The Claw Beats The Taxman

Attorney Mark D. Rasch is the former head of the U.S. Justice Department's computer crime unit and today is a lawyer in Bethesda Maryland specializing in privacy and security law.

Remember as a kid going to the arcade and playing "The Claw?" You know, the machine that contained a pile of plush toys, where you would put in an endless stream of quarters, and hopefully be able to snag one of those toys? After about $10 worth of tries, you would eventually win a stuffed flounder worth about a quarter, right? Well the Texas Supreme Court has weighed in on the sales tax consequences of that transaction, which comes down ultimately to the questions of what did the consumer pay for, and what did they receive? And this might provide some limited guidance for other retailers.

When you sell something, the price is supposed to be a bargained-for negotiation between a willing purchaser and a willing seller. You are buying a product or a service. Tub of popcorn, $2. Tub of popcorn at a movie theater, $6 (but for another 25 cents you can get a jumbo!) The consumer is buying a product, the product has a specified "value," and that transaction is called a sale. And the government gets a slice of that "sale" – maybe 6 percent of the sales price. Sales taxes typically apply to retail sales (merchant to consumer) of non-exempt tangible personal products, and to certain specified services as well.

So here’s the problem when you try to apply this law to the claw. Despite what the carnies tell you, not everyone’s a winner. It’s a game of chance and skill. What is the machine operator "selling?" A plush toy, or the experience of trying to win one? As the court points out, if there were no toys in the box, nobody would play, and if everyone won each time, the game would be no fun. And if there was a "sale," what would be the price? The retail value of the item if sold otherwise? The cost of the item to the vendor? The amount paid by the consumer? A skilled consumer (or a lucky one) could get that stuffed Elmo for a quarter, a less skilled one could pay $20 with the same result, and a less patient one could get no toy at all. These are the kinds of issues that occupy the highest minds in Austin.

Ultimately, the Texas Supreme Court ruled that the transactions were not taxable, based upon the juxtaposition of several provisions of the tax code (what is a sale, what is a taxable service, what is tangible personal property, what is a service that is an Integral part of a taxable service, what is a sale for resale, what is the coin operated machine exemption, and the application of the (Texas Tax) Commissioner’s Rule for the operators of games or concessions). The government argued that "when each participant does not receive a prize, the game operator–or concessionaire–is not a retailer, but a consumer of the items it purchases to provide its services."Thus, the tax authority argued, the concessionaire could not claim the resale exemption when it transferred those toys to the consumer. The Texas Supreme Court disagreed, and found that these transactions were exempt from taxation. So, unless you are intimately associated with the corn dog and cotton candy industries, what does this mean to you?

We all know that sales are not generally about the product itself, but frequently about the experience surrounding the product. When you pay $4.50 for a Starbucks blonde coffee instead of $1.75 for the Dunkin Donuts brew, you are paying for the big brown leather chair you had to chase that snot-nosed teenager out of, and the fact that you can hang out at the café for a few hours. That "experience" is part of the "value" of the coffee, and is reflected in its taxable price.

These things are not exempt from taxation because they are an integral part of it. But what if Starbucks charged a "sitting fee" (or alternatively gave a take-away discount) and split the cost of the product from the service (assuming the service was not itself taxable).

Apple offers "Applecare" services – a warranty extension service. During the warranty period, you get free customer service; afterwards you pay. Imagine if Nordstrom’s did the same. To speak to a salesperson for help with sizes, etc., costs $5, but that is taken off the cost of the blouse or shoes.

So $50 shoes now cost $45 plus a $5 salesperson service charge. Assuming that the "service" is not taxable (and it probably is, since I am not a tax lawyer and hopefully can write that on my tombstone), can we split products and services for sales tax purposes? Should those Best Buy kiosks at the airport include a claw to exempt the headphones or charger from sales tax?

Each of these "schemes" has already been tried, and most of them unsuccessfully. For example, many states exempt food from sales tax. If you buy an orange for $30,000 (tax free) you get to buy a new car for only a buck (plus 6 cents in sales tax.) That dog won’t hunt. Taxing authorities are pretty vigilant about protecting their slice of the pie. The claw exception is a tiny chink in the armor, but I wouldn’t expect it to have much effect outside the boardwalk.

If you disagree with me, I'll see you in court, buddy. If you agree with me, however, I would love to hear from you.

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