CCI Europe, Inc. v. Arizona Department of Revenue

IN THE
ARIZONA COURT OF APPEALS
DIVISION ONE

CCI EUROPE, INC., Plaintiff/Appellee,

v.

ARIZONA DEPARTMENT OF REVENUE, Defendant/Appellant.

No. 1 CA-TX 13-0002
FILED 3-12-2015

Appeal from the Superior Court in Maricopa County
No. TX2010-000404
The Honorable Dean M. Fink, Judge

AFFIRMED

COUNSEL

Steptoe & Johnson, LLP, Phoenix
By Patrick Derdenger, Bennett Evan Cooper
Counsel for Plaintiff/Appellee

Arizona Attorney General’s Office, Phoenix
By Jerry A. Fries, Benjamin H. Updike
Counsel for Defendant/Appellant

OPINION

Judge Maurice Portley delivered the Opinion of the court, in which
Presiding Judge Patricia A. Orozco and Judge Randall M. Howe joined.
 CCI EUROPE v. ADOR
Opinion of the Court

P O R T L E Y, Judge:

¶1 We are asked to determine whether CCI Europe, Inc. (“CCI”)
is required to pay the transaction privilege tax on the proceeds it receives
from its software license agreement and maintenance agreements with
Phoenix Newspapers, Inc. (“PNI”). Because the software is used as part of
the manufacturing process to produce the printed version of the Arizona
Republic newspaper, the proceeds from the agreements are statutorily
exempt. Accordingly, we affirm the tax court’s summary judgment.

FACTUAL AND PROCEDURAL BACKGROUND

¶2 CCI develops and sells software to facilitate the production of
printed newspapers. The software performs all layout, formatting, and
typesetting functions necessary to produce printed editions of a newspaper.
For example, the software automatically: creates the page layout for the
newspaper, margin width, column width, as well as spacing and location
of articles, editorials, advertisements, photos, and graphics; assigns a
naming convention that identifies each page and its relationship to the
finished product; and in the printing process, dictates whether pages are
printed in color, or in black and white.

¶3 CCI granted PNI a 99-year license to use its software to
produce the printed Arizona Republic in 1997. Additionally, the parties
entered into software maintenance agreements where CCI agreed to
provide PNI with new software updates and releases, as well as support
and software troubleshooting.

¶4 After CCI was audited for the period between June 2002 and
May 2006, the Arizona Department of Revenue (the “Department”)
determined that CCI owed transaction privilege tax in the amount of
$82,511.44 plus interest on its income from the software agreements with
PNI. CCI unsuccessfully protested the assessment through the
administrative process, arguing that the income from the agreements is
deductible under Arizona Revised Statutes (“A.R.S.”) section 42-5061(B)(1)
(2014),1 which exempts gross proceeds realized from the sale of machinery
or equipment “used directly in manufacturing[.]”

1Absent material revisions after the relevant dates, we cite the current
version of a statute unless otherwise indicated.

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Opinion of the Court

¶5 CCI filed an appeal to the tax court and subsequently moved
for summary judgment.2 After briefing and argument, the tax court
determined that “the software, and by extension the maintenance
agreements, are exempt under A.R.S. § 42-5061(B)(1)” and granted CCI
summary judgment. The Department then filed this appeal.

DISCUSSION

¶6 The Department contends the tax court erred by ruling that
the gross income CCI earns from the sale of software to PNI is exempt from
taxation under § 42-5061(B)(1). Specifically, the Department argues that:
(1) newspaper publishing is not manufacturing; but (2) even if newspaper
publishing is manufacturing, the software is not “used directly” in the
manufacturing process.

¶7 We review de novo the grant of summary judgment.
Wilderness World, Inc. v. Ariz. Dep’t of Revenue, 182 Ariz. 196, 198, 895 P.2d
108, 110 (1995). We also review de novo the tax court’s construction of
statutes. Ariz. Dep’t of Revenue v. Cent. Newspapers, Inc., 222 Ariz. 626, 629,
¶ 9, 218 P.3d 1083, 1086 (App. 2009).

