July 26, 2018
Texas law imposes the sales and use tax under Chapter 151 of the Texas Tax Code. The sales tax and use tax are complimentary. The Comptroller generally audits both simultaneously. Since both the seller and purchaser are jointly liable for the sales and use tax, the Comptroller may assess tax against either party.
A. What is Manufacturing?
Manufacturing is the process of converting raw materials, components, or parts into finished goods that meet a customer’s expectations or specifications.1 For Texas sales and use tax purposes, manufacturing is effectively synonymous with fabricating or processing tangible personal property for sale.2
Fabrication involves making, building, producing, or assembling components of tangible personal property, or making tangible personal property work in a new or different manner.3
Example. Making pipe from raw steel.
Processing involves the physical application of materials and labor to modify or change the characteristics of tangible personal property.4
Example. Coating or threading steel pipe.
Example. Using equipment to dig gravel out of a gravel/caliche pit and simultaneously crushing the materials to fit into another crusher is processing.5
Example. Purely excavating caliche is not processing; there must be simultaneous crushing.6
Processing includes assembling components of tangible personal property to make a finished product (versus taking finished items and placing them into packaging for shipping, which is not manufacturing).
Processing does not include restoring, remodeling, packing, unpacking or shelving tangible personal property that belongs to someone other than the manufacturer. Remodeling involves making over tangible personal property, in a similar but different way, or changing the style, shape, or form, without causing a loss of its identity, or without causing the property to work or function in a new or different manner. Example. Cutting, respooling, and delivering cable according to customers’ specific needs was determined not to be manufacturing because cutting and wrapping cable doesn’t alter its characteristics.7
3. Repairing or Rebuilding Tangible Personal Property
Manufacturing also involves repairing or rebuilding tangible personal property owned by the manufacturer for the purpose of being sold.
4. Manufacturing Process
The Texas legislature originally enacted manufacturing exemption (now Tax Code Sec. 151.318) in 1961. The legislature’s general purpose was to (i) encourage economic development in Texas, (ii) avoid pyramiding the sales and use tax on successive buyers and sellers, which would result in the ultimate consumer paying sales tax on sales tax, and (iii) strike a balance between the policy of avoiding multiple taxation and the need to raise revenue for the state. The manufacturing exemption has been amended roughly every three years since inception and has been expanded to include semiconductor fabrication cleanrooms and equipment, photographic props used in printing, and pharmaceutical biotechnology cleanrooms and equipment. Manufacturing includes each operation beginning with the first stage of production of tangible personal property and ending with the completion of tangible personal property having the physical properties, including packaging, that is has when transferred by the manufacturer.8 The Exemptions chapter describes in more detail how to identify the various stages of manufacturing.
B. Sales Tax
Sales tax generally applies to any sale of a taxable item in Texas. Use tax applies to the storage, use or consumption of a taxable item in Texas. The two taxes are complimentary. Together, the State may impose the sales and use tax up to a state tax rate of 6.25% plus local tax rates not to exceed an additional 2.0%. Taxable items include sales of tangible personal property and certain listed services. Sales of tangible personal property are presumed to be taxable, unless an exemption applies. There is no such presumption for services. The list of services is enumerated in Texas Tax Code Sec. 151.0101. The Comptroller bears the initial burden of proving that a particular service falls within a category of taxable services. In order to understand how the sales tax applies, it is useful to break down the sales tax definitions, piece by piece.
1. Sales Tax Imposed
Texas imposes the sales tax under Texas Tax Code Sec. 151.051(a). The sales tax is imposed on each sale of a taxable item in this state:
Example. A watch manufacturer located in Dallas ships a watch to a customer in Austin. The watch manufacturer is required to collect and remit Texas sales tax from the customer.
In order to understand how the sales and use tax work, it is also important to understand the distinction between when the sales tax is imposed and when the use tax is imposed.
2. Use Tax Imposed
Texas imposes the use tax under Texas Tax Code Sec. 151.101. The use tax is imposed on the storage, use, or other consumption in this state of a taxable item purchased from a retailer for storage, use, or other consumption in this state. The use tax will generally apply to items purchased out-of-state for use in Texas: Example. An Oklahoma watch manufacturer ships a watch to a customer in Austin. The customer is required to pay Texas use tax on the sales price of the watch. The watch manufacturer may or may not be required to collect it, depending upon whether the manufacturer has nexus in the state.
