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December 19, 2014

2014-Issue 50—While the Streamlined Sales Tax Governing Board continues its efforts to nullify the current Supreme Court jurisprudence that governs state sales tax nexus laws, the state of Texas has opted to lower the bar for physical presence by incorporating modern facts into the Quill v. North Dakota narrative. In a recent State Office of Administrative Hearings ruling, a Texas Comptroller of Public Accounts administrative law judge (ALJ) found that a Utah business (the Taxpayer) had substantial nexus with Texas because it licensed electronically delivered software and images to Texas customers. The determinative factor was not the mode of software delivery. The ALJ’s decision hinged on the logic that the taxpayer conceded having tangible personal property in Texas by retaining all property rights in its license agreements.

The Business Activity Research Team (BART) within the Comptroller’s office conducted a nearly 10-year audit of a Utah corporation that sold computer software and digital content through the Internet. BART took the position that the Taxpayer’s licensing of computer software to Texas customers created a physical presence and substantial nexus. The Taxpayer disputed that contention because its business activities in Texas were limited to the delivery of computer software primarily through the Internet, the occasional delivery of software via common carrier, and attendance by personnel at two conferences in Texas. In addition to disputing the merits of the state’s nexus claims, the Taxpayer requested penalty abatement and sought insolvency relief because of the magnitude of the audit adjustment.

The Taxpayer’s Business

The Taxpayer’s COO testified at the Comptroller’s hearing that its software and digital content are licensed to customers and rarely sold. Its software licenses typically ran for an indefinite period of time and did not require a renewal. Furthermore, the Taxpayer did not sell software maintenance and did not charge for updates to existing versions of licensed software. Examination of the Taxpayer’s license agreements revealed many details that one would expect to see in a software license agreement. Purchasers were granted non-exclusive, non-transferable license to use the software. Customers were granted the right to make a limited number of backup copies and to use the software on customer-owned computers, but customers were not allowed to copy or unlawfully disseminate the Taxpayer’s software. Most of the agreements stated that the Taxpayer retained all rights to the licensed products, and some of the agreements stated that copyrights and intellectual property rights remained with the Taxpayer or its licensors. All of the license agreements contained language stating that the licensed products are the property of the Taxpayer.

Employee Activity in Texas

Four Taxpayer employees entered the state of Texas twice during the audit period. Both times the employees attended industry conferences in the state. The employees did not present at product exhibitions, solicit sales, or market products at either conference. Citing both the Scripto and Tyler Pipe cases, the ALJ found that the employees did not trigger nexus because they did not solicit sales (Scripto), market products or develop customer relationships (Tyler Pipe). The ALJ stated that any such solicitation or marketing activities would have created nexus.

While the ALJ’s decision did not hinge on that statement, it is a noteworthy comment because the applicable statutory nexus rules state that the “regular or systematic solicitation of sales” creates nexus. Also worth mentioning is the fact that the ALJ did not include the “regular or systematic solicitation of sales” nexus criteria when extensively quoting other nexus criteria in the same statute. While the activities of employees in the state did not satisfy the nexus standards articulated by the Supreme Court, the physical presence of the four employees in the state was not ruled de minimis. This comment by the ALJ suggests that BART would be within its rights to assert an aggressive and selective application of nexus laws to one-off and infrequent employee activities in the state.

The Software Agreements

The ALJ’s ruling turned on the nature of the software agreements, but the ALJ’s interpretation of the software agreements differed from the positions advanced by BART. BART focused on the inclusion of computer programs in the definition of tangible personal property. The ALJ stated that the statutory definition of tangible personal property did not automatically confer nexus. BART also advanced the position that the software licensing agreements were akin to a taxable lease because Texas customers possessed tangible personal property licensed by the Taxpayer. The ALJ once again disagreed with BART because the Taxpayer’s customers did not exclusively possess the software, and exclusive possession is a requirement for a taxable lease. Citing another Comptroller’s ruling, BART argued that there is precedent for treating a software license agreement like a lease, but the ALJ distinguished the instant case because the Taxpayer received one-time payments and there were no recurring payments that were analogous to a lease stream.

After a lengthy presentation of facts and analysis, this ruling appeared to be headed in a favorable direction. The ALJ sided with the Taxpayer after analyzing two seminal Supreme Court cases, refused to literally apply the plain language of the statutory definition of tangible personal property, and even rejected a seemingly analogous Comptroller’s ruling. These are all substantive determinations. Unfortunately, sales and use tax is notoriously form-over-substance based.

All of the software agreements “expressly provided that [Taxpayer] retained all other property rights to its products.” Because the Taxpayer retained all other property rights over its licensed software and did not dispute the fact that other property rights included tangible personal property rights, the ALJ found that the Taxpayer conceded that its software was tangible personal property. The decision came down to the phrase “all other property rights” in the software agreements.

Based on this logic, the Taxpayer had physical presence, and the ALJ applied the bright-line physical presence standard articulated inQuill. There was some discussion of the amount of software in the state. The ALJ reviewed the Taxpayer’s revenues and ruled that the amount of sales into Texas exceeded any reasonable de minimis threshold, thus the Taxpayer had nexus in Texas.

As one would expect, the ALJ denied the Taxpayer’s request for an interest waiver. Furthermore, the ALJ denied insolvency relief because the Taxpayer had positive cash flow even though it posted losses for tax purposes.

Alvarez & Marsal Taxand Says:

This audit was initiated by the Texas Business Activity Research Team. As you might guess, that is not a typical field audit division. BART is a group within the Comptroller’s office that focuses on nexus issues and out-of-state companies. In the past, BART focused on vessels, pleasure boats and airplanes used in interstate commerce or by corporate executives. At least in this case, BART focused on the form of modern commerce and not how transportation realities create physical presence. Other states have special audit divisions that are similar to BART, and this Comptroller’s hearing sets an example for how those states can evolve nexus auditing approaches.

The Taxpayer in this Comptroller’s hearing can certainly appeal this ALJ decision. For now, this ruling establishes an aggressive precedent for software companies that do not have Texas offices or employees and have Texas customers. The ALJ suggested that any solicitation or marketing at a single conference in Texas could create nexus (although this suggestion is not determinative). Ultimately, the ALJ’s decision turned on the use of the phrase “all other property rights,” so the Taxpayer’s retention of all property rights meant that its software licenses were tangible personal property. Both positions by the ALJ establish a very low bar for the bright-line physical presence standards needed to create substantial nexus. If other states latch on to the logic developed in this ruling, the ever-growing world of software, cloud computing and digital products may not have to wait for the passing of the Marketplace Fairness Act or another form of federal intervention. 


Scott Jackson
Senior Director, Atlanta
+1 404 260 4080

Craig Beaty, Managing Director, contributed to this article.

For More Information

Craig Beaty
Managing Director, Houston
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Benjamin Diaz
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John Easterday
Managing Director, Chicago
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Alejandro Joya
Managing Director, Miami
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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