¶8 When reviewing tax statutes, we liberally construe statutes
imposing taxes in favor of taxpayers and against the government, but
“strictly construe tax exemptions because they violate the policy that all
taxpayers should share the common burden of taxation.” Ariz. Dep’t of
Revenue v. Capitol Castings, Inc., 207 Ariz. 445, 447, ¶ 10, 88 P.3d 159, 161
(2004). We will not, however, construe an exemption so strictly “as to
defeat or destroy the [legislative] intent and purpose.” Id. at 447-48, ¶ 10,
88 P.3d at 161-62 (quoting W.E. Shipley, Annotation, Items or Materials
Exempt from Use Tax as Used in Manufacturing, Processing, or the Like, 30
A.L.R. 2d 1439, 1442 (1953)).

I.

¶9 Our transaction privilege tax is an “excise tax on the privilege
or right to engage in an occupation or business in the State of Arizona.”
Ariz. Dep’t of Revenue v. Mountain States Tel. & Tel. Co., 113 Ariz. 467, 468,

2 CCI simultaneously filed three motions for partial summary judgment
supported by a combined statement of facts. The first addressed whether a
newspaper publisher is a manufacturer; the second addressed whether the
CCI software qualifies for the machinery and equipment deduction; and the
third motion addressed whether gross receipts from software maintenance
agreements are subject to Arizona transaction privilege tax.

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556 P.2d 1129, 1130 (1976); Karbal v. Ariz. Dep’t of Revenue, 215 Ariz. 114, 116,
¶ 10, 158 P.3d 243, 245 (App. 2007). It is not a sales tax, but a tax on the
gross receipts of the seller’s business activities. See A.R.S. § 42–5008; J.C.
Penney Co. v. Ariz. Dep’t of Revenue, 125 Ariz. 469, 472, 610 P.2d 471, 474
(App. 1980) (“The legal incidence of the transaction privilege tax is on the
seller[.]”).

¶10 There are a number of statutory exemptions to the transaction
privilege tax, including an exemption for gross income derived from the
sale of machinery or equipment “used directly in manufacturing.” A.R.S. §
42-5061(B)(1). Section 42-5061(B)(1) provides that:

[T]he gross proceeds of sales or gross income
derived from sales of the following categories of
tangible personal property shall be deducted
from the tax base:

1. Machinery, or equipment, used directly in
manufacturing, processing, fabricating, job
printing, refining or metallurgical operations.
The terms “manufacturing”, “processing”,
“fabricating”, “job printing”, “refining” and
“metallurgical” as used in this paragraph refer
to and include those operations commonly
understood within their ordinary meaning.

A.R.S. § 42-5061(B)(1) (emphasis added).3

¶11 The “machinery and equipment exemption” was created to
promote business investment and increase state revenue from income and
property taxes. Capitol Castings, 207 Ariz. at 448, ¶ 13, 88 P.3d at 162. And
§ 42-5061(B)(1) furthers that legislative intent. Id.

3 Arizona use tax, which is complementary to the transaction privilege tax,
is subject to the same exemption for machinery or equipment used directly
in manufacturing. See A.R.S. § 42-5159(B)(1); Ariz. Dep’t of Revenue v. Care
Computer Sys., Inc., 197 Ariz. 414, 420, ¶ 25, 4 P.3d 469, 475 (App. 2000)
(Fidel, J., dissenting) (explaining that transaction privilege taxes and use
taxes are complementary taxes).

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Opinion of the Court

II.

¶12 Although the Department contends that CCI is a retailer
selling software, including updates and releases,4 the Department does not
dispute that CCI’s software is machinery or equipment.5 See Capitol
Castings, 207 Ariz. at 450, ¶ 22, 88 P.3d at 164 (determining that a computer
used in business is machinery or equipment). However, the Department
argues that the statutory exemption does not apply because newspaper
publishing is not “manufacturing.”

A.

