Editor: Mary Van Leuven, J.D., LL.M.
Texas is the consummate football state. From peewee to NFL games, Texans are well accustomed to seeing flags thrown and penalties called midgame. At times, these calls can and do change the outcome of the game. Preparing tax returns is not as fun as watching a good football game, but in neither situation do taxpayers expect the rules to change at halftime.
This is somewhat like what happened when the Texas Comptroller's Office published the final version of revised Administrative Rule Section 3.591, Margin: Apportionment, in the Texas Register. As amended, this regulation significantly revises the rules for sourcing receipts to Texas, and almost all taxpayers, particularly those engaged in service industries, will be affected by the rule changes. The explanatory text in the register provides that many of the additions or revisions are expositions of existing comptroller policy. An example of this: The revised general rule for sourcing service receipts "is an exposition of the Comptroller's current interpretation of the sourcing statute, which has been endorsed in part by the [Texas] Court of Appeals opinion in the Sirius XM Radio litigation." Because the rule is applied both prospectively and retroactively, taxpayers must reassess past plays and think about upcoming audits.
The receipts-producing, end-product act
Perhaps the most significant change is the revised general rule for sourcing service receipts, which is applied if the service is not specifically addressed elsewhere (there are special rules for certain types of receipts, e.g., advertising services, internet hosting services, loan servicing activities). Texas law apportions receipts from providing services to the location where the services are performed. If services are performed both inside and outside of Texas, then the receipts are attributed to Texas in proportion to the fair value of the services that are rendered in Texas. The final regulation adds guidance on interpreting the location where a service is considered performed. Under the revised rule, a service will generally be performed at the location of the receipts-producing, end-product act or acts.
This new test, so to speak, aligns with language adopted by the Texas Court of Appeals in Hegar v. Sirius XM Radio, Inc., 604 S.W.3d 125 (Tex. Ct. App. 2020). In that case, the court held that the receipts-producing, end-product act associated with the provision of satellite radio service is the taxpayer's activating a customer's chip set in a satellite-enabled radio. This occurs where the customer's radio is located, which is likely in the customer's residence or car. Sirius XM is not yet final; the taxpayer's petition for review before the Texas Supreme Court is pending.
Additionally, if there is a receipts-producing, end-product act, the rule will not consider the location of other acts, even if those acts are essential to the performance of the receipts-producing, end-product act. This result is also consistent with Sirius XM, as the Appeals Court held that producing programming content for satellite radio stations was a non—receipt-producing act, albeit an essential one.
The revised rule provides scant guidance on how a taxpayer should determine the receipts-producing, end-product act associated with a service. If there is no receipts-producing, end-product act associated with the service (and again, it is not clear in the rule when this would be the case), then the locations of all essential acts may be considered in determining where a service is performed. However, beyond directing the taxpayer to consider all essential acts to determine the location where a service is performed (assuming there is no receipts-producing, end-product act), the rule provides no examples or guidance on how to measure those essential acts and make a conclusion as to the ultimate location where the service is performed.
Taxpayers that perform certain types of services (e.g., tax preparation or legal services) may question whether their services have receipt-producing, end-product acts or whether the services are considered to be performed in more than one state so that fair-value analysis is required. It can be argued the receipts-producing, end-product act of a tax return preparation service for a Texas taxpayer is the delivery of the return to the taxpayer, even though parts of the return may be prepared in multiple states. Similarly, pretrial legal work might be part of the receipts-producing, end-product act of a trial. Applying the test, receipts from preparing the return would likely be sourced to Texas, which is the location of the customer receiving the tax return, and receipts related to the trial would be sourced to the location where the trial is held. The finalized rule, however, provides an example of a law firm charging clients for work performed both inside and outside of Texas and requires a fair-value analysis. Ultimately, the Comptroller is the deciding referee in this game and will control which way the ball goes when determining if a service produces an end-product act or not.
Internet hosting services
One other change in the rule that might catch players off guard is a new definition of "internet hosting services." Since 2014, by statute, receipts from internet hosting services have been sourced to the customer's location. The revised rule now defines internet hosting services to include real-time or on-demand access to several computer services including, but not limited to, data storage and retrieval, videogaming, database search services, entertainment streaming, data processing, and marketplace provider services. Internet hosting excludes telecommunication services and cable television services, along with internet connectivity services, internet advertising, and internet access to download digital content only. The preamble to the revised rule acknowledges that some of these services extend beyond what might ordinarily be considered internet hosting services.
