The New York Division of Taxation has again convinced the Tax Appeals Tribunal to hold that the “primary function” test need not be applied in favor of a “mixed bundled” test for determining the taxability of transactions involving services and software.
In its August 27 decision in Matter of NetVoyage Corp., the tribunal upheld the administrative law judge determination that a Utah corporation’s document management services were subject to New York sales tax as prewritten software. The NetVoyage decision is significant as the first from the tribunal to apply the recent Supreme Court, Appellate Division’s ruling in Beeline.com v. Tax Appeals Tribunal. In Beeline, the appellate division ruled that the tribunal had not erred by failing to formally apply the primary function test as argued by the taxpayer, because “it is clear from its determination that it engaged in its functional equivalent by thoroughly assessing whether the license provided to petitioner’s clients to use the [software] is incidental to the services rendered.”
However, in NetVoyage, the tribunal did not read this statement from Beeline as requiring a primary function analysis or its functional equivalent. Instead, the tribunal limited the taxability analysis to whether “the software component of the transactions was essential to the product sold.” The tribunal also highlighted that the court in Beeline had “reiterated that the relevant point was this Tribunal’s determination that ‘the software had market value distinct from the services rendered.’”
Throughout the last century, New York courts and the tribunal established a reliable framework using a “primary function” test to distinguish between taxable tangible personal property (TPP) and nontaxable services. This framework was consistently applied, often producing reasonable results. The primary function test looks to whether the customer is principally purchasing a nontaxable service or taxable TPP. Until recently, the taxability of transactions involving inseparable components of services and software, defined under New York law as TPP, was consistently determined by the courts under the primary function test.
More recently, the tribunal has adopted the view that for transactions involving both services and software, they are “mixed bundled” transactions, and the primary function test does not apply. Under the mixed bundled analysis, as stated in NetVoyage, “the software component of the transaction may render the entire bundled transaction taxable when the software is an essential part of the transaction, as opposed to only incidental, even if the software is only a component piece of the transaction … or when the software has a market value distinct from the services rendered.”
While we cannot say whether NetVoyage would have prevailed under the primary function test, taxpayers should be able to rely on a consistent standard in New York—and the primary function test is that precedential standard. The mixed bundled standard is not the historical precedent and establishes a difficult standard for any service provider that uses software or the internet to deliver its services.
For example, if a medical practice uses a software as a service (SaaS) platform for patients to schedule appointments and to provide access to patient information, including diagnostic results, and if patients are issued a license to govern the use the platform, do the medical services result in a mixed bundled transaction subject to New York sales tax? Would the result change if the platform also includes video and analytical tools for virtual medical appointments hosted over the internet? Under a mixed bundled test, is the software essential under this fact pattern, or only incidental?
It would have been clear under prior precedent that the primary function of these transactions is the nontaxable medical services. However, it is much less clear if the software is essential or has a market value distinct from the medical services in the context of a virtual medical visit and is, therefore, taxable under the mixed bundled test.
As noted by the tribunal in NetVoyage, the taxpayer in Beeline has requested leave to appeal to the New York State Court of Appeals, the highest court in New York. Practitioners and technology-based service providers alike can hold out some glimmer of hope that the precedential standard of the primary function test will be restored in place of the more recent concept of mixed bundled transactions.
We note also that there are other taxpayers in the appeals pipeline that will likely continue to make arguments based on the primary function test, as well as arguments that the taxation of certain services is discriminatory in violation of the federal Internet Tax Freedom Act when “similar” non-internet-based services are not subject to sales tax in New York.
If you have any questions, or would like additional information, please contact one of the attorneys on our State & Local Tax team.
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