Texas Rules That Taxpayer is Providing Taxable Data Processing Services

Whether a particular service should be classified for sales tax purposes as an exempt information service or a taxable data processing service is not always clear, and choosing incorrectly can result in unexpected sales tax exposures.

By Jess Johannesen, SALT Manager

As technology continues to evolve and reshape the way that businesses operate, state tax laws often struggle to keep the same pace.  As more products and services can now be provided electronically and/or remotely via software-as-a-service (SaaS), it has become increasing difficult to determine the proper classification of a particular service, most notably in situations where the offering contains elements of two or more services, one of which is taxable and one of which is not.  This can lead to situations where a business does not collect sales tax when it should have.

A recent case from the Texas Court of Appeals illustrates this conundrum in which the taxpayer argued that its online management solution should be treated as an exempt information service, but Texas ultimately held that the solution should instead be treated as a taxable data processing service.[1]

The taxpayer in the case provides online management solutions to customers in the food-service industry.  The solutions typically included information on each customer’s procurement, manufacturing, inventory and sales.  The taxpayer would obtain raw data from the customers and their vendors, and the taxpayer then used its own algorithms to process and present the data in a user-friendly format intended to, “help [the taxpayer’s] customers run their businesses.”  The customers would access the solution via a secure website to obtain summarized reports.

Texas regulations define an information service as “furnishing general or specialized news or other current information, including financial information, by printed, mimeographed, electronic, or electrical transmission, or by utilizing wires, cable, radio waves, microwaves, satellites, fiber optics, or any other method now in existence or which may be devised, and electronic data retrieval or research.”[2]  Such services are generally taxable but there are certain exemptions.  In particular, “the sale of information that is gathered or compiled on behalf of a particular client is not subject to tax if the information is of a proprietary nature to that client and may not be sold to others by the person who gathered or compiled the information.”[3]

A taxable data processing service is defined as “the processing of information for the purpose of compiling and producing records of transactions, maintaining information, and entering and retrieving information.”[4]

The taxpayer argued that its solutions are properly classified as an “information service” that is exempt since the customer is paying for information that is proprietary in nature and will not be sold to other parties.  While the taxpayer recognized that in order to provide the information in the format desired by the customer it had to perform some data processing, it contended that such data processing is merely a “constituent component” used to provide the information service.  Ultimately, the taxpayer’s position was that the essence of the transaction was, “the conveyance of an ‘online management solution; or a ‘consulting report,’ and not the provision of a data-processing service.”

The state disagreed, pointing out that the contracts provide that customers pay the taxpayer to, “collect the Customers’ data, reformat and aggregate the data, enter data into [the taxpayer’s] databases, search for data relative to Customer’s desired reports, cull unnecessary data, compile data, manipulate data, store data, and backup data.”  The state argued that the value of the taxpayer’s service lies within the collection and manipulation of the data to provide a user-friendly format to assist customers with various management tasks.  Data processing was not “ancillary” to the taxpayer’s provision of some other service.

Ultimately, the Court agreed with the state, concluding that the taxpayer’s services are taxable data processing services as opposed to nontaxable proprietary information services.  This case illustrates the complexities of determining how your products or services may be treated for sales tax purposes.  Some states may ultimately consider this taxpayer’s solution to be a data processing service, an information service, or even SaaS or some type of software license depending upon the state’s rules and definitions and the application of interpretive principles such as the “essence or true object of the transaction.”

With economic nexus rules now almost universal among the states, your business may need to consider more taxability issues than before when nexus may have been limited to your physical presence.  Aprio’s SALT team has experience assisting clients with these type of taxability analyses in any state so that your business remains in compliance with its sales tax obligations and does not incur unexpected tax liabilities and penalties.  We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jess Johannesen, SALT manager, at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the June 2019 SALT Newsletter.

[1] Instill Corporation v. Glenn Hegar, Comptroller of Public Accounts of the State of Texas, and Ken Paxton, Attorney General of the State of Texas, 03-18-00374-CV (Texas Ct. of App., 3rd Dist., 05/31/2019).

[2] TX Admin. Code §3.342(a)(2)

[3] TX Admin. Code §3.342(a)(5)(A)

[4] TX Admin. Code §3.330(a)(1)

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.