Are the data processing services a provider performs after taking over a bank's in-house 'item processing' operations exempt from Connecticut sales tax under the outsourcing exemption?

Plain-English summary

Connecticut taxes computer and data processing services (Conn. Gen. Stat. § 12-407(2)(i)(A)). But an "outsourcing exemption" in § 12-412(74) exempts such services when they're rendered by a provider that "acquired the operations of a data processing facility from the customer," where the customer had operated that facility for its own use. This ruling was the first time DRS interpreted that exemption.

The provider did bank "item processing" — inputting, verifying, sorting, balancing, and reporting check data and producing customer statements, all by computer. Two banks that used to do this in-house outsourced it to the provider after July 1, 1991. The two deals looked different: with one bank, the provider first moved into the bank's own data center, used its equipment, and hired most of its staff, then months later relocated to its own town and bought some of the equipment; with the other, the provider used its own location from the start and hired only a few of the bank's people. The question: do these services qualify for the exemption?

The whole case turned on what "acquire the operations of a data processing facility" means. DRS rejected both extremes:

• Too loose: merely performing some functions a customer used to do in-house — that would let a customer split one facility among several vendors, each claiming to have "acquired" its piece.
• Too strict: requiring the provider to stand in the customer's shoes at the same location, with the same equipment and employees — that would defeat the very purpose of outsourcing, which is to save costs and gain a specialist's economies of scale.

DRS's rule (as of 1995): to "acquire the operations of a data processing facility" means to take over all of the data processing functions the customer formerly performed at a specific location of its business premises. The intent that the provider take over all functions at that location must be manifest in the contract from the outset — otherwise the services are presumed taxable. Crucially, the provider may but need not use the customer's premises, employees, or equipment. A customer can keep doing its own data processing at other locations.

Applied here, both banks handed over all of the item processing at a particular location, and the contracts said so — so the provider's services were exempt.

Important update: DRS flagged that this ruling is amplified and distinguished by Ruling 96-8. A 1995 amendment (1995 Conn. Pub. Acts 160, § 45) added new statutory language that dropped the strict "all functions at a specific location" requirement, so that any portion of a customer's data processing that is outsourced can qualify. For post-amendment periods, look to 96-8's broader test, not the stricter one stated here.

What this means for you

Data-processing and business-process outsourcing providers

If you take over a customer's in-house data processing, the services you then bill can be exempt — and you do not have to keep the customer's old building, machines, or staff to qualify. You can move the work to your own site and use your own equipment. What mattered under this 1995 ruling was that you took over all the data processing at the customer's location and the contract said so from day one.

Get the intent into the contract from the start

The exemption depends on the parties' manifest intent at the outset that the provider take over the operations. A vague or after-the-fact arrangement is presumed taxable. Draft the outsourcing agreement to state clearly what operations are being taken over.

Know which version of the exemption applies to your period

This ruling states the original, stricter test (entire facility's operations at one location). A 1995 amendment loosened it, and Ruling 96-8 applies the broader version — under which even a portion of a customer's data processing can qualify. Match the test to the tax period at issue; the current rule is more generous than the one described here.

The service is otherwise taxable

Absent the exemption, item processing and similar work is taxable computer and data processing service under § 12-407(2)(i)(A). The exemption is the only thing keeping it untaxed, so its conditions matter.

Common questions

Q: What is Connecticut's data-processing "outsourcing exemption"?
A: Under Conn. Gen. Stat. § 12-412(74), computer and data processing services are exempt when the provider "acquired the operations of a data processing facility" from a customer that had run it for its own use. This ruling was DRS's first interpretation of that language.

Q: Do I have to keep using the customer's building, staff, and equipment?
A: No. DRS held the provider may but need not use the customer's premises, employees, or equipment. Requiring that would defeat the cost-saving purpose of outsourcing. You can move the work to your own location.

Q: Does taking over just part of a customer's data processing qualify?
A: Under this 1995 ruling, no — you had to take over all of the data processing at a specific location. But a 1995 amendment (applied in Ruling 96-8) later broadened the exemption so that any portion can qualify. Which rule applies depends on the tax period.

Q: How do I prove the exemption?
A: The contract must show, from the outset, the intent that the provider take over the customer's operations. Absent that evidence, the services are presumed taxable.

Citations and references

Statutes and regulations:

• Conn. Gen. Stat. § 12-412(74) (as amended by 1993 Conn. Pub. Acts 332, § 23) (outsourcing exemption — services by a retailer that acquired the operations of a customer's data processing facility operated for the customer's own use)
• Conn. Gen. Stat. § 12-407(2)(i)(A) (computer and data processing services enumerated as taxable)
• Conn. Agencies Regs. § 12-426-27(b)(1) (defines computer and data processing services — computer time, storing/filing information, retrieving/providing access to information)

Related legislation and ruling (described in prose, not linked):

• 1995 Conn. Pub. Acts 160, § 45 (amendment broadening § 12-412(74))
• Ruling No. 96-8 (amplifies and distinguishes this ruling; applies the 1995 amendment so that any portion of a customer's data processing can qualify — the "all functions at a specific location" test here no longer governs post-amendment periods)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 95-9

Original ruling text

Ruling 95-9, Sales and Use Taxes / Computer and Data Processing Services / "Outsourcing Exemption"

Ruling 95-9

Sales and Use Taxes

Computer and Data Processing Services

"Outsourcing Exemption"

This Ruling is amplified and distinguished by Ruling 96-8

FACTS:

A company (the "Company") is engaged in the business of providing computer and data processing services to banks, which services consist of inputting, verifying, sorting, balancing and reporting of data from checks and other items written by a bank's customers and accepted by the bank, and producing bank statements for customers, all by means of computers. These services are known as "item processing."

