State & Local Tax Alert: Texas Comptroller Finds Sales Tax Nexus Through Software Licenses

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State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP ________________________________________________________

Texas Comptroller Finds Sales Tax Nexus Through Software Licenses

The Texas Comptroller has affirmed an Administrative Law Judge (ALJ) decision that a

software company is required to collect and remit sales and use tax on its sales of software

licenses to Texas customers.1 The ALJ found that the presence of software in Texas

constituted nexus because the company owned tangible personal property in Texas

(although the software was licensed to other entities in Texas). The ALJ then determined

that the nexus was substantial because of the amount of fees generated by the tangible

personal property in the state.

Background

The taxpayer, a Utah corporation that sold computer programs and digital content

primarily through the Internet, also delivered products via common carrier, such as the

U.S. Postal Service. During the relevant period, the taxpayer sold multiple software

products to customers in Texas, but did not have employees or an office in the state. The

taxpayer’s employees had been in the state twice since 2002 for educational conferences,

but they did not solicit orders while in Texas.

Computer programs generally were not purchased by customers, but were licensed to the

customers so that they had a limited right to use the program or content on a limited

number of computers. Thus, the purchase and use of the taxpayer’s products were

governed by license agreements. All of the agreements provided that the licensed

products remained the property of and proprietary to the taxpayer. Also, most of the

agreements explicitly provided that the taxpayer retained all rights in, title to, and

ownership of the licensed products.

Under Texas law, an out-of-state retailer who is engaged in business in Texas and who

makes a sale of a taxable item for storage, use, or consumption in Texas is required to

collect use tax from the purchaser.2 The scope of being engaged in business in Texas is

1 Decision, Hearing Nos. 106,632, 108,626, Texas Comptroller of Public Accounts, Sept. 19, 2014 (released Nov. 2014). Note that Texas has a unique system for contested tax cases. The Texas Comptroller can refer a contested case to the State Office of Administrative Hearings (SOAH). ALJs from the SOAH conduct administrative hearings and then prepare a Proposal for Decision (PFD) regarding the contested case. The Comptroller then decides whether to accept or reject (in whole or in part) the PFD. If the taxpayer disagrees with the Comptroller’s decision, the case may be appealed to the state district court. 2 TEX. TAX CODE ANN. § 151.103(a).

Release date

February 18, 2015

States

Texas

Issue/Topic

Sales and Use Tax

Contact details

John LaBorde Houston T 832.476.3605 E [email protected] Pat McCown Dallas T 214.561.2350 E [email protected] Terry Gaul Houston T 832.476.5088 E [email protected] David Somerville Houston T 832.476.3601

E [email protected]

Annie Kuntz Houston T 832.487.1418 E [email protected] Jamie C. Yesnowitz Washington, DC T 202.521.1504 E [email protected] Lori Stolly Cincinnati T 513.345.4540 E [email protected] www.GrantThornton.com/SALT

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fairly broad and includes the following catchall phrase: “otherwise [doing] business in this

state.”3

The Comptroller reasoned that because the software is tangible personal property under

Texas law,4 the taxpayer’s tangible personal property was physically present in the state,

and the taxpayer had derived receipts from the property, that the taxpayer had substantial

nexus with Texas.5 Because of the substantial nexus, the taxpayer had the obligation to

collect use tax from its Texas customers. Subsequently, the Comptroller found that the

taxpayer had failed to collect tax on its sales in Texas and assessed taxes, penalties and

accrued interest for the period from January 1, 2002 through June 30, 2010. After this

assessment, the taxpayer began collecting tax. The taxpayer brought this action seeking a

waiver of the penalties and a refund for taxes remitted after June 30, 2010. According to

the taxpayer, it was not required to collect tax because it did not have substantial nexus

with Texas.

Taxpayer Had Substantial Nexus

The ALJ used the Complete Auto test to determine the validity of the Comptroller’s

assessment.6 Under this test, a tax will be sustained against a Commerce Clause challenge

so long as the tax “is applied to an activity with a substantial nexus with the taxing state, is

fairly apportioned, does not discriminate against interstate commerce, and is fairly related

to the services provided by the state.”7 The ALJ quickly dismissed the last three prongs of

the test by explaining that “it is well settled that the Texas use tax is fairly apportioned,

does not discriminate against interstate commerce, and is fairly related to the services

provided by the state.” Therefore, the remaining issue in the case was whether the

taxpayer had substantial nexus with Texas.

The ALJ did not find that the employees’ conference attendance was a possible source of

nexus because they were present in Texas only to learn about developments in the

industry. However, the ALJ found that the taxpayer did have nexus with Texas because it

had tangible personal property in the state. Software is tangible personal property for sales

tax purposes in Texas.8 The software still belonged to the taxpayer because the license

agreements explicitly provided that the software remained the taxpayer’s property after sale

and download.

