In reversing a trial court decision, the Texas Court of Appeals for the Third District ruled that a taxpayer providing subscription transmission and broadcasting services must source receipts to Texas based on the percentage of subscribers located in Texas.1 The Court of Appeals did agree with the trial court that the taxpayer was not entitled to subtract certain payments made to automobile manufacturers as part of its cost of goods sold (COGS) deduction.
The taxpayer, Sirius XM, is a satellite radio company engaged in producing music, sports, news, talk, and entertainment programming. The programming is delivered by Sirius XM to customers throughout the nation via satellite transmission to subscribers’ radios. Sirius XM transmitted its programming to its satellites which were commanded and controlled from earth stations located outside Texas. Approximately 70% of Sirius XM’s programming consisted of original content produced by Sirius XM for its subscribers, which was generally produced from studios located outside Texas. Sirius XM’s production in Texas was limited to one channel transmitted from a location in Hillsboro, Texas, that was neither owned nor leased by Sirius XM. This channel included content from a host who transmitted from his home in Fort Worth, Texas.
Sirius XM primarily derived revenue from subscription fees for its satellite-radio services. Most of its customers subscribed on a periodic basis, and they received Sirius XM’s programming using satellite-enabled radios. Most of Sirius XM’s new subscription growth came from purchasers and lessees of new and used automobiles equipped with satellite-enabled radios. The integrated circuits for the satellite-enabled radios included the encryption, conditional access, and security technology necessary to exclusively access Sirius XM’s satellite radio.
Sirius XM did not manufacture or provide the radios. Instead, the subscribers typically purchased or leased vehicles with the radios already installed, and Sirius XM subsidized a portion of the radio manufacturing costs. Sirius XM also had agreements with major automakers to encourage them to install the satellite-enabled radios in their vehicles as either factory or dealer-installed equipment. These payments were referred to as “revenue shares and hardware subsidies.” The “revenue shares” were computed on a percentage of subscription revenue and the “hardware subsidies” were computed as a flat fee per vehicle.
For the 2010 tax year, Sirius XM calculated its margin for Texas franchise tax purposes by subtracting COGS. For the 2011 tax year, Sirius XM calculated its margin by subtracting 30% of its revenue. Sirius XM calculated its apportionment factor by sourcing revenues based on where it produced its programming and the relative costs of those activities in Texas and outside the state.
The Comptroller audited Sirius XM’s returns for the 2010 and 2011 tax years. On audit, the Comptroller adjusted Sirius XM’s apportionment factor to reflect the percentage of Sirius XM’s subscribers in Texas compared to total subscribers. During the audit, Sirius XM also requested the Comptroller to include the revenue shares and hardware subsidies in its COGS calculations, which the Comptroller denied. Sirius XM paid the assessment resulting from the audit under protest and sued the Comptroller in trial court. After a bench trial, the trial court ruled in favor of Sirius XM and ordered the Comptroller to issue a refund related to the sourcing of revenue for apportionment purposes.2 However, the trial court did not allow the inclusion of the revenue shares and hardware subsidies in Sirius XM’s COGS deduction.
Sourcing of receipts based on subscriber location
In calculating the apportionment formula for Texas purposes, taxpayers are required to determine the business done in the state.3 To determine the amount of business done in the state, taxpayers must include receipts from each service performed in the state.4 The Texas regulations provide that sales of services are apportioned to the location where the service is performed.5 The Texas Supreme Court has historically interpreted the phrase “services performed within Texas” to mean that “the act done . . . must be located in Texas.”6 Furthermore, the Comptroller has ruled that taxpayers must look at end-product acts that are receipt-producing activities.7
While both parties agreed that “services performed within Texas” means that the “act is done in the state,” the parties disagreed on the application of the law to Sirius XM’s facts. The Comptroller challenged the trial court’s finding that Sirius XM’s end-product, revenue-producing act was the production and distribution of its programming. The Comptroller argued that the production and distribution of the programming is a non-receipt producing, albeit essential, support activity. They further argued that the only receipt-producing end-product is the performance of audible radio service for the customer. In the Comptroller’s view, the only end-product, revenue-producing act that allowed each subscriber to receive Sirius XM’s programming occurred when Sirius XM either activated or deactivated the chip set in the subscriber’s satellite enabled radio, which the Court acknowledged could be done remotely.
The Court of Appeals agreed with the Comptroller that the act occurred at the location of the satellite-enabled radio. The Court reasoned that since Sirius XM’s service is providing radio programming to its customers and the act of providing the programming occurred at the subscriber’s location, the subscription receipts from Texas customers should be included in the numerator of the Texas apportionment fraction.
With respect to application of the end-product test, Sirius XM argued that the franchise tax is “origin based” and not “market based.” Sirius contended that in order to determine “where the act is done,” taxpayers must look to where the “service provider performs its service-related activities.” As a result, Sirius XM argued that the trial court correctly applied the end-product test by looking to the location of its production and transmission activities.
In support of its argument, Sirius XM relied on the appellate court’s previous decision in what it claimed was a similar and applicable case.8 In Westcott, the taxpayer produced programming in Texas, based on its subscribers’ needs, delivered across the country. The taxpayer’s services included live broadcast sessions, interactive question and answer sessions, testing and other educational and training services. The Court in Westcott also agreed with the “where the act is done” standard and held that “it is clear that where the ‘act is done’ in this case is in Texas, rather than in the states of the subscribing clients.” In Westcott, the Court found that while the satellite transmission of the programs was a convenience, the subscribers were paying for the substance of the programs. Since the taxpayer developed these programs in Texas, the Court found that the taxpayer performed these services in Texas.
