Update on Michigan Supreme Court sales tax decision for Catalina Marketing.

In the July-August 2004 issue of The Tax Executive, we wrote about the Michigan Supreme Court decision in Catalina Marketing. (1) In that May 2004 decision, the court held that a different test applied for determining the taxability of "mixed" transactions for sales and use tax purposes than the one promulgated by the Department of Treasury. Before Catalina, the Department used the "real object" test, described in a 1995 Revenue Administrative Bulletin (RAB), (2) to determine taxability when a transaction involves both the provision of services and the transfer of tangible personal property. Both the Michigan Tax Tribunal and the Court of Appeals applied the real object test when deciding Catalina. The Michigan Supreme Court overruled the lower court decisions and applied the "incidental to service" test. The decision represented the second time in two years that the Supreme Court rejected a position taken by Treasury in a RAB.

Catalina's clients are consumer product manufacturers. Catalina provides its clients with "alternative mass marketing strategies" through its "Checkout Coupon" program. The program utilizes the universal product bar codes, which retailers scan at the checkout register. Catalina has developed hardware and software to collect data on the products as they are being scanned. The data is then transferred electronically to Catalina's computers in Florida or California. Catalina computers in each retail store analyze whether to produce a coupon or an advertising message printed by thermal printers near the checkout scanners. The computers, printers, hardware, and software, as well as the paper stock utilized by the printer, are all owned by Catalina. Catalina has 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 at that time.

The manufacturer acquires exclusive access to a certain product category (e.g., soup, diapers, pasta sauce), as determined by the manufacturer, in four-week cycles. The content of the coupon or the advertising message is provided 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 or prevent one from being issued by a competitor. However, 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 other advertising message is satisfied that anything is printed.

The manufacturer pays Catalina a base fee plus a fee for each coupon or advertising message in excess of a certain level. The base fee and coupon fee vary, depending upon whether the triggering event is a purchase of the manufacturer's product, a competitor's product, or a product complementary to that of the manufacturer-client. The variance relates to the degree of difficulty and level of sophistication in data 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. The manufacturer-client pays Catalina the base fee for the four-week cycle in advance, without regard to whether any coupons or advertising messages are issued.

In 1996, the Michigan Court of Appeals issued the University of Michigan (3) decision which employed the "incidental to service" test rather than the "real object" test to determine whether a mixed transaction was subject to sales tax. Under the incidental-to-service test, sales tax will not apply to transactions 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 a provision of a service.

In its Catalina decision, the Michigan Supreme Court criticized the Michigan Tax Tribunal and the Michigan Court of Appeals for accepting Treasury's administratively created real object test over the incidental-to-service test set forth in University of Michigan. The Court noted out that Treasury's real object test came from a RAB, which does not have the force of law because such bulletins are not adopted under the State's Administrative Procedures Act. (4) ARAB merely states the department's interpretation of statutes, while a published Court of Appeals decision has binding, precedential effect over the Tax Tribunal, (5) and the Court of Appeals. (6) The Supreme Court explained that the weakness of the real object test was that it focused exclusively on the perspective of the purchaser. This narrow focus was not supported by the statute, which "weighs not only the perspectives of the parties to the sale, but also the nature of the product and service." (7)

Under the incidental-to-service test, sales tax does not apply if, looking objectively at the entire transaction, it principally involves the provision of a service, even though tangible personal property is exchanged incidentally. If so, the transaction is not a sale at retail under MCL 205.51(b). The Supreme Court set forth six factors 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 transferred, and

6. any other factors relevant to the particular transaction.

The Supreme Court ordered the Tax Tribunal to issue a new decision applying the incidental to service test, ordered Catalina and Treasury to each submit a brief to the Supreme Court 35 days after the decision of the Tribunal on remand, and granted Catalina and Treasury the opportunity to request oral argument.

Even before the remand decision of the Tribunal, the Department of Treasury issued a new RAB, No. 2004-3, to replace RAB 1995-1. The new RAB provides:

   RAB 2004-3. This bulletin replaces RAB 1995-1.
   The "real object test" advocated by RAB 1995-1 is
   rescinded and should no longer be used. The "real
   object test" is replaced by the "incidental to service
   test" prescribed by the Michigan Supreme Court in
   its opinion of May 5, 2004 for Catalina Marketing
   v Department of Treasury, -- Mich --; 678
   N.W. 2d 619 (2004).

