Texas court interprets service sourcing rules

On March 25, 2022, the Texas Supreme Court ruled in Sirius XM Radio, Inc. v. Hegar that service revenue for Texas franchise tax purposes is sourced to the state where the service is performed, rejecting the Texas Comptroller’s use of the “receipt-producing, end-product act” test.¹ In reversing the Texas Court of Appeals, the Texas Supreme Court held that a satellite radio producer and distributor should source its subscription receipts based on the location where the radio programming was produced rather than the location where its subscribers received the radio signal.

Background

The taxpayer, Sirius XM Radio (“Sirius”), is a producer and distributor of radio programs using satellites. Subscribers to Sirius pay a monthly subscription fee to access the radio programming. Sirius has over 150 radio channels, the majority of which are produced by Sirius in studios located in New York City and Washington D.C., with one show broadcast from Texas for a period of time. The taxpayer’s content is transmitted to its satellites launched from Kazakhstan from uplink facilities in New Jersey, Washington, D.C., and the state of Georgia. Once the signals are sent back to earth from the satellites, they are either sent directly to the radio or to repeaters (used in densely populated areas), at least some of which are located in Texas. The satellites are controlled from facilities in Panama, Ecuador, and Georgia. Once the signal reaches a customer’s radio, it is decrypted, which allows the customer to listen to the programming.

At issue in Sirius was the proper sourcing of the taxpayer’s receipts from these satellite radio subscriptions. The taxpayer initially sourced its revenue based on the locations where it produced its programming and on the relative costs of those activities in Texas and elsewhere. On audit, the Texas Comptroller of Public Accounts determined that the taxpayer should apportion its receipts based on the location of its subscribers, not based on the location where its programs are produced. The Comptroller reached this conclusion based on its position that services should be apportioned to the state in which the receipt-producing, end-product act takes place.

The taxpayer paid the assessed tax under protest and brought suit for a refund. A Texas district court held for the taxpayer, finding that Sirius performed most of its services outside Texas and ordering a refund of over $2 million for the 2010 and 2011 tax years. The Comptroller appealed this decision, however, and the Texas Court of Appeals reversed the district court’s decision.²

The Court of Appeals agreed with the Comptroller that a service is performed in Texas if there is a “receipt-producing, end-product act” based on the language in the Texas apportionment statute. This statute provides in relevant part that “the gross receipts of a taxable entity from its business done in this state is the sum of the taxable entity’s receipts from . . . each service performed in this state.”³ The Comptroller argued, and the Court of Appeals agreed, that since the radios decrypted the signal at the location of the end user, the act of decrypting the radios was a service performed at the location of the end-user. Receipts, therefore, were sourced to Texas if the radio, or subscriber, was located in the state. Sirius appealed this decision to the Texas Supreme Court.

Receipts sourced to state where radio programming is produced

The issue presented to the Texas Supreme Court was whether the taxpayer’s receipts from Texas subscribers were receipts from a service performed in the state. Sirius argued that since most of its employees and equipment are located outside Texas, only a small portion of its revenue should be sourced to the state. The Comptroller contended that since the act of decrypting the signal occurred at the location of the radios used by the taxpayer’s customers to listen to its broadcasts, the service is performed at the location of the radio (resulting in substantially more revenue being sourced to Texas).

Before the court decided the sourcing issue, it considered which service was the revenue producing act. The Comptroller argued that the service Sirius performed was the act of decrypting the signal at the subscriber’s radio, which should be apportioned to Texas if the “receipt-producing, end-product act” was performed in the state. According to the Comptroller, the “receipt-producing, end-product act” was enabling each user’s radio to receive Sirius’s signal. Sirius argued that the service it performed was the act of producing and distributing content to its subscribers, the vast majority of which occurred outside Texas.

The court initially considered the definition of “service,” relying on its previous decision in Van Zandt v. Fort Worth Press for the proposition that “service” means the “performance of labor for the benefit of another.”⁴ With regard to the phrase “performed in this state,” the court looked to its previous decision in Humble Oil & Refining Co. v. Calvert, which defined the phrase as an “act done” that is “located in Texas.”⁵ The court determined that the Texas legislature did not intend for it to ignore the location of the service performer and instead look to the location where the performance is received or its effects felt. Furthermore, the court reasoned that if the legislature had intended to do so, it could have used that language as it did when discussing the sourcing of revenue from the sale of tangible personal property.

