Matt Graham is a senior manager at Moss Adams in Seattle and teaches a graduate-level accounting class at Gonzaga University.
In this article, Graham examines the Texas Sirius XM case and the complex challenges of state tax compliance.
Copyright 2023 Matt Graham.
All rights reserved.
The Marquis de Lafayette, a key figure in the American Revolutionary War era, said, “Laws must be clear, precise, and uniform for all citizens.” As a society, we fundamentally agree on this precept and strive toward its ideals, but we fall short more often than we would like to admit. One area where we fail to embody these ideals wholeheartedly is state tax law.
Using modern technologies and online marketplaces, people are doing business across state borders more than ever. When taxpayers venture outside their home states, they’re confronted with a complex patchwork of state and local tax jurisdictions with different laws — or similar laws but varied interpretations. Doing business in more than one state can be a complex endeavor regarding state taxation, even before considering the more nuanced issues. This brings us to the Sirius Problem.
The Sirius Problem is not just a play on words. It refers to the outcome in the Texas Supreme Court decision in Sirius XM Radio,1 wherein the court struck down the comptroller’s interpretation of a sales sourcing statute primarily on the grounds that it was inconsistent with the plain language of the statute. In the wake of Sirius XM, I couldn’t help but ask how taxpayers are expected to comply with state tax laws in situations in which the law plainly states one thing, but the tax agency charged with its administration has — often through a series of nonbinding administrative rulings or guidance — interpreted it another way inconsistent with its meaning.
Sirius XM was a turning point for the comptroller’s office because the plain meaning rule of statutory interpretation won out over the comptroller’s position, which some people view as results-oriented. While it would be nice to say that everything is now right in the world and we can all move on with our day, the sad truth of the matter is that this aberration is not an outlier.
I’ll delve into Sirius in more detail and provide examples of when the plain meaning rule may strike again. This analysis isn’t a call to arms; it’s a reflection on what we can learn from the case, and how we can aspire to heed the words of Lafayette and promote a system in which the laws are clear, precise, and uniform for all.
The Sirius Case
Sirius XM provides subscription-based satellite radio services such as music, podcasts, news, and shows to customers everywhere, including Texas. This content is produced and transmitted primarily from locations outside Texas. The question reviewed by the Texas Supreme Court was whether Sirius’s services should be attributed to the locations of its employees and equipment — the infrastructure that makes the service possible — or the location where the signal is decrypted in the satellite-enabled radio and received by the customer — the location of receipt of the service.
The Texas franchise tax apportionment statute established in 1959 addresses the issue: “The gross receipts of a taxable entity from its business done in this state is the sum of the taxable entity’s receipts from . . . each service performed in this state.”2 While this sourcing rule seems simple enough, the comptroller began applying what it called the receipt-producing, end-product act test in administrative guidance in the early 1980s.3 A series of comptroller decisions were published through 2017 generally following the same logic with one outlier.4 Then came Sirius.
In 2018, the comptroller’s office audited Sirius XM and determined it should attribute receipts based on the location of its subscribers, not based on where its programs are produced and transmitted. Sirius was assessed over $2.5 million in tax on the grounds that the “service performed in this state” was the service of “unscrambling” the radio signal. Sirius paid the assessment and sued for a refund. The district court issued its opinion in favor of Sirius but the comptroller appealed. The Texas Court of Appeals reversed the district court’s decision and found in favor of the comptroller. Sirius petitioned the Texas Supreme Court for review and the writ of certiorari was granted.
The supreme court’s opinion follows a simple approach, which is to look at the plain meaning of words in a statute when it does not define a term. In this analysis, the court concluded that the concept of performance requires an overt act by the taxpayer accomplished through the taxpayer’s property and personnel to collectively deliver the service.
