New regulations may retroactively affect your technology company’s tax burden. If you’re doing business in Texas, you’ll need to review your compliance with these updates.
Key insights
- Updated regulations from the Texas comptroller could have a significant impact on technology companies doing business in Texas.
- Your tax filing requirements in Texas depend on whether you’ve established nexus, and the definition has recently shifted to include economic nexus.
- Updated regulations dictate that software purchases can be considered tangible property, a service, or an intangible.
- These changes are applied retroactively, and could bring additional compliance requirements or may provide a tax savings opportunity for your company.
Could your technology company have new tax filing requirements in Texas?
After years of court cases and changing positions, the Texas comptroller recently updated their apportionment regulation, which includes major changes to how services are sourced.
The changes cover multiple industries and may be especially complicated for the technology industry. To fully grasp these changes, it is important to understand how Texas currently treats software companies, how these apportionment changes affect who files a Texas Franchise Tax Return, and what revenue is apportioned to and taxed by the state of Texas. Additionally, since the statute became effective in 2008, there may be retroactive implications to consider.
What is nexus?
With most states, a taxpayer may have a tax filing requirement once they’ve been determined to have a substantial connection to a state, known as nexus. This connection gives the state the right to subject the taxpayer to tax. The most commonly known nexus standard is a physical presence in the state, whether permanent or temporary, which would likely create nexus.
Are you subject to nexus in Texas?
After the 2018 South Dakota v. Wayfair Supreme Court decision, states are now starting to enforce economic nexus. This type of nexus is created based on a threshold of economic activity (i.e., sales) in a state, defined for the Texas franchise tax as $500,000 of in-state sales. This seems simple enough — until we start discussing proper sourcing of revenue against which to measure the threshold.
Apportionment and its effect on in-state taxes
Apportionment is a concept that determines — based on the level of activity a business has in a state — what percent of overall income a state can tax. This is accomplished by looking at an assortment of factors, so any tax due gets divided among all the states in which the business operates (using a set of ratios comparing in-state to out-of-state activity). The key for taxpayers is understanding the amounts sourced to the in-state activity for each specific ratio.
Apportionment has grown more complex over the years, due to states’ varying apportionment methods and sourcing rules. Ideally, apportionment rules would result in a company being taxed on 100% of its income across multiple states — no more, no less. However, due to differing rules by state, you can find yourself in a situation where your business is taxed on significantly more or less than 100%.
Sourcing the sales of tangible personal property to each state is relatively simple since they are sourced based on where the item is shipped. Services, on the other hand, are more complicated — states can use a myriad of different methods, such as “market sourcing” or “cost of performance.” But what about the software industry? Is software tangible personal property? Is it a service? Is it an intangible? It all depends on the state, and under the new Texas rules, it can be all three.
Texas apportionment rules
Texas provides a great example of this in their updated regulations.
Tangible personal property
If software is delivered on a disc or other tangible medium, it is treated as a sale of tangible personal property (sourced to the state to which it was purchased in store or shipped).
Intangible asset
If the software is transferred by any non-physical means (e.g., download), it is treated as the sale of an intangible asset, and those sales are sourced to the location of the payor which is defined as the legal domicile of the payor. If your customer is a corporation or LLC, the sale is sourced to the state of formation. If the customer is a partnership, trust, or joint venture, the sale is sourced to the entity’s principal place of business.
This location of payor rule may seem odd, but it might be beneficial for software clients to know where their customers are incorporated or headquartered — it might even save them tax by pushing revenue outside of Texas to common legal domicile states like Delaware or Nevada.
Service
That leaves us with software accessed online, also known as software-as-a-service (SaaS). Texas treats SaaS as the sale of an internet hosting service that is sourced to the location from which the customer accesses the SaaS, whether from their headquarters, regional offices, or homes. While Texas does not call this sourcing methodology “market sourcing,” it is functionally the same.
Why does this matter?
Your company may now face a “new” filing requirement in Texas due to this change in sourcing rules as you assess the amount of sales sourced to the state. Additionally, companies must now evaluate nexus against the established economic threshold of $500,000.
As noted above, this regulatory change affects a statute that was imposed starting in 2008. The state’s position is that the new interpretation applies to historical years and can create filing requirements, along with tax due for all open periods.
This change of apportionment for SaaS may provide benefits as well. Taxpayers who have historically sourced large amounts of receipts to Texas — where the work is being performed — could have an opportunity, as the new rules allow revenue to be sourced to other states, which could lower the Texas apportionment and tax due.
How we can help
This much should be clear: software sourcing is complicated in Texas. With these new complications, a state and local tax professional may be able to provide guidance to help you navigate these changes. Our team of tax professionals is here to help you dissect these changes and understand how they may impact you.