature of Catalina's Business

Catalina Marketing Corporation's clients are consumer product manufacturers. In the words of the Michigan Supreme Court, Catalina provides its clients with "alternative mass marketing strategies" through its "Checkout Coupon" Program. The Checkout Coupon Program utilizes the universal product codes, or bar codes, that appear on the packaging of most consumer goods. The retailer scans the bar code at the checkout register to tabulate the sale, generate a receipt, and monitor their own inventories. Catalina has developed hardware and software to collect data on the products as they are scanned at the checkout register. Under the program, Catalina contracts with its manufacturer-clients to develop a marketing program to target certain specified shoppers as they check out at a grocery store or other retail establishment and to deliver a coupon or advertising message on the basis of what they buy.

In the example used by the Supreme Court, "if Catalina's manufacturer-client is Campbell Soup, Campbell can contract to have a coupon reading 'one dollar off your next purchase of Campbell Soup' printed at the supermarket checkout counter whenever someone purchases a can of its soup, in order to encourage repeat business. Or, Campbell Soup can specify that the one dollar off coupon for Campbell Soup be printed out whenever a competitor's brand of soup is purchased or whenever someone buys a box of crackers. If the shopper does not buy any of the triggering items, no coupon or advertising message is printed. Catalina's coupons and advertising messages are printed on thermal paper; they do not use sharp graphics or bold colors."

The data collected by the scanner are transferred electronically to one of Catalina's central computers located in Florida or California. Catalina has installed personal computers in each retail store as well as thermal printers near the checkout scanners that it uses to produce either a coupon or an advertising message. The computers, printers, hardware, and software, as well as the paper stock utilized by the printer, are owned by Catalina.

Catalina provides its manufacturer-clients with exclusive access to a certain product category such as soup, diapers, pasta sauce, etc., as determined by the manufacturer in four-week cycles. The content of the coupon or the advertising message is specified by the client- manufacturer. Catalina plays no role in coupon design. When the Catalina software program analyzes the bar code information read by the supermarket checkout scanner, the software can cause a coupon or other advertising message to issue. In reality, the most frequent consequence of a scanned product purchase is that the purchase is identified as not a target purchase and no coupon or advertising message is issued. It is only when the criteria specified by the client-manufacturer for the issuance of a coupon or message has occurred that anything is printed.

The Catalina Performance Agreement calls for the payment by the manufacturer to Catalina of a base fee, plus a fee for each coupon or advertising message over a certain level. The base fee and coupon fee varies, depending upon the product category involved, and whether the triggering event is a purchase of the manufacturer's product, the purchase of a competitor's product, or the purchase of a product which is complimentary to that produced by the manufacturer-client. The difference in the price charged by Catalina relates to the relative degree of difficulty in data analysis and the level of sophistication of the analysis that the Catalina software must perform in order to determine whether, and how, to appropriately respond to the triggering event identified by the manufacturer-client. Significantly, the manufacturer-client pays Catalina the base fee for the four-week cycle without regard to whether any coupons or advertising messages are issued at all. This compensates Catalina for granting the manufacturer access to its customized proprietary software and the manufacturer's exclusive use of that software for a specific product category during the four-week market cycle.

The Audit

The Michigan Department of Treasury took the position that Catalina was in the business of printing coupons and assessed Michigan use tax to Catalina based upon the fees it received from its manufacturer-clients. The Michigan Tax Tribunal affirmed the assessment by employing the real object test set forth by the Michigan Department of Treasury in its Revenue Administrative Bulletin 1995-1. Under this RAB, the Tribunal looked at whether, solely from the perspective of the manufacturer-client, the real object was the purchase of a tangible good or the receipt of services. The Court of Appeals affirmed using the real object test.

Both the Tribunal and Court of Appeals ignored the Michigan Court of Appeals decision in University of Michigan, Board of Regents v Michigan Department of Treasury, 217 Mich. App. 665, 553 N.W.2d 349 (1996) in which the court had employed the incidental-to-service test. Under this test, sales tax will not apply to a transaction where the rendering of a service is the object of the transaction, even though tangible personal property is exchanged incidentally. The test looks objectively at the entire transaction to determine whether the transaction is principally a transfer of tangible personal property or the provision of a service.

