Water tower landscape

In an increasingly service-based economy, one of the most bewildering issues facing tax professionals is the application of “place of performance” or “cost of performance” rules to various types of services, especially those that are more commodified. Broadcasters and providers of software as a service could find themselves with unexpected sourcing results. The Texas Supreme Court recently encountered this issue in Sirius XM Radio, Inc. v. Hegar concerning the sales factor sourcing of receipts from satellite radio subscriptions for Texas franchise tax apportionment purposes. Sirius broadcasted more than 150 satellite-radio channels and conducted most of its operations outside of Texas. The company’s headquarters, transmission equipment, and production studios were all based outside of Texas. 

For Texas franchise tax purposes, Sirius sourced its subscription receipts based on the locations from which it produced programming, using the relative costs of those activities in Texas and elsewhere. The Texas Comptroller audited Sirius and determined that the taxpayer should have sourced its subscription receipts using the location of its subscribers. The Texas Supreme Court held that a service is performed in Texas if the labor for the benefit of another is done in the state. Given the statute’s focus on the location where the service is performed (not received), the “most natural reading of ‘service performed in this state’ supports locating the performance of the service at the place where the taxpayer’s personnel or equipment is physically doing useful work for the customer.”

The Texas Supreme Court’s holding appears to be in accord with the U.S. Tax Court’s decision in a similar case. Comm’r v. Piedras Negras Broadcasting Co. involved a Mexican corporation that operated a radio broadcasting station located on the Mexican side of the Rio Grande but maintained in the U.S. bank accounts, a mailing address, and a hotel room for the collection of advertising income. Ninety-five percent of the taxpayer’s income was received from U.S. advertisers (secured through an independent contractor in the U.S.), pursuant to contracts executed in Mexico. The remaining 5 percent of its income was received from the rental of its Mexican broadcast facilities pursuant to contracts executed in Mexico for the sale of such “radio time.” 

The court found that the taxpayer’s income was exclusively derived from the operation or rental of its broadcast facilities in Mexico, and thus allocated all of the taxpayer’s income to sources outside the U.S. according to the place-of-performance and place-of-use source rules applicable to personal services and the rental of property, respectively, notwithstanding the U.S. contacts.

The court stated the following:
We think the language of the statutes clearly demonstrates the intendment of Congress that the source of income is the situs of the income-producing service. The repeated use of the words within and without the United States denotes a concept of some physical presence, some tangible and visible activity. If income is produced by the transmission of electromagnetic waves that cover a radius of several thousand miles, free of control or regulation by the sender from the moment of generation, the source of that income is the act of transmission. All of respondent’s broadcasting facilities were situated without the United States, and all of the services it rendered in connection with its business were performed in Mexico. None of its income was derived from sources within the United States.

While Texas’ “place of performance” language is relatively simplistic, other states have wrestled with applying the more complex Multistate Tax Compact (MTC) language, or variations thereof, to the specific types of service. The classic definition of income-producing activity states, in pertinent part, the following: 

The term “income producing activity” applies to each separate item of income and means the transactions and activity directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profits.

If the income-producing activity spans across multiple states, the service revenue is generally sourced based on the greater cost of performance or in proportion to the cost of performance. The problems inherent in the application of the MTC to certain service sales were obvious from the outset. As one of the drafters observed:

Another problem arises in conjunction with sales other than sales of tangible personal property. Section 17 of the uniform act attributes these sales to the states in which the income-producing activity is performed. If the activity is performed in more than one state, the sales are attributed to the state in which the greater proportion of the activity was performed, based upon costs of performance. In many types of service functions, this approach appears adequate. However, there are many unusual fact situations connected with this type of income and probably the general provisions of Section 18 should be utilized for these cases. If we assume that the activity involved is the servicing of industrial equipment, the formula provided in the uniform act could easily be applied and the result appears equitable. In contrast, assume that the sales item involved is advertising revenue received by a national magazine publisher. The state of activity would be difficult, if not impossible, to ascertain, so it would appear that this type of income may well be apportioned on the same basis as subscription income. The national conference considered this problem at length and concluded that for certain types of sales income, exceptions would have to be established by the tax collection agencies, since no formula seemed to be satisfactory for every conceivable factual situation. Generally, it was felt that the provisions of Section 17 were the best that could be designed to cover the greater proportion of the cases.

As the following chart shows, several states with place-of-performance or income-producing activity rules have reached a market result for specific types of services. 

State Case/Ruling Outcome
Arizona Walter E. Heller W., Inc. v. Arizona Dep’t of Revenue, 161 Ariz. 49 (1989) Market
Arkansas Administrative Hearings Decision, 22-154, March 24, 2022 Market
Florida Florida Technical Assistance Advisement No. 13C1-011, November 21, 2013 Market 
Idaho Cable One, Inc. v. Idaho State Tax Comm’n, 337 P.3d 595 (Id. 2014) Market 
Oregon AT&T Corp. & Includible Subsidiaries v. Department of Revenue, 357 Or. 691, 358 P3d 973 (2015) Market
Pennsylvania (2014 and before) Synthes USA HQ v. Commonwealth of Pennsylvania, No. 108 F.R. 2016, July 24, 2020 TBD by PA Supreme Court
South Carolina DIRECTV, Inc. v. South Carolina Dep’t of Revenue, 804 SE2d 633 (Ct. App. 2017) Market
Tennessee BellSouth Adver’g & Publ’g Corp. v. Chumley, 308 SW3d 350 (Tenn. App. 2009) Market 

Taxpayers should carefully examine their current sourcing positions in states that have not adopted a market-based sourcing regime for potential opportunities or exposures. 

If you or your client would like assistance with apportionment, please contact our State & Local Tax Services group. For more information, reach out to your advisor or submit the Contact Us form below. 

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