In 2011, the Comptroller revised Rule 3.346 to specifically exclude the following from the definition of “use”:9
- • the sale of tangible personal property or a taxable service in the regular course of business;
- • the transfer of a taxable service as an integral part of the transfer of tangible personal property in the regular course of business;
- • the transfer of tangible personal property as an integral part of the transfer of a taxable service in the regular course of business;
- • the exercise of a right or power over tangible personal property for the purpose of subsequently transporting the property outside Texas for use solely outside of Texas; or
- • the exercise of a right or power over tangible personal property for the purpose of processing, fabricating, or manufacturing of tangible personal property into other property or attaching the tangible personal property to or incorporating the tangible personal property into other property that will be transported outside Texas for use solely outside of Texas.10
Example. A manufacturer purchases a desk from an out-of-state supplier for use in the accounting department that serves the manufacturing facility. The out-of-state supplier does not charge Texas sales or use tax. The purchase of the desk is for the manufacturer’s own use and is therefore subject to Texas use tax. The manufacturer should accrue and remit use tax on the purchase price for the desk, including any related charges, such as shipping and handling costs. If the manufacturer is not required to hold a Texas sales and use
3. Tax Rate
The sales tax rate is six-and-a-quarter percent (6.25%) of the sales price of the taxable item sold.11 Local tax rates may increase this by up to two percent (2.0%) for a maximum sales and use tax rate of eight-and-a-quarter percent (8.25%) of the sales price. These same rates apply for the use tax.12
4. “Sale” or “Purchase”
Texas Tax Code Sec. 151.005 defines “sale” or “purchase” to mean any of the following when done or performed for consideration (i.e., in exchange for something of value):
a. A transfer of title or possession of tangible personal property;
b. The exchange, barter, lease or rental of tangible personal property; [see Rule 3.294 for rental and lease of tangible personal property and when tax is paid];
c. The performance of a taxable service;
d. The charge for an extended warranty or service contract for the performance of a taxable service;
e. The transfer of title or possession to a ticket or other admission document for an amusement service;
f. The collection of an admission fee for an amusement service (individual performance, subscription series, membership privilege);
g. The collection of dues or a fee, charge or assessment, initiation fee, etc for special privilege, status or membership in the club or organization;
h. The use of a coin-operated machine;
i. The production, fabrication, processing printing, or imprinting of tangible personal property for consumers who directly or indirectly furnish the materials for the work (e.g. monogramming services);
j. The furnishing and distribution of tangible personal property by a social club or fraternal organization (e.g. fundraisers, t-shirts, promotional items);
k. The furnishing, preparation, or service of food, meals or drinks;
l. A transfer of possession of tangible personal property where the seller retains title as security for the payment price;
m. The transfer of title or possession of special order tangible personal property that has been produced, fabricated or printed to the customer’s specifications.
5. Lease Transactions
A lease or rental of tangible personal property is taxable as a sale. The primary difference between various types of leases or rentals is that the sales tax timing is different for operating leases, as contrasted with financing leases. Comptroller Rule 3.294 outlines the requirements for each.
An operating lease allows for use of the leased property for a certain time period. For sales and use tax purposes, a written contract is generally treated as an operating lease unless it meets the definition of a financing lease. The Comptroller treats all oral leases as operating leases. Tax is generally due on each payment a lessee makes under an operating lease.
A financing lease, in contrast, is more like a sale, so the Comptroller requires collection and remittance of the entire tax liability up front. Rule 3.294(a)(1) defines a “financing lease” as a written lease contract containing either (1) a transfer of title to the property to the lessee at the end of the lease; or (2) a “bargain purchase option” allowing the lessee to purchase the property at a nominal price at the end of the lease (usually less than 10% of the fair market value of the property at the time the option is to be exercised). The Comptroller will also consider a lease to be a financing lease if the lease term is equal to or greater than 75% of the property’s estimated economic life and the contract makes no provisions for returning of the property to the lessor.13 In addition, the Comptroller will designate a lease as a financing lease if the residual value of the leased property is less than 10% of the property’s fair market value at the inception of the lease and the contract makes no provisions for returning the property to the lessor.