According to the court, the Comptroller’s use of the “receipt-producing, end-product act” test was an attempt to determine the location of the service. In the court’s view, this test was not consistent with a plain reading of the statute, where the legislature chose the term “performed” rather than “received.” The court explained its focus was on the words of the statute itself, not on “extraneous concepts like ‘receipt-producing’ or ‘end-product act,’ which do not appear in the statute.” As a result, the court held that the most natural reading of the statute was to locate “the performance of the service at the place where the taxpayer’s personnel or equipment is physically doing useful work for the customer.”⁶

The court found that Sirius is in the business of producing and broadcasting radio content, not the business of decrypting signals. After acknowledging that, in a narrow sense, the taxpayer’s customers paid to have their radios decrypted, the court reasoned that decryption is for the benefit of Sirius, not its subscribers, who would prefer that the signal be free rather than encrypted. The court explained that encrypting the signal was a method to manufacture scarcity and extract payments from Sirius’s customers, which benefits Sirius rather than an end user.

In reversing the Court of Appeals, the Supreme Court concluded that the “receipt producing, end-product act” test should be used to determine what the service is, but not where it should be sourced. Having determined that the relevant act was the process of producing and distributing content, the court agreed with Sirius that its receipt of subscription fees should be sourced to the location where Sirius produces its programming and not to the location of the subscribers’ radios. The court remanded the case to the Texas Court of Appeals to determine the fair value of Sirius’s services that are performed in the state.

Commentary

The Texas Supreme Court’s ruling in this case is consistent with its previous decisions regarding the apportionment and sourcing of service revenue. This decision applies an origin-based methodology using cost of performance that historically has been following by Texas and is supported by the state’s statutes. The Court of Appeals’ decision seemed to be inconsistent with Texas law by applying a market-based sourcing methodology. The lower court’s decision may have caused some confusion by applying market-based sourcing even though it did not seem to be supported by Texas law. Thus, the Supreme Court’s decision arguably provides clarity by rejecting the Comptroller’s use of market-based sourcing.

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. This decision benefits taxpayers such as Sirius XM Radio that have significant operations outside Texas and have many customers located in the state. However, this decision is not favorable for taxpayers that have Texas-based operations that sell services to a broad multistate market. For taxpayers in this situation, service revenue would be sourced to Texas because the taxpayer’s production equipment is located in the state.

There has been a consistent trend of states enacting legislation to change from cost-of-performance to market-based sourcing for sales of services, but the Texas legislature has not followed this trend. The Texas Supreme Court interpreted the Texas statutes and applied the cost-of-performance sourcing methodology. At this point, the Texas legislature is requiring that services be sourced to where they are performed rather than where they are received. The Supreme Court determined that the Texas statutes did not support the Comptroller’s use of market-based sourcing. Thus, the sourcing method used by Texas currently differs from the sourcing method used by many states.

States that follow a traditional cost-of-performance methodology source revenue from sales other than sales of tangible personal property to a state if the greater proportion of the income-producing activity is performed in the state than in any other state, based on costs of performance.⁷ However, the Texas approach differs because receipts are sourced to a state to the extent the service is performed in the state. Therefore, taxpayers such as Sirius XM Radio that mainly perform their services in other states may still be required to apportion a small percentage of their service receipts to Texas.

The Texas Supreme Court explained that the use of the Comptroller’s “receipt-producing, end-product act” test is consistent with Texas law to the extent it is used to determine what qualifies as the “service performed” but is inconsistent with Texas law when it is used to determine where a service is performed. Therefore, the Comptroller’s test can still be used in deciding what qualifies as the service performed.

The Court of Appeals’ decision may have created uncertainty regarding sourcing of service revenue in Texas. Taxpayers who changed their sourcing methodology based on the Court of Appeals’ decision should analyze the impact of this recent decision on their prior Texas Franchise Tax filings and on their income tax provision and consider whether amended returns are warranted.

1 Texas Supreme Court, No. 20-0462, March 25, 2022.
2 604 S.W.3d 125 (Tex. App. 2020). For a detailed discussion of the Court of Appeals’ decision, see GT SALT Alert: Texas OKs in-state radio subscription sourcing.
3 TEX. TAX CODE ANN. § 171.103(a).
4 359 S.W. 2d 893, 895 (Tex. 1962).
5 414 S.W.2d 172, 180 (Tex. 1967).
6 In a footnote, the court analyzed the origins of the “receipt-producing, end-product act” test. The court found that the test was first discussed in an administrative ruling but had never been used by courts to determine where receipts should be sourced. The original intent of the test was to determine what the service was as opposed to where it was performed. As such, the court abandoned the use of the test to help determine where a service was performed.
7 See VA. CODE ANN. § 58.1-416.A.