Two banks, which previously performed such item processing operations at their own data centers, "outsourced" their item processing operations to the Company after July 1, 1991. In each case, the Company took over all of the item processing activities which the bank had performed at an individual physical location. Pursuant to its contract with one of the banks, the Company initially occupied the bank's data processing facility and utilized all of the bank's equipment. The Company offered positions to all of the bank's data processing employees, and most accepted and became employees of the Company. Several months later, the Company moved this item processing operation away from the bank's location to the Company's own location in another town, and purchased some of the bank's equipment. Half of the original bank employees remained with the Company. Pursuant to its contract with the other bank the Company did not initially occupy the bank's data processing facility, but instead used the Company's own location. Only a few of the bank's employees were hired by the Company. Some, but not all, of the bank's equipment was utilized by the Company.

ISSUE:

Whether the computer and data processing services performed by the Company for the banks are exempt from sales and use taxes under Conn. Gen. Stat. §12-412(74) as computer and data processing services rendered by a retailer who has acquired the operations of its customers' data processing facilities.

DISCUSSION:

Conn. Gen. Stat. §12-412(74), as amended by 1993 Conn. Pub. Acts 332, §23, exempts the following:

Sales of computer and data processing services rendered to a customer (A) by a retailer which, on or after July 1, 1991, acquired the operations of a data processing facility from the customer, provided such customer operated the facility for its own use or (B) by a retailer which, on or after July 1, 1993, acquired the operations of the data processing facility from the retailer described in subdivision (A) of this subsection, provided such customer formerly operated the facility for its own use.

The item processing services that the Company renders for the banks are computer and data processing services described in Conn. Gen. Stat. §12-407(2)(i)(A) which are taxable unless the exemption under Conn. Gen. Stat. §12-412(74) applies. (See Conn. Agencies Regs. §12-426-27(b)(1), which defines such services as including, among others, "providing computer time, storing and filing information, and retrieving or providing access to information.") After July 1, 1991, the Company began performing the services for the banks, which had formerly operated data processing facilities for their own use.

The Department has not previously had occasion to construe the exemption in Conn. Gen. Stat. §12-412(74). At issue is the scope of the phrase "acquired the operations of a data processing facility from the customer," as it is used in the statute. At one extreme, the phrase could be construed to mean that a service provider must do nothing more than perform some of the data processing operations the service recipient previously performed for itself at a particular location. In that case, a service recipient might outsource the operations of one facility to several different service providers, each of which could claim to have "acquired" the particular operation or operations it performs. At the other extreme, the phrase could be construed to mean that a single service provider must replace the service recipient as the operator of the same, unchanged data processing facility previously operated by the service recipient, remaining at the same physical location and using the same equipment and employees.

Viewed as a whole, the phrase "acquired the operations of a data processing facility" appears to require that an entire facility and all the operations performed at that facility must be taken over by a single service provider. If not, the General Assembly could as easily have drafted the subsection to exempt data processing services "performed by a service provider for a service recipient which had previously performed such services for itself," or words to that effect. In using the verb "acquire" the General Assembly apparently meant that the service provider must have obtained something previously belonging to the service recipient, not merely that it should have begun to provide some services previously done "in-house" by the service recipient. The phrase "the operations of a data processing facility" underscores the apparent intention of the General Assembly that what is to be acquired is a specific operation or set of operations performed at a specific location. However, to require that a service provider continue to use exactly the same equipment, employees and location as that of its service recipient to perform the operations would not be consistent with the purpose of outsourcing itself, which generally involves the realization of cost savings by the service recipient by allowing reduced personnel costs and sometimes also the advantage of the economies of scale available to a specialized service provider with its own equipment and its own physical location.

Therefore, for purposes of Conn. Gen. Stat. §12-412(74), to "acquire the operations of a data processing facility" means to take over all of the data processing functions formerly conducted by a service recipient at a specific location of the service recipient's business premises where such computer and data processing functions were performed. Depending upon individual circumstances, a service recipient may or may not continue to perform other data processing functions for itself at other locations. The intention of the parties that all of the data processing functions of the service recipient at a particular location will be taken over by the service provider must be manifest in the language of the contract between them from the outset of the performance of the services, in order for the services to be exempt. Absent such evidence, it must be presumed that the services are taxable. The service provider may, but need not, utilize the service recipient's premises, employees or equipment in performing its services after the acquisition of the operations of the service recipient's data processing facility.

The item processing operations "outsourced" by the banks to the Company are all of the data processing functions formerly conducted by the banks in a particular location of their business premises, and the contracts between the Company and the banks so indicate. Therefore, the Company has "acquired the operations of a data processing facility" in each case, and the computer and data processing services rendered by the Company to the banks are exempt from sales and use taxes.

RULING:

The item processing services provided by the Company to the two banks are exempt under Conn. Gen. Stat. §12-412(74) as computer and data processing services rendered by a retailer which acquired the operations of a data processing facility from customers now receiving the Company's services.

LEGAL DIVISION

July 19, 1995