Subsequently, the Tax Tribunal ruled in favor of Catalina. Applying the incidental-to-service test, the Tribunal found that Catalina's transactions with its customers were principally for the provision of services even though tangible personal property was exchanged incidentally.

What the Buyer Sought

The Tribunal examined the "Performance Agreements" entered into between Catalina and its customers, as well as Catalina's 10-K reports for fiscal years 1992-1994. From these, the Tribunal concluded that Catalina's clients expected to get services rather than tangible personal property. Under the Performance Agreement, the "advertiser" contracted for Catalina's services and Catalina promised not to issue coupons for any other advertiser or retailer for the specified product category during the contracted-for period. The 10-K described the "principal services" provided by Catalina as the exclusive right to have coupons printed during a cycle, its primary source of revenue as "the sale of product category cycles to manufacturers," and its primary goal as becoming the "industry leader in supplying in-store electronic marketing services."

What the Seller's Business Is

The Tribunal found that Catalina was in the business of developing and operating a computer network linked to its data processing hubs in California and Florida in order to provide data analysis and marketing services for its customers. The Tribunal did not find that Catalina was a coupon printer as alleged by the Department.

Whether the Goods Were Sold as a Retail Enterprise for Profit

The Tribunal rejected Treasury's attempt to distinguish the University of Michigan case because it involved a nonprofit entity. The Tribunal referred to the 10-K in concluding that Catalina was providing "consumer product manufacturers and supermarket retailers a cost-effective method of implementing a targeted marketing strategy"--a service, not a sale of tangible personal property.

Whether the Goods Were Available for Sale Without the Service

As to the fourth factor, all parties agreed that Catalina did not sell only coupons to anyone. Therefore, Catalina was not in the business of selling coupons separate from the service.

Extent of the Contribution of the Services to Value of the Property

The Tribunal looked at the 10-K and concluded that any coupon printed had little or no value without the data gathering, analysis, marketing, and distribution services that preceded any printing. The Tribunal focused on Catalina's customers paying for the exclusive right to obtain Catalina's services for a particular product category, and that the fee was fully earned at the start of the contract without regard to whether any coupons were ever issued.

Conclusion

The Tribunal found that Catalina's transactions were a service, the transfer of tangible personal property "merely incidental." It therefore cancelled the sales tax assessment. The incidental-to-services test developed in Catalina is a clearer, more comprehensive test for determining the true nature of a transaction involving both services and tangible personal property. The true object test only looks at the transaction from the viewpoint of the buyer. Although printing a coupon and the targeted marketing services performed by Catalina both result in a coupon being printed, under the incidental to services test, the transaction must also be viewed from a comprehensive perspective what is the seller in the business of selling, where the seller makes its profit, and whether goods are available without the service. This perspective requires development of a robust evidentiary record and should lead to better decisions. Catalina is also a reminder that Revenue Administrative Bulletins do not have the force of law in Michigan, but are merely Treasury's interpretation and are subject to successful challenge.

(1.) Catalina Marketing Corporation v Michigan Department of Treasury, 470 Mich. 13, 678 N.W.2d 619 (2004).

(2.) RAB 95-1.

(3.) University of Michigan, Board of Regents v Michigan Department of Treasury, 217 Mich. App. 665, 553 N.W.2d 349 (1996).

(4.) MCL 24.201, et seq.; Danse Corp. v. Madison Heights, 466 Mich. 175, 181, 644 N.W.2d 721 (2002).

(5.) MCR 7.215(C)(2).

(6.) MCR 7.215(C)(2), (I)(1).

(7.) Catalina Marketing, 470 Mich. at 24.

PATRICK R. VAN TIFLIN and JUNE SUMMERS HAAS are partners in the law firm of Honigman, Miller Schwartz and Cohn LLP in Lansing, Michigan. They represented the taxpayer in Catalina Marketing before the Michigan Supreme Court and on remand before the Michigan Tax Tribunal. Ms. Haas was formerly Michigan's Commissioner of Revenue. Both she and Mr. Van Tiffin have participated in TEI meetings at the chapter and Institute level.