Texas district court applies cost of performance sourcing rules

Kevin Herzberg
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Pat McCown
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Jamie C. Yesnowitz
Washington, DC
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Chuck Jones
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Lori Stolly
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A Texas district court recently ruled that cost of performance sourcing rules applied to source subscription revenues received by a satellite radio company.1 The Texas comptroller had argued that the revenue should be sourced based on the locations where the satellite transmissions were received by subscribers.

Background The taxpayer, Sirius XM (Sirius), is a satellite radio company engaged in producing music, sports, news, talk, and entertainment programming. The programming is delivered by Sirius to customers throughout the nation via satellite transmission to subscribers’ radios. Specifically, Sirius transmitted its programming to its satellites in orbit which were commanded and controlled from earth stations located outside Texas. To supplement its satellite signal coverage, Sirius used terrestrial repeaters, some of which were located in Texas.2 For the 2010 and 2011 tax years, Sirius maintained its headquarters and produced, recorded, edited and transmitted its audio entertainment services almost exclusively outside Texas. Sirius filed Texas Franchise Tax returns for those periods and apportioned its subscription revenues based on the locations where its primary production facilities were located.
The comptroller audited Sirius’s returns and concluded that the subscription receipts should be reapportioned to Texas based on the locations where the satellite transmissions were received by subscribers. Accordingly, the comptroller assessed Sirius for the additional tax and related interest, which Sirius paid under protest. Sirius sued the comptroller for a refund by filing a petition with the district court.
District Court decision Texas Franchise Tax apportionment rules provide that “[r]eceipts from a service are apportioned to the location where the service is performed. If services are performed both inside and outside Texas, then such receipts are Texas receipts on the basis of the fair value of the services that are rendered in Texas.3 Texas has historically applied an end product test in determining where a service is performed, focusing on “the specific, end-product act for which the customer contracts and pays to receive, not on non-receipt producing, albeit essential, support activities.”4

Sirius called two expert witnesses at trial. The first performed an analysis determining the percentage of Sirius’s value-producing activities in Texas, as compared to those outside Texas based on the costs of the activities. The court found his methodology acceptable, except that it required the calculations to be adjusted to exclude the value of Sirius’s satellites in orbit.5 Notably, the comptroller did not produce any different analysis regarding the fair value of Sirius’s service in Texas. The second expert, well known to many in the state tax community, was Prof. Richard Pomp. Pomp provided information to the court about the different methods that states generally use to source receipts from the performance of services,6 noting that the comptroller in this case was seeking to apply a market-based sourcing method.
With no detailed written analysis, the court cited the end product test and noted that it was applicable to Sirius, as it was an origin-based method of sourcing. Since Sirius performed its satellite radio subscription service both inside and outside Texas, its receipts were properly apportioned to Texas based on the fair value of the service performed in Texas. Further, the apportionment factors Sirius reported on its 2010 and 2011 originally filed Texas Franchise Tax returns were consistent with the fair value and Sirius was entitled to a refund.
The court also noted that Sirius was entitled to deduct its costs of goods sold (COGS) for the direct costs of producing, acquiring and using its live and prerecorded radio programs. Sirius could not include expenses characterized as “revenue share” and “hardware subsidies” in the COGS calculation. The court did not elaborate further on the composition of the COGS calculation.

Commentary The district court decision rebuffs the comptroller’s effort to apply market-based sourcing principles to source revenues from services. Specifically, the decision is counter to the conclusion reached in Private Letter Ruling 20170305L,7 in which the comptroller concluded that, for Texas Franchise Tax purposes, a taxpayer’s gross receipts from sales of payment risk and fraud prevention solutions are receipts from the sale of services and apportioned based on the location of the taxpayer’s customers. The court’s decision calls into question whether services can be sourced under a market-based concept under the Texas Franchise Tax.

Also, the decision is noteworthy in that it allows the taxpayer a COGS deduction for producing programs, but fails to specify why. A taxpayer’s eligibility for a COGS deduction in computing a margin for Texas Franchise Tax purposes has been the subject of several controversies, including a Texas Court of Appeals decision which narrowed the scope of “tangible personal property” eligible for the COGS deduction.8 No distinction was made regarding whether Sirius qualified under the definition of “tangible personal property” provided by Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A)(ii)9 or (iii).10 This distinction is important because if the deduction is allowable under the former statute,11 it could apply to taxpayers that previously believed they were ineligible for the tax benefit. Until further clarifying guidance is available, taxpayers are left to draw their own conclusions.

1 Sirius XM Radio Inc. v. Hegar, District Court, 261st District (Texas), No. D-1-GN-16-000739, Aug. 14, 2018.
2 Sirius had approximately 700 repeaters nationwide, 22 of which were in Texas.
3 TEX. TAX CODE ANN. § 171.103(a)(2); 34 TEX. ADMIN. CODE § 3.591(e)(26).
4 Originally stated in Comptroller’s Decision No. 10,028 (1980), cited in Comptroller’s Decision No. 104,224 (2013).
5 The satellite value was excluded because the satellites were not subject to any taxing jurisdiction.
6 Professor Pomp indicated that there are two basic methods states use to apportion services: “market” based methods (which look to the location of the service recipient) and “origin” based methods (which look to the location where the taxpayer performs the service).
7 Private Letter Ruling 20170305L, Texas Comptroller of Public Accounts, Mar. 15, 2017.
8 American Multi-Cinema, Inc. v. Hegar, Texas Court of Appeals, Third District, Austin, No. 03-14-00397-CV, Jan. 6, 2017. See Opinion Addressing Application of COGS DeductionAMCGT SALT Alert: Texas Court of Appeals Issues Revised .
9 Personal property that can be seen, weighed, measured, felt of touched or that is perceptible to the senses in any other manner.
10 Films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and other similar property embodying words, ideas, concepts, images, or sound, without regard to the means or methods of distribution or the medium in which the property is embodied, for which, as costs are incurred in producing the property, it is intended or is reasonably likely that any medium in which the property is embodied will be mass-distributed by the creator or any one or more third parties in a form that is not substantially altered. 
11 For purposes of determining the COGS deduction in calculating margin, the definition of "production" included under Tex. Tax Code Ann. Sec. 171.1012(a) was amended by H.B. 2002, Laws 2017 to clarify existing law. Effective September 1, 2017, "production" means (previously, "includes") construction, manufacture, development, mining, extraction, improvement, creation, raising or growth. The legislation substitutes "means" for "includes" and deletes "installation" from the definition of production. 

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