The court also points out that the receipt-producing, end-product act test functions in a way that elevates the technicalities of the transaction, the decryption of radio signals, over the economic reality of the service performed, which is providing radio production and broadcasting services. When looking at the economic substance of the transaction, the court explained that while the result of the customer paying for a subscription to Sirius is the ability to receive decrypted radio programming, “those customers want to listen to radio content. They do not want decryption.” The court sums up this analysis beautifully with an analogy:
Characterizing the service Sirius performs for Texans as “decryption of radio sets in Texas” is like saying the service performed by The Wall Street Journal Online is a “paywall-removal service,” rather than the creation and distribution of news and opinion content its subscribers want to read. But Sirius is no more in the “decryption business” than The Wall Street Journal is in the “paywall-removal business.” Both impose an artificial barrier to render more profitable what would otherwise be a freely available — and perhaps economically unviable — product. No one would pay for Sirius’s decryption without Sirius’s radio content. No one would need to pay for Sirius’s radio content without decryption, but the radio content would still be a valuable service. Encryption allows Sirius to capture a share of that value, but decryption is obviously not the useful labor that Sirius performs.
The court explained that even if decryption were the relevant service, it still would not be performed in Texas because the activation signal for customers’ devices comes from outside the state and the radios that decrypt the signal are owned by the customers. Put another way, Sirius can’t be performing a service using equipment it does not own or control, thus there is no overt act performed by Sirius at a radio’s location. Thus, the court found in favor of Sirius.
The Sirius Archetype
The Sirius XM issue — wherein the law is interpreted in a manner that appears to be prima facie inconsistent with the plain meaning of the text — forms the basis for the archetypal issue I call the Sirius Problem. The problem isn’t just in Texas; it can be found in every state and regarding every tax. Some of the Sirius Problems in state tax law are less troublesome or damaging to taxpayers than others so that there is arguably a spectrum of Sirius Problems ranging from “blatant disregard for the law” to “reasonable minds may differ.” Many of these issues fall somewhere in the middle.
At this point, you might be wondering how understanding tax issue archetypes and an analysis of Sirius Problems will help with your sales tax return this month. The point I’m trying to make here is twofold. First, things aren’t always what they seem when it comes to state tax law. Companies with significant multistate activity should work closely with their SALT consultants to avoid being caught off guard by these legal nuances.
Second, taxpayers, legislators, and tax agencies should use Sirius Problem reckoning events, like the Texas court holding, to understand how we can all contribute to improving the state tax compliance environment. These improvements may include more proactive legislative clarifications on contentious issues that could preempt drawn-out court battles, and stakeholder meetings to improve relationships between taxpayers and tax agencies.
Understanding the common characteristics of these types of interpretive tax issues and naming them helps us describe them quickly, recognize them, do something about them, and facilitate the compilation of an inventory of them across the different states and tax types. Also, calling these types of situations Sirius Problems is more fun than calling them by a more neutralized scholarly term such as potential interpretative violations of the plain meaning rule subject to judicial review and revision.
The Sirius Analogs
When looking at the broad inventory of Sirius Problems in SALT, one area of tax law that consistently comes up is the issue of how to situs the sale of services. Determining which state the sale is attributable to based on the law of the jurisdiction in question was the concept at issue in Sirius XM. Following are a few examples of Sirius Problems regarding sales sourcing in other states when similarly unsettled tax law interpretations have created a complex compliance environment.