¶13 The term “manufacturing” is not defined, but § 42-5061(B)(1)
directs us to apply the “ordinary meaning” of the term. A.R.S. § 42-
5061(B)(1). We do so by looking to established and widely used
dictionaries. See Stout v. Taylor, 233 Ariz. 275, 278, ¶ 12, 311 P.3d 1088, 1091
(App. 2013); see also Hearst Corp. v. State Dep’t of Assessment & Taxation, 308
A.2d 679, 684 (Md. 1973) (stating “[m]anufacture as used in those statutes
is a plain word in everyday use, and as ordinarily understood . . . .”).
For example, the Oxford dictionary defines “manufacture” as to
“[m]ake (something) on a large scale using machinery.”
http://www.oxforddictionaries.com/us/definition/english/manufacture
(last visited February 26, 2015). The online Merriam-Webster dictionary
defines “manufacture” as “the process of making products especially with

4 The Department recognizes that CCI’s support and troubleshooting
services, standing alone, are not “tangible personal property” and would
not be subject to transaction privilege tax. However, because CCI did not
separate its receipts from support and troubleshooting from its receipts
from the software updates and releases, the Department assessed
transaction privilege taxes on all the fees PNI paid CCI under the software
agreements. See A.R.S. § 42-5061(G) (permitting the application of the
transaction privilege tax to both goods and services if the taxpayer does not
separate the income attributable to each on its books).
5 The parties also agree that if CCI’s software is deductible as machinery or

equipment used directly in manufacturing, then the software updates and
releases provided pursuant to the software maintenance agreements are
likewise deductible pursuant to Arizona Administrative Code (“A.A.C.”)
R15-5-120(B), which exempts gross receipts from the “sale of repair or
replacement parts for exempt machinery or equipment.” A.A.C. R15-5-
120(B).

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machines in factories.” http://www.merriam-webster.com/dictionary/
manufacture (last visited March 4, 2015).

¶14 PNI uses printing presses and other machinery daily to
produce large numbers of printed newspapers. The process to create a
printed newspaper is described in the record as follows:

Paper is wound through the printing presses
prior to hanging the plates, and once the plates
are attached, the presses are started, and they
apply ink and water to the plates. The paper
winds through the presses and culminates at a
piece of equipment called the “folder,” which
takes in all the pages, cuts them, folds them into
completed newspapers or sections of
newspapers, and drops them onto a conveyor
system.

Unlike “[p]rinting a newspaper on a hand-operated flat-bed press in the
18th or 19th century [which was] simply the dissemination of information,”
Hearst Corp., 308 A.2d at 688, “[t]he equipment used in printing a
newspaper has become much more sophisticated and more fully
automated.” Id. at 680.

¶15 During the audit period, PNI was producing approximately
3,450,000 copies of the Arizona Republic a week. PNI weekly used
approximately 4,387,835 pounds of newsprint, 65,568 pounds of ink, 63 rolls
of strapping, and 54 rolls of packaging. Raw materials are used and printed
newspapers are the result of the manufacturing process.

B.

¶16 The ordinary dictionary meaning of manufacturing is also
consistent with regulations used by the Department. In the Arizona
Administrative Code, “manufacturing” is defined as “the performance as a
business of an integrated series of operations which place tangible personal
property in a form, composition, or character different from that in which
it was acquired and transforms it into a different product with a distinctive
name, character, or use.” A.A.C. R15-5-120. Moreover, the regulations
define “publisher” as “one who manufactures and distributes a publication
from a point within this state.” A.A.C. R15-5-1303(A) (emphasis added).

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Opinion of the Court

¶17 The administrative regulatory definitions support the
decision that PNI engages in “manufacturing” by producing the printed
version of the Arizona Republic. Specifically, and using CCI’s software, PNI
performs an integrated set of operations, to wit: (1) PNI designs, formats,
lays out, and typesets all content, including articles, editorials,
photographs, graphics, and advertisements to create newspaper pages; and
(2) PNI prints newspapers through a mechanized process using newsprint,
ink, and other materials to produce printed newspapers. The
transformation of newsprint and ink into a different product with a
distinctive name, character, and use — namely, the printed version of the
Arizona Republic — is a manufacturing process.

