Is a drop-shipment facilitation service that routes and translates order/inventory data between e-commerce merchants and their suppliers subject to NY sales tax?

Plain-English summary

The Petitioner sells a "Drop Ship Master" (DSM) service to internet retailers. It connects merchants (web sellers) to suppliers (manufacturers/distributors who ship orders directly to customers) through the Petitioner's Internet "hub." The service receives, converts, translates, and relays order and inventory data between the two sides so each side's own order-processing system can use it automatically (no manual re-keying). Merchants and suppliers can also watch order flow on a dashboard, and the Petitioner enforces each merchant's business rules. Customers supply their own Internet/telecom; the Petitioner uses proprietary software (nothing installed on the customer's machine). It bills a per-order charge, a monthly fee, implementation/training, file-conversion fees, and pass-through VAN/EDI charges.

The Office of Counsel concluded the service is not taxable:

• Tax by primary function. An integrated service is taxed according to its primary function (Matter of SSOV '81). The core of DSM is letting merchants and suppliers exchange and process drop-shipment data.
• The valuable part is data processing. The Petitioner translates the messages so the recipient's computers can do straight-through processing. Because there are many other ways to move the messages (fax, mail), the most valuable part is the processing, not the transmission. So the data-processing aspect is the primary function -- and data processing is not a taxable service.
• Not taxable telecom/message-switching. Section 1105(b)(1)(B) taxes "telephony and telegraphy" (which includes message-switching, 20 NYCRR 527.2(d)(2)), but telegraphy doesn't cover a service where transmission is merely incidental (527.2(d)(4)). The Petitioner doesn't own the telecom lines and provides only the switching aspect, so it's not the taxable message-switching of the regulation's Example 3.
• Distinguished from Easylink. There, the provider controlled the whole transmission pathway and did much less processing (just format translation/templates), so transmission was the primary function. Here, processing is primary. So all the DSM fees and associated charges are not taxable.

What this means for you

EDI / data-exchange / integration platforms

If your service's heart is translating and processing data so two parties' systems can talk automatically -- and the customers bring their own connectivity -- New York treats it as nontaxable data processing, taxed by its primary function. The fact that data moves across the Internet doesn't make it taxable telecom.

The line that makes it taxable

You risk being a taxable telegraphy/message-switching service if you own/control the transmission pathway and your processing is light (mere format conversion). The two markers here that kept it nontaxable: the provider didn't own the lines, and the processing for straight-through use was the valuable core.

Ancillary fees follow the primary service

Implementation, training, file-conversion, and even pass-through VAN/EDI charges rode along as nontaxable because the primary service was nontaxable data processing.

Common questions

Q: Is my data-exchange/drop-ship hub taxable in New York?
A: Not if its primary function is data processing -- translating data so the parties' systems use it automatically. That's nontaxable, even though it travels over the Internet.

Q: Doesn't moving messages make it taxable telegraphy?
A: Not where you don't own the transmission lines and the transmission is incidental to the processing. That's what distinguished this from Easylink.

Q: Are the setup and VAN/EDI fees taxable?
A: No -- they're associated charges that follow the nontaxable primary service.

Q: Can I rely on this opinion?
A: It binds the Department only as to the petitioner. Use it as guidance and confirm your own facts.

Citations and references

• Tax Law section 1105(c) (sales tax on enumerated services)
• Tax Law section 1105(b)(1)(B) (sales tax on telephony/telegraphy services)
• 20 NYCRR section 527.2(d)(2) (telegraphy includes message-switching services)
• 20 NYCRR section 527.2(d)(4) (telegraphy excludes incidental elements of another service)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/sales_ao_2015.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/sales/a15_20s.pdf

