On March 24, 2011, the Texas Comptroller issued a taxability letter ruling clarifying the intent of an amendment to its administrative rule on sales and use tax nexus.1 Texas had amended this rule to add language that owning or using tangible personal property located in the state, including a computer server or software, causes an out-of-state seller to be engaged in business in Texas and required to collect sales and use tax.2 The rule amendment raised many concerns and questions about nexus by taxpayers and tax practitioners because of the broad meaning that could be given to the language regarding "use" of tangible personal property in Texas. The Texas letter ruling addresses some of these questions and concerns, and indicates that Texas is working on amending the rule again for further clarification. As part of the process of amending the rule, Texas is undertaking an analysis of what types of digital content located in Texas will be regarded as tangible personal property and cause an out-of-state seller to have nexus.

Hosting a Web Site on a Third-Party Server in Texas Does Not Create Texas Sales/Use Tax Nexus

Texas taxes software as tangible personal property regardless of whether it is canned or custom software.3 An out-of-state seller is considered to be engaged in business in Texas and required to collect Texas sales or use tax if the seller has a warehouse or otherwise stores tangible personal property that they own in Texas. In addition, an out-of-state seller who derives receipts from the rental or lease of tangible personal property located in Texas is considered to have nexus.4 Texas has previously taken the position that the receipts from the licensing of software located in Texas is effectively the rental or lease of tangible personal property and causes the software licensor to have nexus.5 Texas also does not distinguish tangible personal property in an electronic or digital form and taxes it as tangible personal property.6 For instance, the sale of digital music, photographs and video are taxable in Texas even if delivered to the customer electronically.

The recent letter ruling issued by the Texas Comptroller discusses the intent of the rule amendment to treat software and servers similar to other tangible personal property with respect to nexus and explains that it was meant to be a clarification of existing policy under the current law, rather than a change in the interpretation of the law. The letter ruling acknowledges that since issuing the rule amendment, Texas has received numerous inquiries about the "use" of a "server" causing a person outside Texas to be engaged in business and thus responsible for collecting Texas sales or use tax.

The letter ruling did not attempt to resolve all of the questions that the amendment of the rule has raised. However, in the letter ruling, the Texas Comptroller determined that an out-of-state seller whose only presence and business activity in Texas is limited to having a Web site on a third-party server in Texas, in which the third-party provides all the functionality of the Web site, does not have sales and use tax nexus in Texas.7 In this situation the out-of-state seller would not be required to collect Texas use tax on taxable items shipped or delivered into Texas to customers by common carrier.8

Commentary

The Texas Comptroller's attempt to clarify its sales and use tax nexus rule with respect to software and computer servers to be consistent with existing policy and the current law has led to many questions and concerns. While owning tangible personal property in Texas is a relatively bright line for nexus, the meaning of "use" of tangible personal property, particularly a server, can have implications for out-of-state sellers shipping taxable items in Texas by common carrier and not collecting Texas sales or use tax.

The Comptroller's recent letter ruling is limited to the nexus treatment of out-of-state sellers hosting a Web site on a third-party's server in Texas. However, Texas is analyzing what type of digital content will cause a seller to be engaged in business in Texas and is planning to amend the rule again to hopefully clarify the outstanding questions.

Based on how Texas has treated software as tangible personal property with respect to creating nexus in Texas, it is likely that out-of-state sellers of digital products such as music, photography, and videos will be considered to have nexus in Texas by virtue of having these digital products stored on a computer server located in Texas. In making the attempt to treat all tangible personal property in a similar way, Texas appears to be comparing the electronic storage of software and other digital content in Texas to an out-of-state seller storing its products in a warehouse located in Texas. Texas regards storage by a seller of tangible personal property even in a third-party warehouse located in Texas as sufficient to create nexus, so it is likely Texas will take that same position with respect to software and digital products stored on third-party servers.

However, out-of-state sellers who pay third-party service providers to store the seller's data on a Web site on a server located in Texas may be on safer ground. Texas appears to be limiting the application of the rule amendment to property, such as software and digital products, that is considered tangible personal property under its current sales tax law.

Texas should amend its sales and use tax nexus rule to clarify what digital content is considered tangible personal property that would trigger nexus if stored on servers in Texas. It would also be helpful for the rule amendment to fully address what is meant by "use" of tangible personal property in Texas, specifically whether Texas intended to classify the rental or lease of tangible personal property, such as a server, located in Texas as a "use" of tangible personal property that triggers nexus. Otherwise, questions and concerns will remain regarding whether utilizing third-party service providers to store data, other than Web sites, on a third-party's server located in Texas is the "use" of tangible personal property contemplated in the rule amendment.

Hopefully, further guidance from the Comptroller will clarify the current state of affairs. In the meantime, companies that do not want sales and use tax nexus with Texas should be cautious about having their software or digital products stored on servers in Texas, and likewise, should keep their equipment, particularly servers, outside Texas. Companies should also be careful in any agreements with third-party service providers to have the agreements cover services only (e.g., data processing services) and not have any separate charges that are for the actual "rental" or "lease" of the servers.

Footnotes

1 Taxability Letter Ruling, STAR document 201103016L.

2 34 TEX. ADMIN. CODE § 3.286(a)(2)(E), amendment effective July 11, 2010.

3 TEX. TAX CODE ANN. § 151.009.

4 34 TEX. ADMIN. CODE § 3.286(a)(2)(E).

5 Administrative Hearing 36,237, STAR document 9807720H.

6 TEX. TAX CODE ANN. § 151.010.

7 Texas treats the service of third-party hosting of Web sites (for example, the service of creating "HTML" documents, scanning information and graphics, as well as maintaining such files on a server) as data processing services. Taxability Letter Ruling, STAR document 9707608L. Data processing services are taxable in Texas, although a 20 percent exemption is provided for these services. TEX. TAX CODE ANN. §§ 151.0035, 151.0101 and 151.351. A company that purchases data processing services for the benefit of its operations outside of Texas may claim a multistate benefit exemption by giving the service provider an exemption certificate. The purchaser is then responsible for reporting and paying Texas use tax on the portion of the service in which the benefit of use is in Texas. 34 TEX. ADMIN. CODE § 3.330(f).

8 Note that owning, leasing or renting a server in Texas would result in nexus. Taxability Letter Ruling, STAR document 9806518L.

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