There are special rules when equipment (e.g. construction equipment) is leased with an operator. If the leased equipment is provided with an operator at a lump-sum price, which includes both labor and materials, the equipment lease with an operator is treated as a service. The service may be taxable or nontaxable depending upon what type of work is performed.
When a charge for an equipment rental is separately stated, the equipment rental charge is subject to sales or use tax as the rental of tangible personal property. A separately stated labor charge may or may not be taxable, depending upon the service performed.
Note. For purposes of the manufacturing exemption the lease term is important. In order for qualifying equipment to be eligible for the exemption it must be leased for a term of longer than one year.
A sale generally occurs when there is a transfer of title or possession. For special order tangible personal property, the sale occurs when the specially ordered property is segregated from other products being held for sale.14
Custom manufacturers. Custom manufacturers produce tangible personal property to the special order of the customer. Examples include tailor-made clothing, custom-made draperies or slip-covers, or made-to-order furniture.15 A custom manufacturer has made a sale when the custom-made items are segregated from other items being manufactured for sale.
7. When does “Use” occur?
A taxable use occurs when a taxable item is stored, used, or otherwise consumed in Texas. A taxable item is presumed to be held for use in Texas if it is held here for longer than 30 days.16
8. “Taxable Item”
A taxable item includes both tangible personal property and taxable services. Tangible personal property is presumed taxable. The presumption does not apply to taxable services.
9. “Tangible Personal Property”
Tangible personal property is “personal property” contrasted with “real property” (i.e., “real estate”). Texas Tax Code Sec. 151.009 defines “tangible personal property” as “personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner… .” For the purposes of the sales and use tax, the term “tangible personal property” includes a computer program and a telephone prepaid calling card.
An item is considered “tangible personal property” if after installation the item’s removal from the property would not cause substantial damage to the property or destroy the item’s intended usefulness. Items designed to be easily removable without permanent damage to the property are generally considered tangible personal property. 17
An item is considered an “improvement to real property” if it is embedded in or permanently affixed to the property if after installation, the item is necessary to the intended usefulness of the building or other structure.18 Examples include stairs, gates and balconies. The sale and installation of items will generally qualify as real property improvement when:
- • the items are individually created to fit specific locations on the property, which vary in size and shape; and
- • the items are permanently installed by such means as the use of toggle bolts, glue, and welding; and
- • the removal of the item will cause substantial damage to the structure or to the item installed.19
Developers of computer programs may be considered manufactures of tangible personal property for sales and use tax purposes. The Tax Code defines a “Computer Program” as “a series of instructions that are coded for acceptance or use by a computer system and that are designed to permit the computer system to process data and provide results or information.” The computer program may be presented on a variety of media, both tangible and intangible:
- • Magnetic tapes
- • Punched cards
- • Printed instructions
- • Other tangible or electronic media
- • Internet download of software for use in Texas20
Before 1987 there was a distinction between the taxability of custom computer programs and other computer programs. Since 1987, there has been no such distinction. However, contract programming services may be excluded from sales and use tax in certain situations, in which case the item being sold is not the computer program itself but the programmer’s services. This is discussed further in the Taxable Services chapter in connection with Repair, Remodeling, Restoration of Tangible Personal Property.
Since the definition of tangible personal property includes computer programs, computer program developers may be able to claim the manufacturing exemption for certain equipment used to develop a computer program.
Note: The Comptroller’s Rule 3.308 governing “Computers – Hardware, Software, Services, and Sales” was last revised in December 1987. The Comptroller’s office is in the process of revising various rules. Proposed rule amendments are published in the Texas Register for public comment before they become final. The Court in Verizon North, Inc. v. Comptroller, Cause No. 03-08-00151-CV, Tex. App – Austin (May 22, 2009), considered whether Verizon North, Inc. owed tax on its purchase of computer software for use by an affiliate. The software, at the time of purchase, was not ready for its final use, because it needed to be modified and customized for the end user.
