It is unremarkable that big technological advances usually bring about new ways of doing the same old business, or sometimes create entirely new industries.
It is also unremarkable that significant technological changes often leave states scrambling to update their tax codes and regulations.
What is remarkable is that it doesn’t take a great deal of technological change to send state tax laws and regulations reeling — sometimes all it takes is a technological tweak to what’s already, and readily, available.
A Picture Is Worth a Thousand Words, But Is Not Always Taxable
In EKB Inc., the taxpayer is a professional wedding photographer who uses digital photography in performing his services. He offers several wedding packages for purchase, ranging from $2,500 to $11,000.
In general, a contract spelled out how many of the taxpayer’s photographers would attend the event, and for how many hours, and the contract provided for the transfer of digital images to the client via DVDs or flash drives.
The contract also provided that the clients owned the digital images before the wedding, and nearly all contracts specified that the purchaser further owned the copyrights to the images. Some packages included linen prints and coffee table books of wedding pictures; the most expensive package included an iPad and an 8×10 digital frame, with wedding photographs downloaded on each.
After taking the photographs, the taxpayer used a computer program to adjust lighting, crop images, and remove images with poor quality. The images were transferred electronically to the client to make their selections. Once the clients made their selections, the photographs were uploaded onto a DVD or flash drive.
A client who opted for a coffee table book or other prints selected images for those goods also, and the taxpayer engaged a printing service to produce the coffee table book and other items. The taxpayer paid sales tax on all his purchases of tangible personal property — the DVDs, flash drives, digital frames, and iPads — as well as on the printing service for the coffee table books and other items.
The taxpayer was selected for a random audit by the revenue agency, covering 2011 through 2016. It was discovered that the taxpayer had not registered for a sales tax permit and indeed had not collected sales tax during the audit period.
The revenue agency performed its calculations based on the taxpayer’s gross sales, resulting in $61,995 due in tax, penalties, and interest. The taxpayer appealed to the board of tax appeals which upheld the state’s assessment.
The taxpayer argued that his photography was predominantly a service and not the sales of tangible personal property and that photography is a service that is expressly absent from the list of taxable services contained in the tax code.
The revenue agency simply asserted that the language of the relevant code provisions and its regulations were applicable in this case.
From the facts and the arguments, the chancery court distilled three issues for decision: (1) whether the taxpayer is in the business of selling tangible personal property and is therefore required to collect sales tax; (2) whether photography services are specifically designated by statute as a taxable service; and (3) whether the revenue agency’s regulation including photography services as a taxable service unlawfully alters and amends the otherwise applicable statute and is therefore unenforceable.
The chancery court first turned to whether photography was a taxable service and noted that the statutory provision listing all services subject to sales tax in the state does not include photography. The only mention of a service that pertains to photography is “film development and photo finishing.”
The revenue agency’s regulations further define this activity as “developing, retouching, printing, tinting, or other photofinishing activities.” Here too, the chancery court noted, the services of photography and videography are missing.
The chancery court observed that in the past, “photography was limited to the process of capturing images on film, developing the film, and creating a photograph that could be held in one’s hand. If that physical photograph were then sold, it would constitute the sale of a tangible good as contemplated by [the code] but the actual service of taking the photos has never been listed as an actual activity.”
Today, the chancery court continued, digital photography and videography are the norm — images can be transferred electronically, requiring no tangible property at all. Yet in all this time, the state legislature has never added photography or videography to the state’s list of taxable services.
However, there is a different section of the state tax code that concerns digital products, one to which the chancery court turned its attention. This section concerns the taxability of “specified digital products,” which includes “electronically transferred digital audio-visual works, digital audio works, and digital books,” terms the section defines. After review, the chancery court concluded that this section does not contemplate digital photography, or the images produced.
It did not take long for the chancery court to conclude that the taxpayer was not in the business of selling tangible property. The DVDs, flash drives, digital frames, and iPads, as included in the wedding packages purchased by the taxpayer’s clients, were of nominal value. The court noted that the taxpayer testified that DVDs and flash drives cost approximately $2, and that he had paid sales tax on these as well as on the other products purchased in connection with his wedding photography business.
The taxpayer’s situation, the chancery court said, is no different from that of an attorney preparing a deed for a client. The attorney furnishes a tangible document to the client, but the attorney is not assessed sales tax on the cost of the paper.
A related question is whether the taxpayer’s purchases of tangible goods on which he paid sales tax qualified as wholesale purchases, despite his not having registered for a sales tax license. If they qualified, the taxes paid would have an impact on the sales taxes assessed by the revenue agency.
Under the tax code, if a taxpayer pays the retail sales tax on a tangible product purchased from a wholesaler, the taxpayer may take a credit for the taxes paid to the wholesaler against the taxes due on the taxpayer’s subsequent sale of the tangible product.
In this case, the chancery court noted, while the taxpayer kept records of its gross sales, it did not keep records of the tangible products it purchased and upon which it paid sales tax. The revenue agency therefore calculated the sales tax due based on the taxpayer’s gross sales.
However, the court pointed out, although a seller is required to register with the state for a permit before commencing business operations (and the taxpayer did not), if he fails to register but subsequently does so, he is permitted to take a credit for the retail taxes paid on products that otherwise would have been purchased at wholesale.
Moreover, the statute further provides that the credit will be allowed during audit, and any final calculation of sales tax due must take the credit into account. In this case, the chancery court said, the revenue agency’s calculation of tax based on the taxpayer’s gross sales, without allowing for the credit for sales taxes paid, is incorrect. Thus, the agency is attempting to assess a tax that is not authorized by statute.
