Texas Amends Franchise Tax Apportionment Rule With Significant Changes to Sourcing Provisions

On January 4, 2021, the Texas Comptroller of Public Accounts adopted revisions to the Texas franchise tax apportionment rules that were proposed on November 2, 2020 under 34 Tex. Admin. Code section 3.591. The revisions apply to a broad range of services and sales of property; incorporate a number of legislative changes, court decisions and some Comptroller rulings; and update definitions. The amendments bring both favorable and adverse changes for taxpayers subject to Texas franchise tax, with considerable changes to the sourcing provisions for receipts from services, including advertising services, transportation services and internet hosting, and receipts from sales of computer hardware and digital products, capital assets and investments, interests in single-member limited liability companies (SMLLCs) and sales of securities through an exchange. Except as otherwise noted in the amended rule, these changes are generally effective retroactively to January 1, 2008.

 

Details

Services: The revised rules continue to require gross receipts to be sourced from sales of services to the location where the service is performed. If the service is performed both inside and outside
of Texas for a single charge, the receipts are still allocated between performance locations based on the fair value of the service rendered at each location. 

The revised rules define where a service is performed as the location of the receipts-producing end-product act or acts. If there is a receipts-producing, end-product act, the location of other acts will not be considered even if they are essential to the performance of the receipts-producing acts. If there is not a receipts-producing, end-product act, the locations of all essential acts may be considered. If the service was performed both inside and outside of Texas for a single charge, units of service, such as hours, may be considered. If costs are considered, costs should be limited to those directly related to the service and not overhead costs.

There is limited guidance in the revised rules as to what constitutes a receipts-producing, end-product act associated with a service and no examples to assist taxpayers in applying the concept.

Internet hosting: Based on legislation enacted in 2013 and effective for franchise tax reports originally due on or after January 1, 2014, the revised rules provide that gross receipts from internet hosting services are sourced to the location of the customer.
 
Internet hosting services include, but are not limited to, data storage and retrieval, video gaming, database search services, processing of data and marketplace provider services. In the preamble to the revised rules, the Comptroller acknowledges that the examples extend beyond what ordinarily may be considered as internet hosting services. Thus, since the revision is effective for reports originally due on or after January 1, 2014, taxpayers will need to determine if their services constitute internet hosting and, if so, whether their sourcing determinations need to be revisited.
 
The customer’s location when purchasing internet hosting services is determined by where the purchaser, or the purchaser’s designee, consumes the service. Receipts from some services may be sourced to multiple customer locations or to multiple customers. The new provisions contain examples illustrating the application of this sourcing rule.

Computer hardware and digital property: The revised rules include new sourcing provisions for sales of “digital property,” which is defined as computer programs and any content in digital format that is either protected by copyright law or that is no longer protected by copyright law due solely to the passage of time. As outlined in the rules, the sourcing of such receipts is dependent upon how the digital property is transferred to the purchaser. The new sourcing rules for digital property can be summarized as follows:

• Gross receipts from the sale or lease of digital property installed on computer hardware or other fixed physical media are sourced as a sale of tangible personal property. Importantly, this is a change from the Comptroller’s prior guidance, which sourced gross receipts from all sales of software to the location of the payor.

• Gross receipts from the delivery of digital property by means other than fixed physical media (i.e., electronically) are sourced using the location of the payor rule.

• Gross receipts from the delivery of digital property as a service are sourced to the location where the receipts producing, end-product act is performed. For example, cable television subscription receipts are gross receipts from the use of digital property and are sourced to the audience location.

• Gross receipts from the delivery of digital property as part of an internet hosting service are sourced to the location of the customer. For example, gross receipts from access to software-as-a-service (SaaS) are treated as receipts from digital property delivered as part of an internet hosting service and are sourced to the location of the customer. This change reflects the 2013 legislative change enacted with respect to the sourcing of internet hosting services. However, the inclusion of the SaaS example in the amended rule represents a change in policy.

• Gross receipts from the use (as opposed to sale or license) of digital property are treated as receipts from the use of an intangible and are sourced to where the intangible asset is used. For example, a software company’s license of software to a seller of computer hardware for installation on seller’s computer products is treated as the use of a digital product and the gross receipts are sourced to the location of the computer hardware company.

 

Capital assets and investments: For Texas franchise tax reports due on or after January 1, 2021, only the “net gain” from the sale of a capital asset or investment is included in gross receipts. A “net loss” from the sale of a capital asset or investment is excluded from gross receipts. The net gain or net loss is determined on an asset-by-asset basis and a net loss from the sale of one asset may not be used to offset the net gain from the sale of another asset. The net gain from the sale of the capital asset or investment is sourced based on the type of asset or investment sold. This amendment is intended to reflect the Texas Supreme Court’s 2016 decision in Hallmark Marketing Co. v. Hegar.
 
Advertising services: The revised rules consolidate sourcing sales of advertising services for newspapers, magazines, radio, television and other media into a single rule. Sourcing of gross receipts from the dissemination of advertising is based upon the location of the advertising audience. If the locations of nationwide advertising audiences cannot be reasonably determined, then 8.7% of the gross receipts are sourced to Texas. Also, certain taxpayers are allowed the option to source advertising receipts for Texas franchise tax reports originally due before January 1, 2021 using the location of the transmitter, as originally provided in the prior rules.
Transportation services: The original rules allowed for sourcing of transportation receipts to Texas based on gross receipts or mileage. For Texas franchise tax reports due on or after January 1, 2021, taxpayers must use gross receipts.
 
Sale of membership interest in a SMLLC: The revised rules incorporate previous guidance issued by the Comptroller regarding sales of interests in SMLLCs. The sale of an interest in an SMLLC is treated as the sale of an intangible, rather than a sale of the assets owned by the SMLLC (the federal treatment). The net gain on the sale of the SMLLC interest is sourced using the location of payor rule.
 
Texas population percentage updated for securities sold through an exchange: The percentage that applies to securities sold through an exchange when the buyer is not known has been updated from 7.9% to 8.7%. The Comptroller will continue to allow taxpayers to use 7.9% for reports originally due before January 1, 2021.