Royalty fees for the use of intellectual property that were paid under a royalty fee agreement were not subject to Pennsylvania Sales Tax (SUT). Downs Racing, LP v. Commonwealth, 70 MAP 2017, 71 MAP 2017 (Pa. 2018). Payments made under a service agreement for the use of closed-circuit horse-racing simulcasting equipment that included personnel to install, maintain, and operate the equipment, were held to be subject to SUT.

Downs Racing, LP (Downs Racing) operated a casino and several off-track wagering locations in Pennsylvania. For the off-track wagering locations, Downs Racing entered into a service agreement for equipment to provide live displays of races, and personnel to install, maintain, and operate the equipment. For the casino, Downs Racing purchased video poker machines. It executed two separate agreements — one for the purchase of video poker machines and one for the payment of royalty fees for the intellectual property associated with the video poker games that ran on the machines. Downs Racing was assessed SUT on the payments made under the service agreement and filed for a refund of SUT paid on the royalty fees paid under the royalty fee agreement.

Downs Racing argued that none of the payments made under the service agreement were subject to SUT because the true object of the agreement was for the provision of non-taxable audio-visual services, and, alternatively, that the equipment rental charges were not taxable because the service provider retained the right to operate and control the equipment. The Pennsylvania Supreme Court declined to apply a true object test and explained that the service agreement stated that Downs Racing controlled the employees who operated the equipment furnished under the service agreement. Moreover, the charges for the equipment rental and the provision of services were not separately stated in the invoices. Therefore, Downs Racing did not establish that the charges under the service agreement were not subject to SUT.

Downs Racing argued that the royalty payments applied to the right to use intellectual property, which is intangible property not subject to SUT. The court agreed. The court held that royalty fees are intangible legal rights that do not fall within the meaning of corporeal personal property or canned software. The court rejected the commonwealth’s argument that the royalty fees were taxable because they were incidental to the purchase of the video poker machines and the software used to operate them since the fees were billed separately from the poker machines under a different agreement.