Verizon challenged the Comptroller’s imposition of tax because it contended the purchased computer software did not fit the statutory definition of a “computer program.” Texas Tax Code Sec. 151.0031 defines a “computer program” as “a series of instructions that are coded for acceptance or use by a computer system and that are designed to permit the computer system to process data and provide results and information.” The Comptroller’s Rule 3.308(b)(1) further defines a “computer program” as “a series of instructions sold as a completed program which are coded for acceptance or use by a computer system … .” (emphasis added).
The decision focused on the phrase “sold as a completed computer program.” Since the software required further modification before Verizon’s affiliate could put it to use, Verizon argued it didn’t meet the statutory definition. However, the Court determined it did meet the statutory definition, since the computer program could have been run, albeit not at its most optimal capacity, at the time Verizon received delivery of the product. The Court determined the software was “a completed program as sold, regardless of what modifications, extension, and customizations that the purchaser deems necessary for its intended use … .”21
The more recent case of Verizon Business Network Services, Inc. v. Combs,22 considered the taxability of Verizon’s purchases of software feature enhancements, which were first delivered to its Richardson, Texas, location for testing. The Court determined the sales of feature enhancements were sales of computer programs and were subject to Texas sales and use tax because they were first used in Texas.23
The case of 7-Eleven, Inc. v. Combs,24 also considered an aspect of the definition of a “computer program.” Specifically the Court considered whether 7-Eleven was entitled to a refund of sales taxes paid on software transferred to two categories of stores located outside Texas: (1) those owned by third party franchisees and (2) company stores owned by 7-Eleven.
During the audit period, 7-Eleven purchased a nonexclusive, perpetual license to “use, reproduce, and possess” custom computer software designed to manage and automate 7-Eleven’s stores.25
First, the vendor installed “host software” on 7-Eleven’s corporate mainframe. Then the vendor installed “store software” on the in-store computers. The vendor delivered separate “gold masters” of the host software and the store software to 7-Eleven. The “gold masters” allowed the corporate mainframe to communicate directly with the store computers. This formed the “backbone” of the financial system and captured data necessary to conduct and monitor sales and other store functions. 7-Eleven used the software to perform data processing services for the stores.26
Then, the vendor installed software to automate the store’s scanning point of sale (POS) cash registers, which 7-Eleven rented to the stores. This POS software was installed only in the stores. In the original administrative proceeding, the Comptroller found that this software, which was installed in the out-of-state stores was not taxable in Texas. However, the Tax Division filed a motion for rehearing on the grounds that the software was not purchased solely for resale and that it was incidental to the rental of tangible personal property (i.e., the point of sale registers), which disqualified the transaction from exemption. The Comptroller granted the Tax Division’s motion for rehearing and ultimately denied the refund. 7-Eleven paid the resulting tax under protest.27
7-Eleven claimed the resale exemption both as a sale for resale of tangible personal property (software) and as resale of tangible personal property transferred as an integral part of a data processing service. For the franchise stores, the Court of Appeals agreed with 7-Eleven that it had purchased the software for resale to its franchisees and had transferred the software as an integral part of a taxable data processing service. Even though the franchisees were not required to pay tax on the data processing services, because the service benefit location was outside the State of Texas, the transfer had occurred and the exemption applied.28
For the company stores, the Court of Appeals held that 7-Eleven had not established its burden of proving that the store software purchased for the out-of-state company stores was not used in Texas before it was transferred out-of-state and remanded the case to the District Court for further consideration of that issue.29 In its motion for rehearing, the Comptroller argued for the first time that the software-development charges could not be allocated in the manner urged by 7-Eleven because the license agreement for the software “provides for a single charge for a single license,” rather than a price per copy. While the court was troubled that this issue was raised on rehearing, it remanded the case back to trial to determine whether 7-Eleven made any “use” of the store software before and after removing it from its tax-free inventory.
