This Week in State Tax

Two Maryland bills (House Bill 1554 and Senate Bill 1045) that would have imposed a new 2.5 percent sales and use tax on certain specified business services have failed to advance. As previously reported in TWIST, the proposals would have extended tax to a broad range of new services but would have applied only if both the service provider and the customer were business entities. In committee hearings last week, several hundred persons signed up to testify in opposition to the measures.

The legislature’s crossover date – when each chamber sends to the other the bills that they intend to pass favorably – was Monday, March 17, and neither bill advanced from its house of origin. In addition, Governor Wes Moore stated that he did not support the proposals and that they would not be included in his final budget. Legislators are now considering other options to address the state’s $3 billion budget deficit; a 3 percent tax on consumers of “data and information technology services” is among the matters being considered. The Maryland legislature is scheduled to adjourn sine die on April 7. Please contact Jeremy Jester for any questions and stay tuned to TWIST for further legislative updates.

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The Comptroller of Public Accounts recently considered whether the provision of various types of printing equipment and services as part of a “printing as a service” business line qualified as the sale or lease of tangible personal property for certain Texas Franchise Tax deductions and eligibility for the reduced tax rate for retailers and wholesalers. The taxpayer sold, leased, and maintained printers and related equipment. The taxpayer’s revenue came from three lines of business: the direct sale or lease of printing equipment to customers; the sale of maintenance and support services for printing equipment owned by third parties; and a program the taxpayer described as “printing as a service” (PaaS), which covered all aspects of a customer’s printing needs, including repairing, installing, moving, and supplying printing equipment as well as ensuring operation of the equipment. The taxpayer charged its PaaS customers a fee per page printed. On its Texas franchise tax returns, the taxpayer included a cost of goods sold (COGS) deduction for both its sales and leasing business line and its PaaS business line, and it aggregated these two business lines when determining that it was eligible for the reduced tax rate for retailers and wholesalers. An auditor disallowed the COGS deduction to the extent that it related to the PaaS business line and determined that the PaaS business line should not have been included when determining eligibility for the retailer/wholesaler tax rate.

On appeal, the Comptroller determined that at least a portion of the PaaS business line was properly classified as sales of a service, meaning that the taxpayer could not include the service-related PaaS expenses in its COGS deduction or its PaaS receipts in the rate determination. On the COGS deduction, the Comptroller noted that service providers are generally precluded from claiming the deduction. (The Texas Franchise Tax is imposed on total revenue minus specified deductions. A taxpayer that cannot or does not take the COGS deduction can choose from deductions equal to 30 percent of its total revenue or $1 million.) Even assuming that some activities in the PaaS business line could be properly characterized as the sale of tangible personal property, the Comptroller concluded that the taxpayer had not provided sufficient documentation to calculate a COGS deduction for that portion of the business line. Similarly, the Comptroller concluded that the taxpayer had failed to demonstrate what portion of revenue from its PaaS business line should be allocated to sales of tangible personal property (as opposed to services) when determining if it was eligible for the reduced retailer/wholesaler rate. Accordingly, the taxpayer was required to use the 30 percent of total revenue deduction (the most favorable deduction after removing PaaS expenses from COGS) and the standard tax rate when computing franchise tax due. Contact Jeffrey Benson with questions about Comptroller Decision No. 119,652.

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In a recent decision, the Supreme Court of Texas ruled that a private prison contractor (taxpayer) was not an agent or instrumentality of the federal or state government and thus was not entitled to a sales tax exemption on certain purchases. The taxpayer owned and operated correctional facilities throughout the United States for the detention of federal and state inmates. The taxpayer, a Florida incorporated entity operating through multiple LLCs, contracted with government clients to operate detention facilities in Texas via a service contract directly with federal or state agencies or by subcontracting with counties that had contracted with the U.S. government to house federal prisoners. The taxpayer purchased items necessary to operate the facilities, such as electricity, natural gas, food, and furniture, and did not pay tax on its purchases under the taxpayer’s belief that it was an agent or instrumentality of either the federal or state government and therefore exempt from tax. The Comptroller audited and assessed a deficiency which the taxpayer challenged; on hearing, the Comptroller upheld the assessment. After paying the tax owed, the taxpayer challenged the assessment in district court. The trial court and appeals court upheld the deficiency, and the taxpayer appealed to the Texas Supreme Court.

In Texas, sales tax is imposed on the sale of tangible personal property and certain services unless an exception applies. Texas law provides an exemption for purchases by governmental entities defined as (1) the United States, (2) unincorporated instrumentalities of the United States, (3) a corporation that is an agency or instrumentality of the United States and is wholly owned [directly or indirectly] by the United States, or (4) this state. A Comptroller rule further delineates that certain entities are generally considered exempt if they (1) are unincorporated agencies and instrumentalities funded by the U.S., (2) carry out specific programs of the U.S., (3) are managed and controlled by officers of the U.S., (4) have officers that are appointed by the U.S., (5) perform commitments of the United States under an international treaty, and (6) are not organized for private profit.

The supreme court explained that the taxpayer at best satisfied two of the six characteristics required to be considered an agent or instrumentality of the federal or state government given the taxpayer was partially funded by the federal and state governments and carried out a specific program of housing federal and state detainees. The court ultimately rejected the taxpayer's argument that it should be considered an "instrumentality" based on performing a "quintessential government function." The supreme court emphasized that the statutory criteria for tax exemption required more than simply performing a government-like function; it required a closer nexus to government control and ownership. The taxpayer, as a private, for-profit corporation, did not meet the necessary criteria, such as being wholly owned by the government or being unincorporated and managed by government-appointed officers. Consequently, the Texas Supreme Court affirmed the lower courts' rulings, holding that the taxpayer did not qualify for the sales tax exemption as a government instrumentality. Contact Karey Barton for more information on GEO Grp., Inc. v. Hegar.

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