EKB Inc. is what can happen when a technology advances to create something “new,” like digital photography, but the state’s laws and regulations are not updated accordingly. It is not impossible to interpret a statute or regulation in such a way to encompass the new technology; however, courts like the one in EKB Inc. tend to frown on states’ attempts to expand the law and regulations beyond their obvious intention. The matter is on appeal.
One question that the chancery court’s opinion raises is what resolution the revenue agency and the taxpayer will reach regarding the taxpayer’s sales tax liability.
It’s interpretation of section 27-65-3 says that for gross sales the taxpayer made before obtaining a seller’s permit, the revenue agency cannot calculate and assess the sales tax due if the taxpayer can’t provide the information on the retail taxes it paid on business purchases.
Of course, it’s true that many of the missing records are likely easy to obtain. For example, the taxpayer probably purchased the DVDs and flash drives in bulk, and it’s equally probable that the suppliers have kept the sales records. The coffee table book printer would also have retained records of the taxpayer’s purchases.
Yet what if there was tangible evidence of the purchases but the records for those purchases were destroyed, perhaps by fire or flood, and the same is true for the records belonging to the taxpayer’s suppliers? For such cases, I was unable to find in the state’s sales tax code an alternative for calculating the tax due, which seems to mean the taxpayer’s gross sales would go untaxed.
Turning the World Upside Down
Sometimes a seemingly innocuous change in a well-established business model occasioned by an advance in technological development can upend an entire tax structure designed for a particular industry. This is what happened to state and local governments and the travel industry with the advent of online travel agencies (OTAs).
Most OTAs operate under the travel industry’s “merchant model,” the same venerable business model used by travel wholesalers. A travel wholesaler bundles, for example, accommodations and air travel into a package and negotiates deep discounts for airline and hotel rates in exchange for higher volumes of business.
Under the merchant model for hotel accommodations, a state’s hotel occupancy tax is based on the net room rate paid by the wholesaler, not the retail room rate that would have been paid by a customer. Because the hotel room was provided as a package component, the customer pays the wholesaler for the room (and other package components), not the hotelier.
Industry experts mark the confluence of a sharp decline in travel and the rise of hotel vacancy rates after the 9/11 terror attacks as the catalyst that enabled OTAs to emerge as major hotel distribution channels.
OTAs had begun negotiating with hotels in the late 1990s to sell hotel rooms at wholesale, unbundled from other travel components. After the terror attacks the OTAs provided hotels with another, and welcome, market outlet.
However, the problem with the arrangement soon became apparent. OTAs had the pricing flexibility by which they could dramatically undercut a hotel’s pricing structure.
Hotels responded to the loss of control over their pricing structure by negotiating into their agreements with OTAs a provision that ensured OTAs could not discount rooms below the hotel’s retail pricing. The result was that hotels regained control over retail pricing while leaving OTAs as merchants of record on stand-alone hotel bookings.
However, the new arrangement drew the attention of state and local tax agencies. A hotel occupancy tax is a transaction tax measured by the retail price of a room.
When a traveler books a hotel room directly, the hotel is the merchant of record and collects tax on the price it sets for the room. The same is true if the booking is made through a travel agent as intermediary.
The hotel is the merchant of record, collects tax on the price it set for the room, and pays the agent’s commission in a separate transaction. However, when an OTA is the merchant of record as well as the intermediary, the math works out differently.
The hotel and the OTA will have negotiated a wholesale rate of a room, which will be less than the price the hotel charges for similar accommodations. The traveler pays the OTA’s price for the room — that is, the wholesale rate plus the OTA’s markup. The OTA remits tax to the hotel based on the room’s wholesale rate.
The revenue agencies, however, didn’t see it that way. From their perspective, tax is levied on the room’s retail rate, which is the price paid by the traveler for the room, regardless of any underlying arrangements between the hotel and the OTA.
As one might expect, litigation exploded. According to a National Tax Foundation report, by 2016 34 states, the District of Columbia, Puerto Rico, and hundreds of localities filed suit against OTAs for unpaid taxes.
Not surprisingly, the results were mixed. Some courts held that OTAs were not subject to hotel occupancy taxes because the OTAs’ “commission” or “service fee” charged to the traveler did not represent a portion of the price for the hotel room.
Other courts ruled that hotel occupancy tax ordinances did not apply because OTAs were not hotels as defined by law. Along that same line of argument, some courts ruled that although OTAs were not hotels, they controlled their room inventory and were subject to occupancy tax on that basis.
A handful of state courts ruled in favor of the states and localities, finding that the statutes clearly stated that regardless of how the money was divided behind the scenes, the total amount paid by a traveler for a hotel room was subject to tax.
As of today questions regarding the taxation of hotel room bookings by OTAs, as well as how OTAs should be defined within the tax structure, continue in the courts and in the legislative chambers.
Several jurisdictions, be they state or local, have amended their tax laws to specifically include OTAs within their coverage or are currently considering legislative amendments. Others have attempted to mirror their existing stand-alone hotel tax regime by redesignating OTAs as “hotel merchants” and then applying the regime to the OTA’s markup.
The different approaches, of course, are bound to create more confusion. One thing is certain, however: The tiny tweak that disrupted the travel industry over a decade ago will continue to do so for some time to come.
Technological change doesn’t need to be substantive to throw state tax laws and regulations into disarray; the seemingly most insignificant change can cause a disruption of magnitude.
Hopefully, past protracted and painful experiences have taught states the importance of paying attention not just to the tech industry’s earthquakes, but to the tremors too.