Digital products include such things as photographs and music. Downloaded music and pictures cause a physical change to the medium on which they are stored; therefore, they can be measured and are considered tangible personal property.30
Software as a Service
The Comptroller treats the sale of software, canned or custom, as the taxable sale of tangible personal property. “Software as a service” (SaaS) providers allow use of software via the Internet or other digital means without the customer actually taking possession of the software itself. In the context of SaaS, customers may use online applications to enter, store, manipulate and monitor data. The Comptroller generally considers the SaaS transaction to be the sale of taxable data processing services.31
Example 1. SaaSY, a California corporation with sales personnel in Texas, makes sales to Texas manufacturers. SaaSY’s manufacturing customers use its online business application to record and manage their business transactions. The business application software resides on servers at the manufacturer’s data center. Data and information entered by the manufacturers are also stored on SaaSY’s servers in California. The manufacturers access the software through the Internet. No special hardware or software is needed to access the software; only Internet access, for which the manufacturers are required to supply their own hardware and software. The manufacturer’s employees generate and enter the business information, which serves as the basic platform for business operations, allowing them to manage inventory, record sales, fulfill orders, process payroll, execute accounting functions, manage employees and create financial statements. The online software holds all customer data in a single database, allowing access to all performance metrics in a customizable, realtime dashboard.
The application’s comprehensiveness is illustrated by the payroll component, which allows a manufacturer to enter data once and manage all of its payroll functions, including paying employees and calculating earnings, deductions, taxes and company contributions. This component can also prepare, print and file IRS forms such as the W-2 and 1099-MISC and tax returns for federal, state and local jurisdictions.
Customers obtain a non-exclusive, non-transferable license to use the service and to display content solely for the customer’s internal business operations during the term of the agreement. The license agreement is not a concurrent user license, and the customer may not copy, modify, reverse engineer, disassemble, attempt to discover any source code, or otherwise modify the software. Under the license agreements, customers give SaaSY a license to copy, store, record, transmit, maintain, display, view, print, or otherwise use customer data to the extent necessary to provide the service to customers. The Comptroller determined that SaaSY was providing taxable data processing services to the manufacturers. The manufacturers transmit the data directly to SaaSY’s servers in California, which manipulate and process the data to prepare a tax return. SaaSY’s service goes so far as to actually file the tax return for its customers (the manufacturers) and guarantee the accuracy of the information and the timeliness of the filing. It also stores the data for future payroll use and so that it can be retrieved in the event of an audit. The fact that the manufacturers themselves were entering the data had no effect on the service’s taxability.32
The Comptroller has interpreted the Tax Code definition of “tangible personal property” to also include “electricity.”33 Since the Tax Code defines tangible personal property to include electricity, manufacturers of electricity are treated as manufacturers under the sales and use tax laws. Manufacturers of tangible personal property are eligible for treatment as manufacturers under the sales and use tax laws. However, service providers are not afforded the same treatment.
But Not Telecommunications
Although the Comptroller considers electricity to be tangible personal property, the same is not true for telephone signals, which are similarly generated. GTE Southwest v. Combs34 considered whether the manufacturing applied to equipment a local exchange carrier used to provide telecommunications products to its customers. The manufacturing exemption applies to “tangible personal property” used in “manufacturing, processing, or fabrication of tangible personal property for ultimate sale.” GTE contended that its telecommunications product consisted of “voice and data transmissions in the form of electronic signals, dial tones, busy signals, ring tone signals, digital addresses, and electricity to power the system, all of which are ‘measured,’ ‘felt,’ and ‘perceptible.’”35 Telecommunications, unlike electricity, is taxed as a service under Texas Tax Code Section 151.0101. The equipment itself did not necessarily transfer to the customers as part of the taxable service. The Comptroller therefore denied GTE’s claim for a refund of sales and use tax it had paid on the equipment it used to manufacture the telephone signals.36 The district court granted summary judgment in favor of the Comptroller and the Court of Appeals affirmed its decision.37
10. “Taxable Services”
Manufacturers who purchase taxable services for their own use will be required to pay sales and use tax on the price of the services consumed. Taxable services are enumerated in Texas Tax Code Sec. 151.0101. They include such things as amusement services; cable television services; personal services; motor vehicle parking and storage services; repair, remodeling, maintenance and restoration of certain tangible personal property; telecommunications services; credit reporting services; debt collection services; insurance services; information services; real property services; data processing services; real property repair and remodeling; security services; telephone answering services; Internet access services; and sales by transmission and distribution utilities to end-use customers whose consumption of electricity is subject to sales and use tax. Taxable services are covered in detail in the “Taxable Services” chapter of these materials.