Receipts from internet hosting are generally considered Texas gross receipts if the customer is located in Texas. The customer location is determined by the physical location where the purchaser or the purchaser's designee consumes the service. The location should be determined in good faith, using the most reasonable method under the circumstances, considering the information reasonably available. Receipts from some services may be sourced to multiple customer locations or to multiple customers. Locations that may be reasonable under the circumstances include the customer's principal place of business, the customer's business unit that is using the computer services, the delivery addresses for individual units of service provided to the customer, the primary place or places of consumption by the customer, the customer's service address, the customer's billing address, or a combination of methods. Numerous examples illustrate these provisions.
While internet hosting receipts have been sourced to the customer location since 2014, it is arguable that taxpayers providing data processing services or streaming services may not have known those services were considered internet hosting services until the revised rule was released. These taxpayers may have used the general rule for sourcing service receipts, which looks to the location where the service was performed, rather than the customer's location.
Capital assets and investments
The final regulation also revises the rules around capital assets and investments and clarifies that only the net gain from the sale of a capital asset is included in gross receipts. A net loss from the sale of a capital asset or investment is not included in gross receipts. For reports originally due before Jan. 1, 2021, a taxable entity may add the net gains and losses from sales of investments and capital assets to determine the total gross receipts from the transaction. For other reports, going forward, the net gain or loss is determined separately for each sale of a capital asset or investment. Although the rules determine net gains and losses on a sale-by-sale basis, there is some uncertainty as to whether that sale-by-sale basis is based on a total transaction-by-transaction approach or an asset-by-asset approach.
The underlying question is this: If a taxpayer sells multiple capital assets in one transaction, is the net gain or loss determined to be the total net gain or loss of that one transaction or will the taxpayer have to look at each individual asset in the transaction to determine each asset's net gain or loss? As an additional interesting inquiry, if it is the latter, will the taxpayer be able to prepare for that if an audit were to arise?
Additional definitions and sourcing rules
The final rule also includes new and revised definitions and provisions addressing the sourcing of certain types of receipts and services, including, but not limited to, advertising receipts, loan servicing activities, computer software services, interest receipts, and receipts from the sale of an interest in a single-member limited liability company (SMLLC).
A new provision consolidates the sourcing rules for advertising receipts across all media. "Advertising receipts," as defined, are sourced to the location of the advertising audience, which can be determined, in good faith, by the physical locations of the advertising considering the information reasonably available. Reasonable locations can include the recorded locations of the advertising audience and the locations listed in published rating statistics. If the locations of nationwide advertising audiences cannot otherwise be reasonably determined, then 8.7% of the gross receipts are sourced to Texas. For reports originally due before Jan. 1, 2021, advertising receipts attributable to a radio or television station transmitter in Texas may be sourced to Texas.
The guidance on sourcing "loan servicing" fees has been updated to provide that gross receipts from servicing loans that are not secured by real property are sourced under the general rule addressing services.
The current rule that addresses "computer software services and programs" has been replaced with guidance on sourcing receipts from "computer hardware and digital property." Ostensibly to aid in applying these rules, the finalized regulation includes several new examples.
The revised regulation also makes minor changes to the rules for sourcing interest, which continues to be sourced to the location of the payer. Now interest received from a national bank is a Texas gross receipt if the bank's principal place of business is in Texas or the bank is organized under the Texas Banking Code. Interest on federal obligations that is excluded from total revenue and interest exempt from federal income tax is excluded from gross receipts entirely.
Additionally, the final regulation provides guidance on the sourcing of the sale of an interest in an SMLLC. The sale is considered a sale of an interest in an intangible asset and should be sourced to the location of the payer.
Lastly, the comptroller adopted amendments to Administrative Rule Section 3.586, Margin: Nexus,to address the U.S. Supreme Court's decision in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018). Although the changes were fairly minor, they do improve certain language and phrases. An example of this improvement is an amendment changing the phrase "is not doing business" to "does not have physical presence." The amendments also update the economic nexus subsection to emphasize certain subsections of Section 3.591 and to include a definition of Texas gross receipts. To conclude the updates, the comptroller outlines the key dates foreign (i.e., non-Texas organized) entities established Texas nexus:
- Prior to Jan. 1, 2019, a foreign taxable entity begins doing business in Texas on the date the entity has physical presence.
- On or after Jan. 1, 2019, a foreign taxable entity's beginning date is outlined as the earliest of the date the foreign taxable entity has physical presence, the date when the foreign taxable entity obtains a Texas use tax permit, or the first day of the federal income tax accounting period ending in 2019 or later in which the entity had gross receipts from business done in Texas of $500,000 or more.
The revisions to Administrative Rule Section 3.591, especially to the extent the rules apply retroactively, may have nexus implications for taxpayers meeting the gross receipts threshold in Texas after applying the revised regulation. Taxpayers should carefully consider the effect of the rule on their future footprint, as well as their prior filing positions.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Contributors are members of or associated with KPMG LLP.
The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.