Texas appellate court allows cost-of-performance to support service revenue sourcing

In brief

Revenue from services is sourced to Texas when the service is “performed in this state.” A Texas appellate court on November 10 ruled that Sirius XM’s cost-of-performance analysis was sufficient to support its conclusion regarding where services were “performed.”  

On appeal by the Comptroller from a district court decision, the appellate court previously found that service revenue was sourced to where the “receipt-producing, end-product act” occurred, which generally reflects customer location. On petition for review by the taxpayer, the Texas Supreme Court reversed and held that the “end-product test” should not be used to determine where a service is being performed.

On remand, the appellate court now has determined that Sirius XM’s cost-of-performance methodology was acceptable in determining the fair value of services performed in Texas.

The takeaway: The Texas Supreme Court decision rejected the “end-product act” test for determining the location of performance. The appellate court on remand affirmed using cost-of-performance as a method in determining fair value of services performed. The court allowed the taxpayer’s cost-of-performance approach to prevail in this case, but other approaches may possibly be available so long as they are deemed to satisfy the “fair value” standard. Because the court did not examine what costs should be included in a cost-of-performance approach, an open question remains regarding the elements of a cost-of-performance analysis. 

The appellate court relied on the rule in effect for the 2010 and 2011 tax years to establish the “fair value” standard applied in this case. However, the “fair value” language was changed in rule amendments adopted on January 15, 2021. Click here for our Insight on the amendments. As a result, for subsequent report years it is uncertain how a future court decision might apply the sourcing rule when a service is being performed both inside and outside of Texas, and whether the rule changes that were adopted might be upheld, overturned, or amended by future court decisions. The Comptroller also has informally communicated that they will be proposing additional rule amendments in light of the decisions of each court. 

[Hegar v. Sirius XM Radio, 3rd Dist. App. Ct., No. 03-18-00573-CV (11/14/22)]

District court

Sirius XM paid the additional tax and interest under protest and filed suit to obtain a refund. The trial court held in favor of Sirius XM, finding that “[t]he apportionment factors Sirius XM reported on its returns for tax years 2010 and 2011 were consistent with the fair value of Sirius XM’s service performed in Texas.”

Texas Supreme Court

On appeal, the Texas Supreme Court held that “service performed in this state,” requires looking to the physical location of the taxpayer’s personnel or equipment that performs the service for which the customer pays. Applying that standard, the supreme court rejected the Comptroller’s contention that Sirius XM performs its service where the customer’s radio is located. The supreme court concluded, instead, that the relevant service provided by Sirius XM is radio production and broadcasting and that “Sirius has little personnel or equipment in Texas that performs the radio production and transmission services for which its customers pay monthly subscription fees.” 

Accordingly, the Texas Supreme Court rejected the “end-product act” test advanced by the appellate court and remanded the decision to the appellate court to determine whether Sirius XM’s cost-of-performance approach was sufficient to support its apportionment of service receipts. Click here for our Insight regarding the Texas Supreme Court’s decision.

Specific methodology not reviewed

The Comptroller asserted that Sirius XM’s cost-of-performance analysis was flawed for several reasons, including the absence of certain costs such as performance royalties paid for content it did not own or produce, and the inclusion of research and development costs in the analysis. The appellate court ruled that the Comptroller cannot raise such an argument on appeal because the Comptroller failed to raise an objection in the district court.