November 21, 2022
Texas appeals court allows taxpayer's use of cost-of-performance data to apportion its subscription receipts for services to Texas
In the latest holding in the Sirius XM Radio1 (Sirius XM or the Taxpayer) Texas franchise tax saga, the Texas Court of Appeals, Third Circuit (appeals court), on remand from the Texas Supreme Court, held that the Taxpayer provided sufficient evidence to support its cost-based analysis of the "fair value" of services performed in the state for purposes of sourcing gross receipts from the sale of services. Accordingly, the Taxpayer can use cost-of-performance data to apportion its subscription receipts for services performed in Texas.
The Texas franchise tax applies to 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 of which 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.
Sirius XM 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 and broadcasting facilities were located, which were primarily outside of Texas. Under audit, the Texas Comptroller revised the apportionment based on where the Taxpayer's subscribers received the satellite transmissions, 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 held 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 the Comptroller's position that the "receipt-producing, end-product act" performed by the Taxpayer in Texas was unscrambling the radio signal at its customers' location.
In March 2022, the Texas Supreme Court held3 that gross receipts from the sale of services should be sourced based on an "origin-based" system. Thus, in determining whether services are performed in Texas for purposes of apportioning receipts, taxpayers should look to where their employees or equipment performed services. (See Tax Alert 2022-0539.) Although the Texas Supreme Court reversed the appeals court's technical ruling, it remanded the case back to that court to review whether the Taxpayer had sufficiently established the "fair value" of services performed in the state by applying the cost-of-performance analysis.
Taxpayer's apportionment method supported by evidence
On remand, the appeals court affirmed the trial court's finding that the method used by the Taxpayer to apportion the fair value of its services performed in the state for tax years 2010 and 2011 was supported by the comparative cost-of-performance evidence presented by the Taxpayer.4 In affirming the trial court's finding, the appeals court rejected the Comptroller's argument that the Taxpayer's evidence to establish "fair value" was legally insufficient because a taxable entity, as a matter of law, cannot use cost-of-performance data to apportion the fair value of its services.
As neither the Comptroller's rules nor the applicable Tax Code provisions define "fair value" under former Rule 3.591(e)(26), the appeals court looked to the dictionary, which defined "fair value" as "the monetary worth of the services at issue, based on an objectively reasonable assessment." The Comptroller, without offering an alternative interpretation of the term "fair value," contended that "nothing in the plain language of Rule 3.591(e)(26) suggests that 'fair value' means 'cost of performance.'" The Comptroller also argued that it was aware of the term "cost of performance" at the time of the Rule's adoption, but did not include it in the Rule; therefore, the rule's "use of the term 'fair value' … indicates that something other than 'cost of performance' was intended." The appeals court disagreed, finding instead that, even though the terms have different meanings, nothing in the Rule mandates the use of a specific method to calculate "fair value" or exclude the use of cost of performance as a reasonable method of assessing "fair value" for apportionment purposes.
The appeals court further noted the Comptroller's previous allowance, in certain circumstances, of cost of performance as "an appropriate method" for calculating "fair value" of services. The appeals court specifically mentioned Letter No. 200807139L (July 24, 2008), in which the Comptroller, citing former Rule 3.591(e)(26), said that the "best means" for determining the "fair value" of services in Texas, when services are performed both inside and outside the state, is the costs attributed to services performed in Texas versus the costs attributed to out-of-state processing. The appeals court concluded that the Comptroller's interpretation of the Rule — allowing "fair value" to be determined using cost of performance — "is not plainly erroneous or inconsistent" with the Rule or the Tax Code.
The appeals court also rejected the Comptroller's alternative argument that the taxpayer failed to prove the costs represent the "fair value" of services performed in Texas because the Comptroller failed to preserve this challenge for appeal by not objecting to the admission of the expert witness testimony at trial.
The appeals court's ruling provides guidance on calculating the "fair value" of services performed inside and outside of Texas and makes clear that cost of performance, as well as other methods, can be used to determine the "fair value" of such services. In light of this holding and the Texas Supreme Court's holding earlier this year, companies doing business in Texas that derive gross receipts from the sale of services should review their apportionment methodologies.
Published by NTD’s Tax Technical Knowledge Services group; Jennifer Brittenham, legal editor
1 Hegar v. Sirius XM Radio, Inc., No. 03-18-00575-CV (Tex. Ct. of App., 3rd Dist., Nov. 10, 2022).
2 Tex. Tax Code Section 171.103(a)(2).
3 Sirius XM Radio, Inc. v. Hegar, No. 20-0462 (Tex. March 25, 2022).
4 At trial, the Taxpayer's witness, an expert in quantitative business modeling, testified that he "used cost data because it was 'systematic and reliable' in representing where [the Taxpayer] performed its activities" and that since he focused on the "unique aspect of [the Taxpayer's] business" he included expenses from value-producing activities (e.g., content production and transmission) and excluded expenses for general support functions (e.g., sales, administration). The trial court found this analysis and conclusion "a credible method for determining fair value."