Can a Texas lab source outsourced service revenue by a cost ratio, or must service receipts be sourced by the fair value of work performed in Texas?

Plain-English summary

A Texas corporation earned revenue analyzing blood samples, performing most of the work at its Texas lab but paying an unrelated out-of-state company to perform the balance on a fee basis (its customers received all reports and bills directly from the corporation and were unaware of the outside company). It proposed to compute the non-Texas share of its service revenue with a cost ratio - fees paid to the outside company divided by total cost of services sold, applied to total service revenue - and asked whether that was acceptable. The Comptroller would not bless the cost method.

• The sourcing rule. Service receipts are apportioned to the location where the service is performed. Where services are performed both inside and outside Texas, the Texas receipts are the fair value of the services rendered in Texas (Rules 3.549(e)(38) and 3.557(e)(33); STAR document 9310L1276E07).
• The cost method was not approved. Because the standard is fair value of services performed in Texas, the Comptroller stated it was unable to provide any opinion on the reasonableness of apportioning receipts on the basis of the cost of services provided.

Currency note: This applies the pre-2008 franchise tax's service-sourcing rules, replaced by the current margin tax (House Bills 3 and 3928) effective January 1, 2008. Treat as historical.

What this means for you

Businesses that outsource part of a service

You could not shortcut Texas sourcing with a cost ratio just because an outside vendor performed some of the work. The measure is the fair value of the services performed in Texas versus elsewhere - not what each piece cost you.

Accountants and tax professionals

Build service-receipt apportionment on the fair value of in-Texas versus out-of-Texas performance, not on a cost-of-services proxy. The Comptroller expressly declined to opine on the cost-based method, which signals audit risk for cost-ratio sourcing under the pre-2008 rules.

Common questions

Q: Can I apportion service receipts using a cost ratio?
A: The Comptroller declined to approve that. Service receipts are sourced by the fair value of the services performed in Texas, not by a cost-of-services ratio.

Q: How do I source revenue when an outside company does part of the work?
A: Determine the fair value of the services performed in Texas versus outside Texas; only the in-Texas fair value is a Texas receipt.

Citations and references

Rules and guidance:

• 34 Tex. Admin. Code Sec. 3.549(e)(38) (taxable capital: service receipts sourced to where performed)
• 34 Tex. Admin. Code Sec. 3.557(e)(33) (earned surplus: service receipts sourced to where performed)
• STAR document 9310L1276E07 (service-receipt sourcing; described, not linked)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200404513L

Original ruling text

April 7, 2004

Dear **:

Thank you for your inquiry concerning apportionment of gross receipts for Texas
franchise tax. You stated that your client, a corporation in Texas, receives
revenue for performing analysis of blood samples. Most services are performed
at the corporation's lab facilities in Texas. An unrelated company located
outside of Texas performs the balance of services on a fee basis. The
corporation includes these fees in its total cost of services sold to
customers. The corporation's customers receive all reports of test results and
all billings directly from the corporation. Its customers are unaware that the
unrelated company performs some services.

You have asked how to apportion the corporation's service revenue to Texas, and
if the revenue resulting from services performed outside of Texas by the
unrelated company should be treated as the non-Texas portion of service
revenue. If so, you have asked if the following method for determining the
non-Texas portion of total service revenue is acceptable. If not, you have
asked how to determine the non-Texas portion.

The method that you have proposed begins with a ratio of total fees paid to the
non-Texas company for services divided by the total cost of services sold.
This ratio is applied to the total service revenue of the corporation to
determine the non-Texas portion of total service revenue.

Service receipts are apportioned to the location where the service is
performed. If services are performed both inside and outside Texas, then such
receipts are Texas receipts on the basis of the fair value of the services that
are rendered in Texas. See Franchise Tax Rules Sections 3.549(e)(38) and
3.557(e)(33) and State Tax Automated Response (STAR) system document number
9310L1276E07. Therefore, I am unable to provide any opinion regarding the
reasonableness of the apportionment of receipts on the basis of the cost of
services provided.

The rules and document mentioned above are available via the
Comptroller's website at www.window.state.tx.us. From the home page, click on
the link to "Texas Taxes," then on the link to "Taxes and Fees - Franchise."
Click on the link for "Rules" or enter the above document number in the box for
research in the .

This response is based on the facts presented and current law. If there are
different or additional facts, the response may change.

Our goal is to provide you with prompt, professional service. Please take a
moment to complete our on-line survey at
http://aixtcp.cpa.state.tx.us/surveys/tpsurv/.

If you have questions about this, my Internet address is
[email protected], or you may call toll free at 1-800-531-5441,
extension 31374.

Sincerely,

Laurie Massengale
Tax Policy Division