While the issue in Sirius represents a tax agency trying to reach a market-based sourcing outcome with an origin-based sourcing law, there are examples of states taking the inverse position. For example, the Washington business and occupation (B&O) tax is a gross receipts tax imposed on sales attributable to the state.5 Generally, receipts taxable under the service and other B&O tax classification include professional consulting services and are attributable to where the customer receives the benefit of the service, as with market-based sourcing.6
In cases in which the taxpayer’s service does not relate to real or tangible personal property, the service is provided to a customer engaged in business, and the service relates to the customer’s business activities, then the benefit is received where the customer’s related business activities occur.7 The examples provided in the sourcing regulation reasonably posit situations in which the work may be performed in one state but the benefit is received in another state and the receipts are attributed to where the benefit is received, not where the work is performed. However, in 2017, the Washington Department of Revenue published a statement asserting that taxpayers should generally attribute receipts from providing staff augmentation services to the locations where the supplied staff is physically located unless the circumstances indicate that the customer controls the supplemental staff from a different location.8
In practice, the Washington DOR has used the interim staff augmentation guidance to deny refund claims, asserting that the benefit of staffing services related to a customer’s advertising functions performed in Washington may be attributed outside the state to the customer’s related market for the product or service advertised. This is essentially the mirror image of Sirius, in that the guidance is arguably trying to elevate the technicalities of the transaction — namely services performed in a specific location under a staffing model — over the economic reality of the service performed as applied to the tax law, which is that the customer received advertising-related services that benefited customers inside and outside the state.
However, in a remarkable plot twist, a recent draft version of the updated sourcing regulation for service income contains a singular example that states: “Example 22. Staffing Co. contracts with ISP Inc., an internet service provider, to provide supplemental marketing employees at ISP’s sole office in State A. ISP sells internet services in States A, B, and C. The activities of Staffing Co.’s employees are promoting ISP’s products. ISP receives the benefit of Staffing Co.’s service in ISP’s market, which in this case is States A, B, and C.”9
The inclusion of this example in the draft updated regulation, which is wholly contradictory to the Washington DOR’s 2017 interim guidance, is likely the result of an embattled DOR trying to course-correct to a more defensible position and is tacitly understood by practitioners to be the correction of a Sirius Problem. This is arguably a good example of how stakeholder discussions and litigation can contribute to resolving a Sirius Problem.
On the flip side, the DOR has simultaneously tried to assert that out-of-state taxpayers providing the same type of services should attribute a portion of their receipts to Washington on the grounds that a portion of the benefit is received in Washington, even when the customer had no business operations within the state. While arguably this application to non-Washington companies is precisely how the sourcing rules are intended to function, it’s one example of how potentially selective enforcement can result in heterogenous outcomes.
Florida is another state that struggles with a Sirius Problem nearly identical to the issue in Sirius XM. In a technical assistance advisement,10 the Florida DOR discussed how the state’s statutes provide a standard income-producing activity sourcing rule, generally understood to be an origin-based, cost of performance, sourcing rule, but that other states such as Arizona and Wisconsin have gone so far as to assert that the income-producing activities were the actual sale of services to its customers, as opposed to the costs of performing those services. Florida’s advisement goes on to explicitly state: “In analyzing the income producing activity, the most important factor to determine is where the customer is located.”
This approach is generally counterintuitive to how these statutes were originally designed in 1966 by the Multistate Tax Compact, which understood that these rules created an origin-based sourcing framework. Further, the compact has been moving toward market-based sourcing in conjunction with economic nexus principles given that the two concepts generally work together.11
Until recently, Florida seemed to be going down the same path Texas did in Sirius, doubling down in litigation, and many of us in the tax practitioner community wondered whether the Florida DOR would also have a day of reckoning like that of the Texas comptroller. That reckoning came in November 2022 when the circuit court of the second judicial district for Leon County, Florida, issued its opinion in the case of Target Enterprises.12
Target Enterprises Inc. (TEI) is a separate and distinct legal entity from the Target store brand and provides administrative support services to Target store locations from its offices in Minnesota. In this case, the “DOR contended that TEI was required to attribute its service receipts to Florida based on a fraction the numerator of which was the retail square footage of Target stores in Florida and the denominator of which was the retail square footage of Target stores across the country.” The Florida DOR alleged that it used this method on the grounds that TEI had not provided sufficient documentation to determine sourcing based on the costs of performance and was therefore entitled to use a reasonable method.
