The Texas Supreme Court ruled in Sirius XM Radio, Inc., v. Hegar, No. 20-0462 that the apportionment of receipts from services under Tex. Tax Code § 171.103(a) must be determined through “origin-based” rather than “destination-based” sourcing. This means that the performance of the service is where the taxpayer’s “personnel or equipment is physically doing useful work for the customer.” The ruling invalidates the Comptroller’s “receipt producing, end product act” sourcing test. The ruling has particular salience for technology companies doing business in Texas that produce and sell services in different states.
Texas Franchise Tax Apportionment
Under Tex. Tax Code § 171.103(a), the apportionment of margin to Texas when determining the Texas franchise tax requires calculating what percentage of the entity’s gross receipts are “from its business done in this state.” For services, Tex. Tax Code § 171.103(a)(2) apportions an entity’s receipts from “each service performed in this state.” The administrative rules further provide that receipts from services “are apportioned to the location where the service is performed.” When services are performed in more than one state, then the value sourced to Texas is the “fair value of the services that are rendered in Texas.”
Sirius XM’s Dispute
Sirius XM provides subscription-based satellite radio to customers throughout the United States. Most of its transmission and production equipment is located outside of Texas. Sirius XM apportioned its receipts based on the locations where it produced its programming and on the relative costs of those activities in Texas and elsewhere. The Comptroller, however, determined that Sirius should apportion its receipts based on the location of its subscribers, not on the location where its programs are produced. The question before the Texas Supreme Court was whether the monthly subscription fees from Texas users were receipts from a “service performed in this state.”
What is a Service?
Sirius argued that the service it performs for its Texas subscribers is the production of radio shows and the transmission of a radio signal, nearly all of which takes place outside Texas. It argued that it properly sourced its receipts from the sales of satellite radio programming subscriptions to where its personnel and equipment performed the radio production and transmission services.
While the Comptroller agreed that the proper test is the location where the service is performed, not the location where the service is received, it argued that the service Sirius performs for its Texas subscribers is the “’unscrambling’ the radio signal,” which takes place on each subscriber’s radio in Texas. The Comptroller argued that the value must be apportioned to Texas, which is the location of the “receipt-producing, end-product act” of unscrambling the radio signal. The Comptroller adopted the “receipt producing, end product act” test when 34 Tex. Admin. Code §3.591 was amended on January 24, 2021.
Under Texas law, “service” means the “performance of labor for the benefit of another.” It is further defined as “useful labor that does not produce a tangible commodity.” A service is “performed in this state” if the labor for the benefit of another is done in Texas. The Court reasoned that the “useful labor” is performed where the employees work, but noted that “[w]hen technology rather than personnel performs the useful act, we look to the location of that equipment.”
The Court noted that the “receipt-producing, end-product act” test to determine the location of the service is inconsistent with the statute, as it would often require courts to focus on the location where the service is received. The Court reasoned that “the Legislature chose the word ‘performed’—not ‘received’—and any test that blurs this critical distinction parts ways with the statute.” The Court concluded that the plain language interpretation of Tex. Tax Code § 171.103(a) required that apportionment follows “origin-based” sourcing. This means that the performance of the service is where the taxpayer’s “personnel or equipment is physically doing useful work for the customer.”
In addressing what service Sirius “performed in this state,” the Court stated that tax cases must “not disregard the economic realities underlying the transactions in issue.” The Court noted that “the economic reality of Sirius’s business is that decryption is not a service performed for the benefit of the customer at all. Sirius’s encryption-decryption model is not for the customer’s benefit. It is for Sirius’s benefit. Encryption is a barrier to access imposed by Sirius—an artificial way to manufacture scarcity—in order to extract subscription payments from customers.”
For taxpayers providing services both inside and outside of Texas and have sourced services to Texas based on a “receipt-producing, end product act” test, Weaver can assist in the analysis to determine if the rationale in the Sirius case warrants changes to the approach.