3 TEX. TAX CODE ANN. § 151.107(a). 4 TEX. TAX CODE ANN. § 151.009. The statute provides that “‘[t]angible personal property’ means personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner, and, for the purposes of this chapter, the term includes a computer program and a telephone prepaid calling card.” (Emphasis added.) 5 This reasoning is further bolstered by 34 TEX. ADMIN. CODE § 3.286(a)(2), which provides “a person is engaged in business in Texas if the person has nexus with the state as evidenced by … [deriving] receipts from a rental or lease of tangible personal property that is located in this state or [owning] or [using] tangible personal property that is located in this state, including a computer server or software.” 6 Complete Auto Transit v. Brady, 430 U.S. 274 (1977). 7 Id. 8 TEX. TAX CODE ANN. § 151.009.


Nexus must be substantial for the state to have the authority to impose a tax. The ALJ

looked to Quill Corp. v. North Dakota in the nexus analysis.9 In Quill, the taxpayer had title

to floppy diskettes in the state, but there were so few that the U.S. Supreme Court refused

to find substantial nexus. The ALJ in this case found that the fees generated from Texas

licenses were large enough to establish substantial nexus. The decision redacted the fee

amounts, so it is unknown what dollar amount the ALJ (and by affirming the decision, the

Comptroller) believes constitutes “substantial.”

The ALJ agreed with the Comptroller except for the Comptroller’s characterization of the

licensing of software as a lease. The ALJ explained that in order to be a lease for tax

purposes, a party must have exclusive possession and control, but not title to, the

property.10 However, the fact that the taxpayer’s customers had non-exclusive licenses to

use the property meant that they were not leasing the property. The ALJ did not re-

categorize the property – it only noted that the software would be classified as tangible

personal property. There was no subsequent discussion, for example, if the transactions

remained subject to sales/use tax as “a transfer of title or possession of tangible personal

property”11 rather than as “the exchange, barter, lease, or rental of tangible personal

property.”12 The ALJ focused his analysis solely on the nexus issue at hand.

Apparently, the taxpayer did not challenge the statutory characterization of software as

tangible personal property, and such statute does not make any distinction in

characterization between software downloaded electronically or delivered in a physical

media form (e.g., disk).13

In summary, the ALJ found that the taxpayer had physical presence in Texas to a degree

that constituted substantial nexus. Following a finding that the taxpayer was not entitled

to insolvency relief or an interest waiver, the ALJ recommended that the assessments be

affirmed and no refund be issued. The Texas Comptroller agreed with the ALJ, making

this hearing decision consistent with long-standing Comptroller policy.14

Commentary

This decision has potentially far-reaching consequences assuming that it is not appealed

and reversed in the judicial process. To be in line with the Comptroller’s policy, out-of-

state companies who license software in Texas must collect use tax. As it is common to

use licenses instead of selling the software outright, many companies are required to

collect use tax.

One problem with relying on this decision in the future is that the amount of fees

generated by the licenses was not disclosed by the ALJ, just that nexus was substantial in

this instance. Based on Quill, it is clear that some presence does not automatically mean

9 504 U.S. 298 (1992). 10 34 TEX. ADMIN CODE § 3.294. 11 TEX. TAX CODE ANN. § 151.005(1). 12 TEX. TAX CODE ANN. § 151.005(2). 13 TEX. TAX CODE ANN. § 151.009. 14 There are numerous prior hearing decisions holding that licensing tangible personal property and deriving receipts from the licenses creates nexus in Texas. For example, see Decision, Hearing No. 36,237, Texas Comptroller of Public Accounts, July 21, 1998.


the presence is substantial. However, after this decision, it is unclear what amount of

receipts the Comptroller deems to be substantial prior to a finding of substantial nexus.

Importantly, this decision is not binding on Texas courts. While this decision represents

the Comptroller’s current policy going back at least to a prior hearing decision from

1998,15 this issue of software licenses creating nexus does not appear to have been

challenged in court. Perhaps the taxpayer in this case or other similarly situated software

company will choose to take this matter to the state district court.

Finally, while computer software is considered to be tangible personal property for sales

tax purposes in Texas, such classification does not necessarily carry over for other Texas

taxes.16 Computer software may be treated, for example, as tangible personal property for

Revised Texas Franchise Tax (RTFT) cost of goods sold deduction purposes,17 as an

intangible asset for RTFT apportionment purposes18 and as intangible personal property

for Texas property tax purposes.19 Each of these classifications presents potential

opportunities to taxpayers as well as traps for the unwary.

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15 Decision, Hearing No. 36,237, Texas Comptroller of Public Accounts, July 21, 1998. 16 TEX. TAX CODE ANN. § 151.009. 17 TEX. TAX CODE ANN. § 171.1012(a)(3)(A)(iii). 18 34 TEX. ADMIN. CODE § 3.591(e)(3). 19 TEX. TAX CODE ANN. § 1.04(6).