However, the audit documentation never claimed that the documentation provided by TEI was insufficient. Thankfully, justice prevailed, and the court concluded that TEI’s income-producing activity took place at the out-of-state location where its employees provided the services rendered in lieu of using the DOR’s proposed square footage method. In the opinion, the court admonished the Florida DOR, writing: “This Court finds that DOR’s proposed apportionment methodology bears no relevant relationship to TEI’s business activity in the State of Florida.” It pointed out that the “DOR’s proposed formula conflates Target’s business activity in Florida with TEI’s business activity.” How the DOR will approach these issues in the future is yet to be seen, but with optimism and caution I say this Florida Sirius Problem may be resolved.
Like Florida, South Carolina uses a similar sales sourcing rule that looks to the location of the income-producing activity, but the Legislature stopped short of including the phrase “based on costs of performance” as part of the rule.13 In the 2016 Dish DBS case, the South Carolina Court of Appeals found that the income-producing activity of a satellite television service took place where the subscribers were located and not where the taxpayer’s other income-producing activities — programming, satellite uplinks, advertising, installation, and call centers — took place.14 In reaching its decision, the court relied heavily on expert testimony that income was generated when the signal was delivered to the customer’s satellite receiver. However, South Carolina’s position in this case suffers from the same interpretive deficiency that we saw in Sirius, in that the concept of performance or activity theoretically requires an overt act by the taxpayer using its property or labor, and ignoring that basic definition can make a sourcing rule difficult for taxpayers to apply consistently.
These are a just a few of the many examples of Sirius Problems out there and this article only scratches the surface of the uncomfortable reality that these problems often function as metaphorical land mines for unsuspecting taxpayers.15
The Origin of the Sirius Problem
As the examples show, Sirius Problems present significant SALT compliance barriers for taxpayers to navigate without skilled professional help. How did we get here? While reasonable minds may differ on this topic, there is a slew of factors that have likely contributed to this environment.
One of the most significant contributing factors worthy of its own discussion is the broad trend of states moving toward outsourcing their tax bases to nonresidents. They are doing this through economic nexus rules, market-based sourcing for services, single-sales-factor (SSF) apportionment formulas, and aggressive interpretations around Public Law 86-272, which limits states’ ability to impose a tax measured by net income if the only activity taking place in the state is soliciting the sales of tangible personal property.
The first three concepts, economic nexus, market-based sourcing, and SSF apportionment, have traditionally been enacted by states simultaneously because the concepts work together to shift the tax base to taxpayers outside the state. For example, Washington simultaneously enacted market-based sourcing, SSF apportionment, and economic nexus thresholds for service B&O taxes effective in June 2010. In that process, the Legislature was clear that the intent was to use this multipronged approach to increase the amount of tax paid by non-Washington companies relative to the volume of business they do with Washington customers.
The Washington approach can be juxtaposed with the Texas approach, which has been to continue to use SSF apportionment for the margin tax without also enacting market-based sourcing or economic nexus rules. It’s unclear why the Texas Legislature did not update the economic nexus and sales sourcing rules to achieve the maximum effect of outsourcing the tax base as other states have done. I can’t opine on this outcome, but it’s reasonable to infer this misalignment in Texas may have contributed to the continued use and expansion of the end-product act test during the rising popularity of market-based sourcing in the last 15 years.
South Carolina, as mentioned earlier, has also taken an aggressive interpretation around the idea of where an income-producing activity takes place. It’s another misaligned state in that the Legislature has enacted SSF apportionment and uses an economic nexus rule, but for whatever reason never updated the sales sourcing rules to reflect a clear market-based sales sourcing approach. In both Texas and South Carolina, it appears the state tax agencies may have tried to step in and fill the gaps to align tax policy more closely with stated legislative goals.
Unrelated to these trends, California recently published technical advice memorandum 2022-01, which takes a far more aggressive interpretation of P.L. 86-272. This memorandum tries to assert that a customer’s ability to interact with features on a taxpayer’s website, such as a customer service chatbot, is an activity that takes place in California and isn’t ancillary to sales activity, so that a taxpayer would no longer be protected for income tax purposes under P.L. 86-272.
