The Texas Supreme Court issued an opinion in the Sirius XM Radio, Inc. v. Hegar case likely to have implications on the Texas Comptroller’s use of a concept called the end-product act related to revenue streams. The opinion could also affect an amended version of the franchise tax apportionment rule finalized in January 2021.

The ruling on March 25, 2022, reversed the Third Court of Appeals decision and affirmed Sirius XM Radio, Inc.’s sourcing of receipts. The Sirius decision could create refund opportunities for some taxpayers, primarily those outside of Texas.

Taxpayers, however, shouldn’t expect the Sirius decision to invalidate all January 2021 changes to the apportionment rule. Companies providing internet-based services should carefully evaluate each revenue stream to determine if the revenue should be sourced based on the location of their customer or the location where the services are performed.

An overview of the case and its implication follows.

Background of Sirius Case

Certain details of Sirius’ revenue sourcing contributed to the court ruling.

The Taxpayer

Sirius XM earns revenue from satellite radio subscriptions. Sirius produces most of the content that it delivers to customers. Most of the company’s equipment and production studios are outside of Texas. The content is delivered to customers via satellite using an encrypted radio signal. Sirius sends a signal from outside Texas to subscribers’ satellite radios that allows the signal to be decrypted.

Sirius doesn’t own the radio equipment used by subscribers.

The Controversy

Texas uses a single receipts factor to apportion taxable margin to the state. The Texas franchise tax law contains minimal language as to how receipts from services should be sourced for apportionment purposes. Texas Tax Code 171.103(a)(2) provides that receipts from services are sourced to Texas for “each service performed in this state.”

Sirius filed franchise tax returns sourcing their receipts from subscriptions based on the location of the production of the content and the transmission of the radio signals. The comptroller audited Sirius and determined that the subscription receipts should be sourced based on the end-product act, resulting in sourcing of receipts based on location of subscribers.

Court Ruling

The comptroller’s audit resulted in what’s commonly referred to as market-based sourcing even though the section of the franchise tax law cited above for services doesn’t contain language enabling that method of sourcing receipts from services.

The comptroller’s position was that the decryption of the satellite radio transmissions was the end-product act for the services provided by Sirius.

The court explained that the economic reality was that the customers weren’t paying for the decryption service; they were paying for the programming. The decryption was only for Sirius’s benefit.

End-Product Act Background

The end-product act was first described in an administrative hearing in 1980.

The taxpayer in that case was a local television station that had a studio and transmitter tower in Texas and a second transmitter tower in New Mexico.

The comptroller argued that the taxpayer’s receipts should have been sourced based on where the advertising services were performed. The taxpayer prevailed in their position that the advertising receipts should be sourced based on the location of the transmitter towers.

The comptroller applied this concept to a variety of services and technology that didn’t exist in 1980. It can be argued that this application of the end-product act is beyond the scope of the analysis in the 1980 hearing.

Comptroller Amends Rule 3.591 for Apportionment

In January 2021, the comptroller finalized an amended version of the franchise tax apportionment rule which contained significant changes.

Most of these changes were retroactive including changes that applied the end-product act.

New Requirement

The timing and retroactivity of this rule created issues for some taxpayers that were in the process of completing their year-end tax provisions. Although the rule doesn’t include the term market-based sourcing, the comptroller’s changes to the rule required market-based sourcing by instructing taxpayers to source receipts from certain types of services based on the location of the receipt-producing, end-product act.

The comptroller’s commentary on the amended rule was that the agency merely updated the rule to make it consistent with long-standing policy.

Inconsistent Arguments

However, there were letter rulings issued by the comptroller that were inconsistent with the amended rule. The comptroller successfully argued in 2003 that revenue from training services produced in Texas and delivered via satellite to customers outside Texas should be sourced to Texas as denoted by Wescott Communications, Inc. v. Strayhorn.

Sirius used the Wescott case in its appeal to the Texas Supreme Court that led to the March 25, 2022, decision affirming their sourcing of receipts.

Potential Implications of the Sirius Decision

Key considerations related to the Sirius decision include:

• Texas has a four-year statute of limitations so refund claims for the 2018 reports—based on 2017—need to be filed by November 15, 2022, if an extension was granted. Otherwise, the statute of limitations expired on May 15, 2022.
• The changes caused by the 2021 amendment to the apportionment rule could affect companies’ tax provisions.
• Several of the previously issued letter rulings were superseded after the apportionment rule was amended but could be instructive in the aftermath of Sirius.
• Texas has historically used the term fair value to determine how receipts should be sourced for service revenue. This is somewhat similar to the term cost of performance except costs that do not directly produce receipts may be excluded. As a practical matter, most taxpayers just use cost of performance.

In determining fair value, all services should be considered including services provided electronically. In some situations, the only fair value applicable to sourcing revenue could be the value related to servers and software.

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