The Texas Comptroller of Public Accounts (Comptroller) has proposed changes to 34 Tex. Admin. Code Section 3.330, which relates to the application of sales and use tax to data processing services. The proposed changes, released on September 13, 2024, are intended to add to and clarify existing definitions, provide examples of taxable and nontaxable services, explain the incidence of the tax, and update provisions on the collection of local sales and use taxes on data processing services. Interested parties have until October 13, 2024, to submit comments on the proposed changes.

The Comptroller has stated that the proposed changes are intended to "help online marketplaces understand their responsibilities" with respect to marketplace providers providing data processing to marketplace sellers. The Comptroller explained that online transactions involve two purchasers, two sales contracts, and two taxable transactions. The purchaser of goods and services through a marketplace pays sales tax on the goods or services, and the marketplace seller, which is purchasing data processing services from the marketplace provider, pays sales tax on those services.

The proposed changes would classify search engine optimization (SEO) services, social media marketing, and lead generation as taxable data processing, codifying the Comptroller's opinion that online advertising is taxable data processing. Additionally, cloud computing would be treated as taxable under this proposed regulation.

Texas law exempts 20% of the value of data processing services from sales and use tax, unless the service qualifies as another type of taxable service (other than an information service), in which case the exemption does not apply. "Data processing services" are defined generally as "the processing of information for the purpose of compiling and producing records of transactions, maintaining information, and entering and retrieving information." These services specifically include:

1. Word processing, data entry, data retrieval, data search, information compilation, payroll and business accounting data production, and other computerized data information storage and manipulation
2. The performance of a totalisator service with the use of computational equipment
3. The use of a computer or computer time for data processing, whether the processing is performed by the provider of the computer or computer time or by the purchaser or other beneficiary of the service

The proposed changes would revise this general definition of data processing services to include "the computerized entry, retrieval, search, compilation, manipulation, or storage of data or information." The new definition would specifically exclude internet access services, transcription of medical dictation by a medical transcriptionist, certain advertisements or links on a website owned by another person, certain electronic payment encryption services, and certain electronic payment settlement services.

The proposed changes would also exclude from the definition of "data processing services" data processing that is sold with and ancillary to another service for a single charge and the data processing service does not have a separate value. In such instances, the taxpayer would bear the burden of demonstrating that the data processing service does not have a separate value and is ancillary to the other service being provided.

The proposed changes would clarify that data processing services are sourced to where they are used, and that services provided for concurrent in-state and out-of-state use are taxable only to the extent they are used or consumed within Texas. In those instances, the purchaser could furnish the service provider with a form from the Comptroller, or a similar form, asserting a concurrent multistate business use and representing that the purchaser will report and pay state and local tax on the taxable portion. Any determination of in-state use allocation by the multistate purchaser would be made using any reasonable and consistent method supported by its business records. Any service provider that accepts a multistate-use certificate in good faith would be relieved of responsibility for collecting and remitting Texas state and local sales and use taxes on transactions subject to the certificate.

For local sales and use tax purposes, transactions would be sourced to the jurisdiction where the sale occurs. This could be where (1) the seller receives or fulfills the order, or (2) the service is delivered. Local use tax would also be due in a jurisdiction where a direct or indirect benefit from the service is delivered, provided that the 2.0% local tax cap has not been exceeded. ¹

Implications

The proposed amendments would significantly change how the Comptroller determines what is taxable data processing. The Comptroller traditionally has relied on the "essence of the transaction" to determine if a service qualified as taxable data processing. The proposed approach would use an "ancillary test" focusing on what the seller is doing rather than what the buyer wants. This policy shift in determining if a service is taxable data processing could vastly expand the definition of data processing. However, such a significant expansion could conflict with the Internet Tax Freedom Act.

Taxpayers should review their revenue streams to determine whether the proposed changes to the regulation would affect their current tax-collection obligations.

Because the proposed changes do not include a specific effective date, they would likely take effect shortly after becoming final. The earliest date that the proposed changes could be adopted is October 13, 2024; whether the proposed changes are adopted on that date would likely depend on the comments the Comptroller receives from interested parties.