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Texas Comptroller Prevails in a Texas Franchise Tax Sourcing Case involving Satellite-Radio Programming — But Taxpayers Could Also Benefit in Other Contexts

By David E. Colmenero and Alex J. Pilawski on May 27, 2020

In a case with potentially broad implications, the Third Court of Appeals recently agreed with the Texas Comptroller that revenues received by a taxpayer from subscription-based satellite-radio programming could be sourced to the location of the subscribers for Texas franchise tax purposes rather than to where the programming actually occurred. See Hegar v. Sirius XM Radio, Inc., 2020 WL 2089132 (Tex. App.—Austin 2020).  While the decision could still be appealed to the Texas Supreme Court, the holding is significant, in part, because if upheld it could potentially expand the State’s ability to tax out-of-state service providers.  However, the holding is also significant and potentially beneficial to many taxpayers because it may create an opportunity for some in-state service providers to source at least part of their revenues out-of-state as well.

The taxpayer at issue, Sirius XM Radio, Inc. (“Sirius XM”), provides subscription-based satellite-radio services to customers throughout the U.S., including Texas.  Approximately 70% of Sirius XM’s programing consists of original content produced by Sirius XM.  Almost all of Sirius XM’s property, equipment and personnel are located outside of Texas.  With only a limited exception, all programming occurs outside the state as well.  Subscribers receive Sirius XM’s programming via satellite-enabled radios, which include the encryption, conditional access and security technology necessary to exclusively access Sirius XM satellite-radio.  Sirius XM does not manufacture or provide radios to subscribers.  It does, however, subsidize a portion of the radio manufacturing cost in order to reduce the price to consumers, and also paid certain automakers to install radios into their vehicles (the “subsidy payments”).

The primary issue in this case was whether payments received from subscribers should be sourced to the location of the subscribers, as the Comptroller argued, or to the location where programming occurred, as Sirius XM claimed.  Section 171.103(a)(2) states that receipts from “each service performed in this state” must be sourced to Texas.  Comptroller Rule 3.591(e) similarly provides that receipts from the sale of services are apportioned to the “location where the services is performed.”  Citing in part to its prior administrative decisions, the Comptroller argued that the “specific, end-product acts for which a customer contracts and pays to receive” should determine where a service is performed.   Under this standard, the Comptroller argued Sirius XM’s production and distribution activities were non-receipt producing, albeit essential support services.  By contrast, the Comptroller argued, “every subscription receipt from a Texas Customer is properly characterized as a receipt from a ‘service performed in this state.’”   Sirius XM argued that the franchise tax rules are “origin based”, not “market based” and that revenues should therefore be sourced to “where the service provider performs its service-related activities.”

A secondary issue in this case was whether Sirius XM could include the subsidy payments in its cost-of-goods sold deduction.  Sirius XM argued that its live and prerecorded radio programs were “tangible personal property” which it “produced” as those terms are defined in the statute.  See Tex. Tax Code § 171.1012(a). It further argued that, because the satellite-enabled radios were necessary for subscribers to received Sirius XM’s programming in their automobiles, the subsidy payments were deductible as a cost of producing the radio programs.  See Tex. Tax Code § 171.1012.

The Court held in favor of the Comptroller on both issues.  The Court first agreed with the trial court that where a service is performed for sourcing purposes refers to where the “receipt-producing, end-product act is done.”  Under this standard, the Court held that the service for which customers contracted was the receipt of Sirius XM programming.  As such, “[t]he receipt-producing, end-product act that allowed each Sirius XM customer to receive Sirius XM programming occurred when Sirius XM decrypted the program by activating or deactivating the customer’s chip set in their satellite-enabled radio, which Sirius XM could do remotely.”  This act occurred where the satellite-radio was located, as the Comptroller argued. 

In support of its holding, the Court distinguished its prior holding in Westcott Communications, Inc. v. Strayhorn,  104 S.W.3d 141, 144 (Tex. – Austin 2003, pet. denied) wherein it held that certain receipts a taxpayer received from training programs should be sourced to Texas.  The training programs at issue in Westcott were developed in Texas but delivered via satellite to an out-of-state audience.  Notably, Westcott involved the same statutory sourcing provision at issue in this case. According to the Court, the taxpayer’s customers in Westcott paid primarily for the substance of the training programs which were developed and produced exclusively in Texas.  By contrast, held the Court, Sirius XM’s programming was available to anyone who contracted to receive programming; and it was the ability to receive that programming through satellite- radio that customers contracted for.  In addition, noted the Court, “nothing in the record suggest[ed] that Sirius XM contracted with individual subscribers or groups of subscribers to develop or produce specific programming.”

The Court likewise held that Sirius XM could not include the subsidy payments in its cost of goods sold.  Citing the Texas Supreme Court’s recent decision in Hegar v. American Multi-Cinema, 2020 WL 1648043 (Tex. 2020), the Court noted that “property with a physical or demonstrable – that is, tangible – presence must be transferred” and that transferring a film’s creative content alone would not suffice.  According to the Court, the Sirius XM subscribers received only a right to access and listen to the programs’ creative content.  In addition, nothing in the record suggested that a subscriber could access the digital information Sirius XM delivered at a later time.  Accordingly, the Court held that subscribers received only the “creative content” of the radio program which fails to qualify as a sale of tangible personal property. 

While the Court’s holding in Sirius XM may seem somewhat complex, particularly as it seeks to distinguish its prior holding in Westcott, it strongly suggests that, at least in some cases, revenues from products delivered electronically should not be sourced to where those products are produced or created for franchise tax purposes.  While this may benefit the State where the service provider is located out-of-state, it could benefit taxpayers where the service provider is located in Texas.  The facts at issue in Sirius XM illustrate how the State may benefit from this holding because it effectively permits the Texas Comptroller to tax a taxpayer located almost entirely outside the State of Texas.  But if the facts were inverted, as they no doubt will be in many cases, a service provider located entirely within the State of Texas may be able to source part or perhaps even all of its revenue to locations outside the State on the same basis.  The question for many taxpayers will be when does this analysis apply to the benefit of taxpayers – an issue that may very well provide the basis for future litigation.  For now, the question will be whether this case gets appealed to the Texas Supreme Court and whether the Texas Supreme Court decides to hear this case.