Joint Legislative Budget Committee

Staff Memorandum

1716 West Adams Telephone: (602) 926-5491

Phoenix, Arizona 85007 azleg.gov

DATE:	April 6, 2018

TO:	Senator Karen Fann

FROM:	Hans Olofsson, Chief Economist

SUBJECT:	UPDATE ON THE DIGITAL GOODS FISCAL NOTES (HB 2479/SB 1392)

We published our fiscal notes on the companion digital goods bills (HB 2479/SB 1392) on March 1. In the 2 fiscal notes, we said that we would be further researching the Arizona League of Cities and Towns estimates on the impact of the bills. On March 2, you wrote us to request that we update you upon completing our analysis. Senator Farnsworth and Representative Ugenti-Rita have made similar requests.

At the time of the fiscal note, the League estimated that SB 1392 would reduce municipal Transaction Privilege Tax (TPT) in 8 survey cities by $(23) million annually. The League extrapolated this result to a statewide municipal TPT loss of $(78) million. Based on 3 more survey responses and a revised methodology, the League now estimates that the statewide municipal TPT loss would be $(45) million. By extrapolation, the League further estimates the state level TPT loss to be $(120) million.

We have the following observations about the League's revenue estimates:

1. The League estimate is overstated to the extent that their estimates include the loss of revenue from streaming services with a download option. The bill sponsors intend that particular digital transaction be subject to taxation. Based on our inquiry, Legislative Council has stated that taxation of those services will depend on how the Department of Revenue (DOR) interprets the bill language. (see Attachment A). Since the publication of the fiscal notes, DOR has not responded to our questions on this issue.

2. If DOR interprets the bill language to require taxation of streaming services with a download option, the League estimates may fall considerably. The League estimates, however, do not separate out this particular category from other types of digital transactions. We have very limited ability to evaluate the remaining tax loss on our own. We cannot access the confidential taxpayer TPT data of individual businesses that was used by the 11 respondents in developing their estimates.

3. The Arizona Tax Research Association (ATRA) has questioned the League's $120 million state impact estimate, since it would represent 60% of the state's current level TPT rental receipts of almost $200 million. Based on input from the cities, the League has responded that companies sometimes wrongly file their digital transactions under the retail classification. Again, our lack of access to the actual taxpayer data limits our ability to evaluate the extent of incorrect filing.

4. Based on anecdotal evidence, we are aware of some currently taxed digital transactions that would be exempt under the bill. One example would be tax-preparation software. Some tax lawyers believe that DOR currently lacks the authority to tax Software as a Service (SaaS)

(Continued)

transactions, but that is a legal issue better addressed by Legislative Council than our office.

5. While the League's estimate may be overstated for the reasons described above, we cannot necessarily conclude that the bill has a minimal impact. As we said in the original fiscal note, we cannot determine the magnitude of the General Fund revenue loss due to the lack of data available to our office. We would have appreciated DOR's insight on the League estimates, but the department has not responded to our inquiries since publication of the fiscal notes.

Please feel free to contact our office if you have any additional questions regarding this matter.

HO:kp

Attachment

xc:	Richard Stavneak, Director Representative Michelle Ugenti-Rita, Ways and Means Committee Chairman Senator David Farnsworth, Senate Finance Chairman

BACKGROUND

House Bill (H.B.) 2479 would exclude from excise taxes gross receipts from streaming services. This exclusion would not apply to downloading.

QUESTIONS

I. To what companies would the tax exclusion and the exception to the exclusion apply? More particularly, how would a company be taxed if it provided nontaxable streaming and taxable downloading?

2. How would this bill be affected if in South Dakota v. Way/air the United States Supreme Court overturns its decision in Quill Corp. v. North Dakota?

ANSWERS

I. The taxability of a company's activities depends on the specifics of each case, so we cannot say whether a particular company's activities are taxable. However, if a company that has taxable and nontaxable activities can identify the revenues from the two different activities, it will be taxed only on the taxable activities.

2. The enactment of H.B. 2479 would not change how the Court's decision in

Way/air would affect this state's taxation of streaming services and downloading.

