Royalties and licensing fees from intellectual property used in the operation of tangible property in Pennsylvania are not subject to sales and use tax. Intellectual property is something separate, and is not merely an ancillary or incidental part of taxable tangible property.
The Pennsylvania Supreme Court on October 25 issued its decision in Downs Racing, granting a notable taxpayer victory. Downs Racing paid royalties and licensing fees to a third party in connection with the operation of gaming machines. On audit, the Pennsylvania Department of Revenue (Department) assessed sales tax, taking the position that the royalties and licensing fees are taxable because they are merely ancillary to taxable tangible property. Before the court, the Department expounded on this theory, arguing that the royalties and licensing fees are analogous to canned computer software found to be taxable in the Dechert case.
The court squarely rejected the commonwealth’s position, and found that Downs Racing’s royalties and licensing fees are not merely ancillary to taxable tangible property. In reaching its finding, the court noted that there was not a clear connection between the commonwealth’s reliance on Dechert and the intellectual property in the instant case. Further, the court was persuaded by the factual record, which established that (1) there were separate agreements for taxable tangible property and related intellectual property; (2) the royalty and license fee charges were incurred on a daily basis, separate from the charges for tangible property; (3) the intellectual property was not necessary to the function of the tangible property; and (4) decisions about which intellectual property to purchase depended on events occurring after the tangible property was purchased.
A common theme in state taxation today is the improper application of old laws to new ways of doing business. Pennsylvania is no stranger to this theme, and in recent history the Department has routinely taken the position that certain nontraditional streams of revenue—like those stemming from intellectual property and SaaS—are part and parcel with taxable canned software. The court’s decision in Downs Racing pushes back against the Department’s broad interpretation of the sales and use tax statutes and its misplaced reliance on the Dechert case. While taxpayers will likely continue to see challenges from the Department around nontraditional streams of revenue, they may take some comfort in reliance on the Downs Racing decision.
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Cosimo A. Zavaglia