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If you are using a database as a data source, the column that corresponds to the merge field containing the image must be of type BLOB ("Image" in SQL Server). If the data source is an array of objects, the value that corresponds to the merge field containing the image should be a simple byte array.
For more information about different data sources see Using a Database as a Data Source and Using an Array as a Data Source.
New to v8.6.1 - the data type can be specified as either BLOB/byte array or as string file path to the image file on the server.
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For more sample code see the Insert Image Demo.