Original ruling text

New York State Department of Taxation and Finance

TSB-A-15(20)S
Sales Tax
May 26, 2015

Office of Counsel
Advisory Opinion Unit

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. S120405A

The Department of Taxation and Finance received a Petition for Advisory Opinion from
“Petitioner”, REDACTEDREDACTED which asks whether Petitioner’s drop shipment
facilitation service (“DSM service”) is subject to New York State sales and use tax. We
conclude that the service is not subject to sales and use tax because its primary function is data
processing, which is not a taxable service under the Tax Law.
Facts
Petitioner provides its Drop Ship Master (“DSM”) service to major retailers in the
Internet retail industry. Petitioner’s DSM service combines advisory services, networking and
data processing capabilities that connect e-commerce retailers (“Merchants”) to third party
manufacturers and distributors (“Suppliers”) who can fulfill Merchants’ customer orders. The
drop shipment process allows web-based Merchants to offer products on their web sites without
the costs and logistical issues of actually warehousing or stocking such products themselves;
rather, orders can be shipped to customers directly from Suppliers’ inventory warehouses.
Petitioner also offers certain advisory and technical services to Merchants and Suppliers,
including the formulation of a drop shipment strategy and operational procedures.
The technical aspects of Petitioner’s DSM service involve connecting both Merchants
and Suppliers to Petitioner’s Internet-based universal “hub” and receiving, processing,
translating and relaying order and inventory-related data between the parties. The DSM service
receives order information provided by Merchants, converts it and translates it so that it may be
processed by Suppliers’ own internal order-processing systems. Likewise, the DSM service
receives order information provided by Suppliers, converts it and translates it so that it can be
read by Merchants’ own internal order-processing systems.
Once a Merchant is set up for DSM service, Petitioner’s employees individually contact
all Suppliers with which the Merchant wishes to transact business through the service.
Petitioner’s employees work with the individual Suppliers to establish a proper connection and
configuration for transacting with the Merchant. Suppliers have the option of interacting with
Petitioner’s service via a browser-based connection (which requires periodically logging into the
system to retrieve orders and provide response data) or an “integrated connection” in which
transactional information is exchanged via a batch-oriented data communications connection.
Supplier training includes identifying the specific requirements that the Merchant dictates (i.e.
timing of when products must be shipped and the Merchant specific business rules that must be
adhered to by Suppliers). All Suppliers that become part of Petitioner’s network must enter into

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Sales Tax
May 26, 2015

a separate agreement with Petitioner and pay for DSM service themselves in order to transact
business with the Merchant using the service.
Petitioner uses its proprietary software applications to provide the technical aspects of its
service, which does not require any software to be installed on its customers’ computers. Once
a Merchant and its Suppliers have configured connections to the DSM service, their ordermanagement systems can exchange data with the service. Merchants provide order-related data
to Petitioner through value-added telecommunications networks (VANs) or directly to Petitioner
through the Internet. Additionally, Merchants and Suppliers can log on to the Internet and access
a “dashboard view” of the drop ship order flow, such as whether orders were delivered on time
or are pending. Merchants and Suppliers have no ability to control or constructively control the
software providing this information: they can merely review the order flow, inventory, etc., and
input information.
As part of its Service, Petitioner ensures that all of the business rules, processes and
preferences specified by Merchants during the setup/implementation phase are followed. As an
example of the type of rules that Merchants may require, a Merchant may require that a Supplier
ship all in-stock orders within 12 hours and that all orders utilize the Merchant’s own branded
packing slip.
Once orders are received, Suppliers provide information, including acknowledgements,
shipping status, fulfillment confirmations (i.e. completed shipments, cancellations), products in
inventory, inventory levels and return notifications, through Petitioner. Merchants can then view
and monitor the various aspects of its drop-shipment transactions in near-real-time throughout
the supply chain.
Order information is received by the DSM service automatically from Merchants’ own
systems. In other words, Merchants do not need to log on to Petitioner’s website in order to
enter information each time a customer’s order is to be placed with a Supplier. Rather,
Petitioner’s system retrieves or receives batches of transactional information sent through the
Internet from Merchants’ own order-processing systems that are then processed and supplied to
the appropriate Supplier in the appropriate format for use by Suppliers’ own order-processing
system. Without Petitioner’s solution, Merchants and Suppliers would exchange order
information manually (for example, by sending information via fax or email). By using
Petitioner’s solution, the process is automated and information is automatically translated and
converted by Petitioner’s service across Merchant and Supplier order management systems.
While Petitioner’s service offers this automated translation and conversion process, it is
important to note that Merchants and Suppliers must separately purchase their own
telecommunications networks or Internet connections to access Petitioner’s service.
Petitioner has the ability to exchange order and inventory data with customers either
directly through the Internet, through a VAN service provider, or through a direct connection
protocol such as AS2, which is an electronic data interchange [EDI] specification intended to
ensure the proper level of security for data transmitted over the Internet. The customer selects
which protocol it wishes to use based on its own technological capacities. If a customer has a
VAN EDI mailbox, it may request that messages to it be sent over VAN EDI. If a customer
chooses that option, Petitioner will use the services of a third-party VAN EDI service provider to
transfer messages to the customer. Petitioner does not provide any VAN EDI capacity or service

