April 4, 2022
Texas Supreme Court clarifies that "origin-based" system applies to sourcing gross receipts from the sale of services for Texas apportionment purposes
In Sirius XM Radio, Inc. v. Hegar, the Supreme Court of Texas (Texas Supreme Court) ruled in favor of the taxpayer, Sirius XM Radio, Inc. (Sirius XM or the Taxpayer), holding that gross receipts from the sale of services should be sourced based on an "origin-based" system.1 Thus, taxpayers should look to where their employees or equipment performed services when determining whether those services are performed in Texas for apportioning receipts for franchise tax purposes.
The Texas Supreme Court overturned the decision by the Texas Court of Appeals, Third Circuit (appeals court) and remanded the case back to the appeals court to address an alternative argument by the Texas Comptroller of Public Accounts (Texas Comptroller) that the Taxpayer may not have provided sufficient evidence to support its cost-based analysis of the fair value of services performed in the state.
The Texas franchise tax is imposed on a taxpayer's taxable margin apportioned to the state. In apportioning its margin, a taxpayer uses an apportionment factor the numerator of which includes gross receipts from business conducted in the state and the denominator includes its gross receipts from business conducted everywhere. Specifically, the statute2 sources the gross receipts from "each service performed in this state [i.e., Texas]" to Texas.
The Taxpayer receives subscription fees from broadcasting satellite radio channels. The majority of the content and programming Taxpayer produces is delivered to its subscribers through satellite transmission to customers' radios. The Taxpayer's production and transmission activities are primarily performed outside of Texas. On its original 2010 and 2011 Texas franchise tax reports, the Taxpayer sourced its subscription receipts to the locations where its primary production facilities were located, only a few of which were in Texas. Under audit, the Texas Comptroller revised the apportionment based on the location where the satellite transmissions were received by the taxpayer's subscribers, resulting in an assessment. The Taxpayer paid the additional tax and interest under protest and sued the Texas Comptroller to recover the disputed Texas franchise tax and interest paid. The Texas district court applied an origin-based sourcing standard looking to where the Taxpayer's production and transmission activities were performed and ruled in the Taxpayer's favor on the issue of sourcing gross receipts. On appeal, the appeals court reversed and found in favor of the Texas Comptroller, agreeing with its position that under the "receipt-producing, end-product act," the service performed by the Taxpayer in Texas was unscrambling the radio signal at its customers' location.
Texas Supreme Court decision
As an initial procedural matter, the Texas Supreme Court dispensed with arguments concerning judicial deference, stating that Texas courts have not adopted agency-deference doctrine as used in the federal courts. Instead, according to the Texas Supreme Court, Texas courts will uphold an agency's interpretation of a statute so long as that interpretation is reasonable and does not contradict the plain language of the statute.
The Texas Supreme Court then turned to interpreting the statute. Under Tex. Tax Code Section 171.103(a)(2), gross receipts from the performance of services are sourced to Texas if the "services are performed in this state." Under a plain reading of the statute, and supported by long-standing precedent, the Texas Supreme Court found a service is performed in Texas when the labor for the benefit of another is done in the state. In so finding, the Texas Supreme Court rejected the Texas Comptroller's use of the "receipt-producing, end-product act" test to determine the location where a service is performed, concluding instead that statutory and case law support an "origin-based" system. Thus, the Texas Supreme Court held that a taxpayer's gross receipts from the sale of services should be sourced to the location where the taxpayer's employees or equipment performed the labor relating to the performance of the service.
The Texas Supreme Court also disagreed with the Texas Comptroller's characterization of the services performed by Sirius XM as decryption services, finding Sirius XM was a radio broadcast and production company. The Texas Supreme Court reasoned that casting Sirius XM's services as decryption services elevated the technicalities of the transaction over the economic realities of the services performed, noting that Sirius XM's customers do not pay more for decryption services than do the customers of an online news service for "paywall-removal" services.
Finally, the Texas Supreme Court determined that the Taxpayer "has little personnel or equipment in Texas that performs the radio production and transmission services for which its customers pay monthly subscription fees" and reversed the appeals court's ruling that had required all of the Taxpayer's gross receipts from its subscribers located in Texas to be assigned to the state.
Although the Texas Supreme Court reversed the appeals court's technical ruling, it remanded the case back to that court to review whether Sirius XM had sufficiently established the fair value of services performed in the state by applying the cost-of-performance analysis.
The Texas Supreme Court's decision could have broad implications for taxpayers conducting business in Texas, as the Texas Comptroller has been asserting the "receipts-producing, end-product act" approach to apportionment of services for quite some time. The decision also appears to invalidate many of the provisions contained in the Texas Comptroller's recently amended apportionment rule 34 Tex. Admin. Code Section 3.591 (see Tax Alert 2021-0035). Specifically, the decision seems to invalidate the revised language in amended 34 Tex. Admin. Code Section 3.591(e)(26), which applies the "receipts-producing, end-product act" test to determine the location of gross receipts from the sale of services.
The amended apportionment rule added other subsections dealing with the sourcing of gross receipts from the sale of other services, including advertising services, which will need to be evaluated in light of the Texas Supreme Court's opinion in this case.3
Additionally, the amended apportionment rule's broad definition of "internet hosting," which now includes entertainment streaming services, marketplace provider services and data processing, will need to be reviewed in light of the court's decision.4 Under the amended rule, this revenue is sourced using the customer location (e.g., destination sourcing). Taxpayers providing these services may observe a conflict between the Texas Supreme Court's interpretation of the statute and the application under the rule. The Texas Supreme Court's commentary in the opinion focuses on the technicalities of a transaction rather than on its economic realities, which seems to conflict with the rule's current language. For example, the Texas Supreme Court noted in its opinion that an online news service whose customers pay for content and not "pay-wall removal" services could be subject to a different sourcing rule than under the current regulation.
The Texas Supreme Court's remand of the case to the appeals court for further investigation leaves open the possibility that other issues and additional litigation on fair value allocations could arise that would affect how taxpayers compute and determine the proper sourcing of gross receipts from the sale of services for Texas franchise tax purposes.
Companies doing business in Texas that derive gross receipts from the sale of services should review the apportionment methodologies in light of the Texas Supreme Court's opinion. Because the decision does not address cost-based analysis, some uncertainty remains as to how both the Texas Comptroller and Texas courts will address this aspect of the rules for sourcing gross receipts.
1 Sirius XM Radio, Inc. v. Hegar, No. 20-0462 (Tex. March 25, 2022).
2 Tex. Tax Code Section 171.103(a)(2).
3 34 Tex. Admin. Code Section 3.591(e)(1).
4 Id. Section 3.591(e)(13).