The Texas Court of Appeals recently issued a decision that applied market-based sourcing for services, despite the state’s statute that requires the sourcing of receipts to the location where the service is performed. In Hegar v. Sirius XM Radio Inc., No. 03-18-00573-CV (Tex. App. Austin, 2020), the court narrowly defined the scope of “performance” as the final act that gets the service to the customer, thereby ignoring all of the costs that went into the performance and production of the service up to that point. Such an application produces a result that equates to market-based sourcing.
For sourcing services, Texas’ sourcing rule reads similar to the cost-of-performance rules adopted in other states: “[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.” Tex. Admin. Code 3.591(e)(26); see also Tex. Tax Code Ann. § 171.103(a)(2). In applying the “fair value” test, Sirius XM sourced its service receipts based on where it produced its programming (Sirius XM produced 70% original content), which was primarily outside of Texas. On audit, the Comptroller narrowed the application of the “fair value” test to only consider the final step (which was performed at the customer location) of a series of activities necessary to provide the overall service.
In overturning the lower court, which had found that Sirius XM had properly sourced its receipts based on where it produced its programming, the appellate court relied on a 1980 decision that looked to the “receipt-producing, end-product act” in determining where services are sourced. See Tex. Comp. Pub. Acc’ts Hearing No. 10,1028 (1980). Under this standard, according to the appellate court, Sirius XM performed its services where it beamed its satellite signal to the subscriber’s radio (i.e., the local decryption of the satellite network that occurred on each subscriber’s radio). The court then concluded that if the subscriber had a Texas address, then that customer’s receipts were presumably sourced to Texas (i.e., market-based sourcing). The court’s application of the “fair value” test in this case does not account for the traditional cost-of-performance indicia, such as the time and resources that went into the production and distribution of the Sirius XM content. And since the final step in providing a service almost always occurs where the customer is located, this holding effectively results in market-based sourcing for services.
In its decision, the court gave significant deference to the Comptroller to interpret its rules. Rather than independently considering what constitutes “fair value” for providing a radio service, the court only sought to confirm that the Comptroller’s interpretation of the rule was not unreasonable and did not directly conflict with the plain language of the statute. Such an analytical framework rarely bodes well for taxpayer litigants and similarly, seemed to seal the fate of the taxpayer in Sirius XM, at least at the intermediate appellate level.
The court’s conclusion in the Sirius XM decision is not unique to Texas. In certain states (e.g., Florida and Pennsylvania), the tax authorities have sourced receipts based on the final, customer-facing step, thereby interpreting and applying a cost-of-performance sourcing rule to produce a market-based sourcing result. We expect to see (and have seen) similar results in other cost-of-performance states as we continue to transition to a services-based economy. In the meantime, we will stay tuned to see whether the Texas Supreme Court decides to review this decision. We anticipate that they will.