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to its customer; rather, Petitioner’s VAN EDI charge is to recoup its expense in using a VAN
EDI service to facilitate the transfer of data to the customer. In no case is Petitioner installing a
protocol for the customer or providing a protocol service to a customer. In all cases, the
customer is selecting the protocol based on its own technological capacities and is independently
acquiring the protocol from an unrelated, third-party service provider. In other words, the
customer’s engagement of a third-party VAN service provider and selection of this protocol
requires Petitioner to engage a separate VAN EDI service provider to enable Petitioner to receive
EDI messages through this protocol method.
Petitioner bills a per order charge for the DSM service, as well as a monthly base fee for
the DSM service. In addition, it bills customers an implementation and training fee for setting up
the service, along with separate fees for the conversion and transfer of inventory files (for the use
of the customer’s trading partners) and an additional fee if Petitioner is required to obtain the
services of a VAN EDI or AS2 provider to communicate with the customer.
Analysis
The Tax Law imposes sales and use tax on the retail sale of tangible personal property,
including prewritten computer software, and the sale, except for resale, of certain enumerated
services. See Tax Law §§ 1101(b)(6); 1105(a), (b), and (c). Among the taxable services is the
sale of “telephony and telegraphy and telephone and telegraph service of whatever nature.” The
words “of whatever nature” indicate that a broad construction is to be given the terms describing
the items taxed. Sales and Use Tax Regulation § 527.2(a)(2). The terms “telephony and
telegraphy” include the “use or operation of any apparatus for transmission of sound, sound
reproduction or coded or other signals.” Sales and Use Tax Regulation § 527.2(d)((2). Included
in the definition of telegraphy are “[m]essage switching services,” which transmit messages to
computers over lines leased from communications carriers, fax services and teletypewriter
services. 20 NYCRR § 527.2(d)(2). On the other hand, a service is not considered telegraphy
where it “is merely an incidental element of a different or other service purchased by the
customer.” 20 NYCRR § 527.2(d)(4).
Petitioner’s DSM service has multiple components, including transferring of messages
between Merchants and their Suppliers, providing Merchants with a means of monitoring on a
near real-time basis the data surrounding their drop shipment program, and consulting with
Merchants to allow them to optimize their drop shipping programs. Integrated services are to be
taxed according to their primary function. See Matter of SSOV '81 Ltd., Tax Appeals Tribunal,
January 19, 1995. Here, the most important part of the DSM service appears to be its service of
allowing Merchants and suppliers to exchange information pertinent to their drop shipment
relationship. This “exchange” component of Petitioner’s DSM service has two aspects: the
transfer of information and the processing of that information to allow the recipient’s computers
to use the information without any manual input. Petitioner’s DSM service acts as a central data
messaging hub that routes business messages or data from one party to another. Given that
Petitioner here does not own the telecommunication lines through which the messages pass, it is
not clear that its DSM service is equivalent to the message-switching service found taxable in
Example 3 of Sales Tax Reg. § 527.2(d)(2).

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It is not necessary to resolve that issue here, however, because of the significant data
processing services Petitioner engages in as part of the DSM service. Specifically, Petitioner
must translate the messages between the subscribers to the service in order to permit straight
through processing of the messages by the recipient’s computers. Inasmuch as there exists a
myriad of ways to get the messages to other subscribers other than through Petitioner’s
technology (e.g., fax or mail), it appears that the most valuable part of Petitioner’s service is this
processing of the messages. Accordingly, in this matter it appears that the data processing
aspect of the service is the primary function of the service, not the transmission element.
This case is distinguishable from Matter of Easylink Intl., Inc. v. New York State Tax
Appeals Trib. (101 AD3d 1180 [3d Dep’t 2012]), in which the Third Department upheld the Tax
Appeals Tribunal’s decision that the taxpayer’s electronic messaging services, which included
fax, telex, e-mail and EDI, were “telegraphy services” subject to sales tax. In that case, the
taxpayer’s service provider was responsible for the whole transmission pathway, whereas here
Petitioner is only providing the switching aspect. Id. at 1182-1183. Moreover, while Petitioner
processes the messages to make them machine readable for the recipient’s system so that the
messages can processed without human intervention, the service provider in Easylink engaged in
much less significant processing involving translating messages between standard formats (e.g.,
from email to fax) and the preparation of messages using templates. See Id. at 1182. In short,
while transmission of messages was the primary function of the service at issue in Easylink, that
is not the case here. Accordingly, Petitioner’s fees for performing the DSM service and its
associated charges are not subject to sales tax.

DATED: May 26, 2015

NOTE:

/S/
DEBORAH R. LIEBMAN
Deputy Counsel

An Advisory Opinion is issued at the request of a person or entity. It is limited to the
facts set forth therein and is binding on the Department only with respect to the
person or entity to whom it is issued and only if the person or entity fully and
accurately describes all relevant facts. An Advisory Opinion is based on the law,
regulations, and Department policies in effect as of the date the Opinion is issued or
for the specific time period at issue in the Opinion. The information provided in this
document does not cover every situation and is not intended to replace the law or
change its meaning.