¶18 Moreover, in 1984, twenty years before Capitol Castings, PNI
asked the Department about the taxability of certain machinery and
equipment it had purchased. By letter, the Department advised PNI that
the listed items of machinery and equipment, including “[c]omputer
systems and parts directly related to [the] production process” would be
exempt from taxation if “used directly in the printing operation” of the
Arizona Republic. The letter has never been rescinded, and, as a result,
constitutes an acknowledgement that printed newspaper production is
“manufacturing.”6 Consequently, based on the ordinary meaning of the
term “manufacturing,” PNI is engaged in manufacturing when it produces
the printed version of the Arizona Republic.7

III.

¶19 The Department also contends that, even if newspaper
publishing is manufacturing, the sale of CCI’s software, and the software
updates and releases, is still taxable because the software is not “used
directly” in manufacturing. CCI argues that the software is “used directly”
in manufacturing the newspaper because it is essential to the completion of

6The Department also argues that if the Legislature had intended to exempt
newspaper printing, it would have listed “publishing” in the list of
deductible activities as it listed “job printing.” See A.R.S. § 42-5061(B)(1).
Because the production of a printed newspaper is manufacturing, the
Legislature did not need to list “publishing” separately. Moreover, because
“publishing” is not separately enumerated in A.R.S. § 42-5061(B)(1), the
exemption does not apply to the non-manufacturing aspects of publishing.
7 The Arizona Board of Tax Appeals has determined that computer

hardware and software utilized in newspaper publication qualifies for the
machinery and equipment exemption. See New Times, Inc. v. Ariz. Dep’t of
Revenue, 1993 WL 261253 (Ariz. Bd. Tax Appeals).

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the finished product and operates with PNI’s printing equipment as part of
an integrated system.

¶20 To determine whether an item qualifies as machinery or
equipment used directly in manufacturing, our supreme court directed
that:

[A] court should examine the nature of the item
and its role in the operations. Items essential or
necessary to the completion of the finished
product are more likely to be exempt. The
prominence of an item’s role in maintaining a
harmonious “integrated synchronized system”
with the indisputably exempt items will also
directly correlate with the likelihood that the
exemption applies. The closer the nexus
between the item at issue and the process of
converting raw materials into finished
products, the more likely the item will be
exempt. As part of its analysis, the court should
consider whether the item physically touches
the raw materials or work in process, whether
the item manipulates or affects the raw
materials or work in process, or whether the
item adds value to the raw materials or work in
process as opposed to simply reducing costs or
relating to post-production activities.

Capitol Castings, 207 Ariz. at 451, ¶ 25, 88 P.3d at 165 (citations omitted). The
court, however, cautioned that “[t]hroughout its analysis, a court must bear
in mind that the goal of the exemption — promoting economic
development — must not be frustrated by too narrow an application of [the
statutory exemption].” Id.

¶21 The CCI software is essential and necessary to the completion
of the finished printed Arizona Republic newspaper. The software performs
the layout, formatting, and typesetting functions necessary to create the
printed newspaper pages. The software assigns a naming convention that
controls the flow of each page through the production and printing process.
The software manipulates words, photographs, advertising and graphics
onto the printed pages. PNI takes the product produced with the CCI
software and, with other software, hardware and raw materials, uses a
mechanical process to manufacture the printed newspaper. As a result, the

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software, including the updates and releases, is integral to the
manufacturing of the paper and are deductible under § 42-5061(B)(1). See
Concord Publishing House, Inc. v. Dir. of Rev., 916 S.W.2d 186, 190 (Mo. 1996)
(noting that newspaper publication involves the mechanical processing of
words and pictures and manufacturing occurs as those works are fixed onto
a printed page).

IV.

¶22 CCI requests an award of attorneys’ fees pursuant to A.R.S. §
12-348(B), which permits an award of fees to a party prevailing in an action
against the State for the assessment or collection of taxes. We grant CCI’s
request for an award of reasonable attorneys’ fees and costs incurred on
appeal upon compliance with ARCAP 21.

CONCLUSION

¶23 For the foregoing reasons, we affirm the judgment.

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