The Court of Appeals differentiated Sirius XM’s facts from Westcott, because Sirius XM’s subscribers paid for the ability to receive general programming, not the development of specific programming for their benefit. While including some original content, Sirius XM did not contract with its subscribers to develop or produce specific programming. The Court found that Westcott did not apply, and Sirius XM’s apportionment should be determined based on the percentage of subscribers located in Texas.
Additional COGS items disallowed
In arriving at taxable margin, the Texas Franchise Tax allows eligible taxpayers to subtract COGS from total revenue.9 During the audit process, Sirius XM attempted to deduct revenue share and hardware subsidy expenses that Sirius XM paid to automobile manufacturers. Sirius XM argued that it sold tangible personal property and that the “goods,” in this case the radio programs, were produced when the subscribers listened to the programs in their vehicles. Since Sirius XM’s subscribers needed the satellite-enabled radios to receive programming, Sirius XM claimed that its payment to the automobile manufacturers should be allowed as a COGS deduction.
The Court of Appeals cited the recent Texas Supreme Court decision in Hegar v. American Multi-Cinema, Inc.10 in rejecting Sirius XM’s argument. In American Multi-Cinema, the Court held that Tex. Tax Code Ann. Sec. 171.1012 requires that “property with a physical or demonstrable—that is, tangible—presence must be transferred. Transferring a film’s creative content alone will not suffice.” The Court reasoned in this case that if Sirius XM had “sold” the radio programming, it could constitute a COGS. However, Sirius XM did not transmit the programming in a manner so that the subscriber could access the information at a later time. As a result, Sirius XM did not transfer property with a physical presence, and therefore, could not claim the revenue share and hardware subsidies as a COGS deduction.
In this case, both parties acknowledged that Texas has historically applied the revenue-producing end-product standard to allocate receipts from the performance of services. Even if one were to accept that Sirius XM’s revenue-producing act was to provide or deny access to programming by activating and deactivating the subscriber’s satellite-enabled radio, the location of where the act occurred is subject to question. The Court acknowledged that this act could be performed remotely, instead of the subscriber’s location. Despite this admission, the Court summarily concluded that this act was done at the subscriber’s location. It is unclear from the text of the opinion if Sirius XM had sought to differentiate where the act occurred from where the effect of the act was received.
In determining that the act occurred at the subscriber’s location, even though the Court acknowledged the physical act of decrypting the program could be done remotely, the Court focused its analysis to reach a decision authorizing market-based sourcing. This is different than looking at where the revenue-producing act occurred, which implies a cost of performance methodology, and stands in contrast to the plain wording of the Comptroller’s own regulations.
This decision appears to create significant uncertainty for taxpayers generating revenue from services, as the difference between cost of performance and market-based sourcing may be substantial if the locations of the taxpayer and its customers are in different states. Businesses with Texas-based operations that sell services to a broad multistate market might want to reevaluate their sourcing conclusions and consider the possibility of refund claims for open tax years under a market-based sourcing regime endorsed by the Court of Appeals. In contrast, businesses with comparatively little presence in Texas that have a disproportionately large amount of Texas customers that benefited from cost of performance calculations potentially may have an exposure item for open tax years to consider. Given the importance of these issues and the differing outcomes at the trial court and the Texas Court of Appeals, the taxpayer may appeal this decision to the Texas Supreme Court.
1 Hegar v. Sirius XM Radio, Inc., Texas Court of Appeals, Third District, Austin, No. 03-18-00573-CV, May 1, 2020.
2 For a discussion of the trial court’s decision, see GT SALT Alert: Texas District Court Applies Cost of Performance Sourcing Rules.
3 TEX. TAX CODE ANN. § 171.103(a).
4 TEX. TAX CODE ANN. § 171.103(a)(2).
5 34 TEX. ADMIN. CODE § 3.591(e)(26).
6 Humble Oil & Refining Co. v. Calvert, 414 S.W.2d 172 (Tex. 1967).
7 Hearing No. 10,1028, Texas Comptroller of Public Accounts (1980).
8 Westcott Communications, Inc. v. Strayhorn, 104 S.W.3d 141 (Tex. App. 3d Dist. 2003).
9 Texas law allows a deduction for “all direct costs of acquiring or producing the goods [sold].” “Production” includes, among other items, improvement or creation, of the goods. “Goods” is defined as “tangible personal property,” which includes live and prerecorded television and radio programs. TEX. TAX CODE ANN. § 171.1012.
10 Texas Supreme Court, No. 17-0464, April 3, 2020. For a discussion of this case, see GT SALT Alert: Texas Supreme Court Issues AMC Opinion Addressing Application of COGS Deduction.
Kevin Herzberg is a leader in the Grant Thornton Florida market territory's Tax Services and SALT practices. He has more than 25 years of broad-based state tax experience, including tax planning, Sarbanes-Oxley Section 404 review, ASC 740 and 450 tax accounting, M&As, ruling requests, tax controversy, and tax compliance.
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Jamie C. Yesnowitz
Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
Washington DC, Washington DC
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