This brings us back to this concept of where an activity takes place. Under the analysis provided by the Texas Supreme Court, California would arguably be in violation of the plain meaning rule because the taxpayer is not acting through persons or property in the state. California may be the first state to take this step regarding P.L. 86-272, but it likely will not be the last, because other states have communicated that they, too, are looking to follow suit.
Apart from the trends in the income and franchise tax apportionment world, other factors that may have contributed to the strained state tax landscape include structural issues such as:
Many state taxes were enacted in an era in which goods were the predominant economic medium, and the country has continued to move toward a services-based economy, eroding a significant portion of many states’ tax bases.
State tax agencies are under tremendous pressure to increase tax revenue, resulting in increasingly broad interpretations of imposition statutes and increasingly narrow interpretations of exemption or deduction statutes.
It is politically safer to quietly pursue expanded interpretations of tax laws through executive branch directives to increase the tax base instead of enacting legislation that explicitly increases the tax burden on the public, even though both have similar outcomes.
Many states don’t offer an independent administrative review of state tax agency actions, further emboldening tax agencies to take positions they know taxpayers will not appeal all the way up the court system because of the cost.
State tax agency employees’ individual performance is sometimes measured by the volume of tax assessed, with less focus on the accuracy of their work or the quality of service provided. This can be likened to questions around the ethics of giving police officers ticket quotas.
An analysis of how we came to have so many Sirius Problems could go on for pages. Regardless of how we got here, the fact is we need to start an honest albeit uncomfortable dialogue about how we fix what some people view to be a broken system. We can’t continue softening the hard realities of that uncomfortable truth. We should look again to Lafayette for wisdom. He said, “I read, I study, I examine, I listen, I think, and out of all that I try to form an idea into which I put as much common sense as I can.”
Tax law is hard enough as it is and having tax law that follows the plain meaning of the words is just common sense.
1 Sirius XM Radio Inc. v. Comptroller of Public Accounts, 643 S.W.3d 402 (Tex. 2022).
2 Tex. Tax Code section 171.103(a)(2).
3 Texas Comptroller of Public Accounts, Hearing No. 10,028 (Nov. 27, 1980).
5 See generally Wash. Rev. Code section 82.04.
6 Wash. Admin. Code section 458-20-19402(301).
7 Wash. Admin. Code section 458-20-19402(303)(c).
8 Washington DOR, Interim Statement Regarding the Attribution of Receipts From Apportionable Staff Augmentation (June 22, 2017).
9 Draft of updated Wash. Admin. Code section 458-20-19402 (WSR 21-22-032).
10 Florida DOR, Technical Assistance Advisement 20C1-001 (2020).
11 Multistate Tax Commission, “Review of MTC Model Sales/Receipts Sourcing and Special Industry Regulations,” Draft Report to the Standing Subcommittee (July 21, 2022).
12 Target Enterprises Inc. v. Florida Department of Revenue, No. 2021-CA-002158 (Fla. Cir. Ct. Nov. 29, 2022).
13 S.C. Code. section 12-6-2295(A)(5).
14 Dish DBS Corp. v. South Carolina Department of Revenue, 2016-001642; 2018-UP-404 (S.C. Ct. App. 2018).
15 Other Sirius Problem examples worth mentioning: Vodafone Americas Holdings Inc. v. Commissioner of Revenue of Tennessee, Dkt. 07-1860-IV (Tenn. Chancery Ct. 2013); Griffith v. Conagra Brands Inc., 728 S.E.2d 74 (W. Va. 2012) (citing Tax Commissioner v. MBNA America Bank, 640 S.E.2d 226 (W. Va. 2006) (cert. denied, 551 U.S. 1141 (2007))); AT&T Corp. v. Department of Revenue, 358 P.3d 973 (Ore. 2015).