DISCUSSION

Taxation under H.B. 2479

House Bill 2479 excludes the gross income, gross receipts and other measures of income related to specified digital goods or specified digital services in determining transaction privilege tax, use tax and county, city and town excise tax liability. Arizona Revised Statutes (A.R.S.) section 42-5002, subsection C, paragraph 11• More specifically, the bill exempts revenues from selling, leasing, licensing, purchasing or using specified digital services or specified digital goods that are remotely accessed from taxation. Id. The exclusion does not apply to specified digital goods that are transferred electronically. Id. These goods would be taxed as provided in A.R.S. sections 42-5061 and 42-6015.

Specified digital goods include digital books, digital audiovisual works and digital audio works. A.R.S. section 42-500 I, paragraph 22. Specified digital services include streaming services, but do not include rights to digital goods that are transferred electronically. A.R.S. section 42-5001, paragraph 23, subdivision (h). "Transferred electronically" means the right to electronic delivery or transfer in whole of specified digital goods to a purchaser or to a purchaser's computer and not by access through the Internet. See, A.R.S. section 42-5001, paragraphs 17 and 27. This definition appears to mean downloading.

So, H.B. 2479 would exclude from taxation revenues from streaming services, but would not exclude revenues from downloading digital books, digital audiovisual works and digital audio works. How these provisions would apply to any particular company depends on the specific facts of each situation. Therefore, we cannot give a general answer to this question.

A general answer can be provided to the question of what is the taxability of revenues from streaming services that include in part the right to download. This situation is no different than any business that conducts taxable and nontaxable activities. It is a matter of proof.

For example, a car repair business sells parts, which is taxable, and provides repair services, which is not taxable. A repair invoice lists parts and labor separately to distinguish the revenues from the taxable and nontaxable activities.

A streaming service provider that provides a right to download would have to distinguish between revenues from taxable and nontaxable services. What this would actually require will depend on the procedures and guidelines prescribed by the Department of Revenue. If a company separates the two revenues streams, only the revenues from downloading would be taxable.

1 All references are to statutory sections as amended by House engrossed H.B. 2479.

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Quill

In Quill, the United States Supreme Court held that a retailer must have physical presence in a state for the state to have substantial nexus with the retailer to tax sales into the state. Quill Corp. v. North Dakota, 504 U.S. 298, 302 (1992). Over the years this decision has been criticized by a number of judges, including current members of the Supreme Court. In fact, Justice Kennedy invited a challenge to the Quill decision, stating, "The legal system should find an appropriate case for this Court to reexamine Quill and Bellas Hess." Direct Mktg. Ass'n v. Brohl, _ U.S. _, 135 S. Ct. 1124, 1135, (2015) (J. Kennedy concurring).

South Dakota accepted the invitation by enacting legislation to tax companies that do not have physical presence in the state but have economic presence in the state. The retail sales tax applies to companies that have annual sales into South Dakota of more than $100,000 or at least two hundred separate sales into the state in a year. S.B. 106, 2016 Legis. Assemb., 91st Sess. (S.D. 2016), § 1. The validity of this taxing scheme is now before the United States Supreme Court. South Dakota v. Wayfair, Inc.,_ U.S._, 138 S. Ct. 735 (Jan. 12, 2018) (cert. granted). At issue in Wayfair is whether the Court will abandon the physical presence requirement for nexus as prescribed in Quill and accept the economic nexus prescribed in the South Dakota law.

It is our understanding that the Department of Revenue considers streaming services taxable under the personal property rental classification. H.B. 2479 excludes revenue from streaming services from taxation, except for revenues from downloading. While the bill would tax downloading in a different way than it is currently taxed, it does not tax any activity that is not currently taxed. Also, Wayfair involves nexus and

H.B. 2479 does not address nexus. Therefore, no matter what the decision in Wayfair, it will not affect taxation under H.B. 2479 any differently than it would affect current taxation.

March 6, 2018

Richard Stavneak, Director, JLBC Ken Behringer, General Counsel

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