The Supreme Court criticized the Tribunal and the Michigan Court of Appeals for accepting Treasury's administratively created real object test when a 1996 decision of the Michigan Court of Appeals had employed the incidental-to-service test in resolving a similar sales tax question. To a certain extent, the Supreme Court was defending the concept of separation of powers under the Michigan Constitution and it saw the adoption of the real object test by the Department as an infringement on the province of the Legislature. The court also struck a separation-of-powers balance by its criticism of the Tribunal and the Court of Appeals in following the Department's administrative bulletin advancing the real object test. The court noted:</p> <pre> The Michigan Tax Tribunal, as a Tribunal inferior to the Court of Appeals, did not have the authority to reject and replace the statutory interpretation set forth by the Court of Appeals in a binding, precedential opinion. ... The Court of Appeal's Panel here also erred in applying the Department's narrow version of the Real Object Test instead of following Board of Regents. A Court of Appeals opinion published after November 1, 1990 is binding precedent not only on the lower courts, but on subsequent panels of the Court of Appeals. </pre> <p>Thus, the 1996 decision of the Michigan Court of Appeals should have been followed by the Michigan Tax Tribunal and the Court of Appeals in Catalina. Moreover, the Department of Treasury should have followed the Court of Appeals decision rather than its own Bulletin administratively adopting real object once the Court of Appeals had ruled in Board of Regents.

Addressing itself next to the substance of the issue, the Court stated:</p>

<pre> The weakness of this [real object] test is that it is not consistent with the statutory definition of "sale and retail." The Real Object test focuses exclusively on the perspective of the purchaser.

However, the purchaser's point of view is not given special consideration under the language of the statute. Instead, the statute's perspective is more broadly focused and requires a fuller analysis that weighs not only the perspectives of the parties to the sale but also the nature of the product and service. </pre> <p>Thus, sales tax will not apply to a transaction where, looking objectively at the entire transaction, the transaction is principally the provision of a service, even though tangible personal property is exchanged incidentally. If the consideration paid in a transaction is not paid for the transfer of the tangible personal property, but for the service provided, and the transfer of the tangible property is only incidental to the service provided, the transaction is not a sale at retail under MCL 205.51(b).

The Supreme Court set forth the following factors (1) to be applied by a court when determining whether the transfer of tangible personal property is incidental to the provision of services:

(1) what the buyer sought as the object of the transaction, (2) what the seller or service provider is in the business of doing, (3) whether the goods were provided as a retail enterprise with a profit-making motive, (4) whether the tangible goods were available for sale without the service, (5) the extent to which intangible services have contributed to the value of the physical item that is transferred, and (6) any other factors relevant to the particular transaction.

The decision of the Michigan Supreme Court in Catalina has potentially broad ramifications across industries. Businesses involved in all manner of personal services are potentially affected. These industries include companies that produce financial reports, credit reports, stock market information, marketing surveys, delivery of news articles and publications, investment portfolio risk analysis, payroll services, communication services, professional services such as lawyers, dentists, engineers and architects, companies that provide videos and other recorded training materials, advertising agencies, and internet access companies that provide access to databases utilizing proprietary software. The scope of this decision is limited only by the imagination of the tax executive and the creativity of the entrepreneur in the new economy.

Collateral Effect

This case represents the second time in two years that the Supreme Court has rejected a position taken by Treasury in a Revenue Administrative Bulletin. These Bulletins are not adopted in accordance with the Administrative Procedures Act, and therefore, do not have the force of law. In Danse Corporation v Michigan Department of Treasury, the Michigan Supreme Court rejected a revenue administrative bulletin that was promulgated by the Michigan Department of Treasury, but that conflicted with the underlying statute it purported to be based upon. Atax executive faced with an administrative bulletin that adversely affects the interest of the taxpayer should not be deterred by the existence of the bulletin, but should instead request discerning analysis of whether the bulletin properly carries out the intent of the underlying statute being administered by the Treasury.

What Remains to Be Done

In an extraordinary procedural move, the Supreme Court retained jurisdiction, ordered the Tax Tribunal to issue a new decision by August 3, 2004, ordered Catalina and the Department of Treasury to each submit a brief with the Michigan Supreme Court 35 days after the new decision by the Tribunal, and granted Catalina and Treasury the opportunity to request re-argument. The retention of jurisdiction by the Supreme Court seems to communicate the keen interest which the Supreme Court has in the proper implementation of the incidental-to-service test in Michigan. It was apparent from the questioning of counsel during oral argument in the Catalina case that the court is very concerned about the effect its decision will have on the development of the new economy, which involves the increasing prevalence of rendition of services versus sale of goods. The forthcoming decisions by the Michigan Tax Tribunal and Michigan Supreme Court should be followed closely by all taxpayers who participate in the new economy.

(1) Many of the factors identified by the Michigan Supreme Court have been adopted in other states. See W. Hellerstein, State Taxation [paragraph] 12.07 [1][a]-[e] (3rd edition).

PATRICK R. VAN TIFLIN and JUNE SUMMERS HAAS are partners in the Lansing, Michigan, office of Honigman Miller Schwartz and Cohn LLP. They represented Catalina Marketing Corporation in the case discussed in this article.