11. “Sales Price” or “Receipts”
Texas Tax Code Sec. 151.007 defines the “sales price” as the “total amount for which a taxable item is sold, leased, or rented, valued in money… .” The total sales price includes:
a. the taxable item sold, leased, or rented;
b. the materials used, labor or service employed, interest, losses, or other expenses;
c. the transportation or installation of tangible personal property; or
d. transportation incident to the performance of a taxable service.
The sales price also includes a service that is a part of the sale and the amount of credit given to the purchaser by the seller. Even if these items are separately stated, or separately invoiced by the same entity that sold the taxable item, they are still subject to sales and use tax.
The sales price does not include the following amounts if they are separately identified to the customer by such means as an invoice, billing, sales slip or ticket, or contract:
a. Cash discounts;
b. Refunds or credits (for tangible personal property or services);
c. Trade-ins (if it’s a type of property the seller sells in the ordinary course of business).
d. The face value of United States coin or currency in a sale of that coin or currency in which the total consideration given by the purchaser exceeds the face value of the coin or currency; or
e. Gratuities. Gratuities include both voluntary gratuities and reasonable mandatory charges for service of a meal or food products (including soft drinks and candy, for immediate human consumption). In order for a mandatory gratuity to be excluded from the taxable sales price (1) the service charge must be separated from the sales price of the meal or food product and separately identified as a gratuity or tip and (2) the employer must disburse the total amount of the service charge (mandatory gratuity) to employees who customarily and regularly provide the service
Tax reimbursements must be clearly identified as “reimbursement for sales tax.” If the charge is not clearly identified as a reimbursement, tax is collected in error and must be either remitted to the state by the contractor or nontaxable service provider or refunded to the customer.38 Line items styled as fee or rate reimbursements on invoices cannot be greater than the fee or rate that applies. The Comptroller does allow for a “gross up” of the charge for a fee or rate reimbursement.
Sales Price for Manufactured Food Items Sold Through Vending Machines The “sales price” or “receipts” of edible products sold for human consumption through a money-operated vending machine is fifty percent (50%) of the vendor’s total gross receipts from sales of those items.
Example. The purchase of a coin-operated coffee machine, which causes a physical or chemical change in the product being processed for sale (i.e. coffee) qualifies for the manufacturing exemption.39 There is an exception for sales of soft drinks and candy, for which the “sales price” or “receipts” are the total gross receipts (one hundred percent, 100%) of the proceeds from those sales.
A person processing food for sale is a manufacturer and may claim a sales or use tax exemption on purchases of equipment and other taxable items that qualify for exemption under Tax Code § 151.318. However, the exemption in Tax Code § 151.317 for natural gas and electricity used in manufacturing is not applicable for gas or electricity used to prepare or store prepared food. These exemptions are covered in more detail in the Exemptions chapter of these materials.
Third Party Services
If a taxpayer purchases a service, such as freight or installation, from a third party (i.e., separate legal entity) who did not sell the taxable item, the third party service is not required to collect Texas sales or use tax so long as the third party invoices the customer directly and the service provided is not otherwise defined as a taxable service. If the third party bills the seller and the seller rebills the customer, the charge is taxable. Example. Sellers’ shipping costs for heavy manufacturing equipment can be expensive. It may be advantageous and cost effective for a manufacturer to obtain the services of a third party who didn’t sell the equipment to ship or transport the equipment to the manufacturer’s location. If the third party service provider invoices the manufacturer directly the manufacturer doesn’t have to pay tax on the charges to ship the equipment.
Tax Included Contracts
The Comptroller generally requires the contract or invoice language specifically state that the “stated price includes Texas sales or use tax” in order to constitute a valid “tax included” contract.40 The contract language must be specific. Other language, such as indemnifications that “all taxes due will be paid by the purchaser” is generally insufficient to create a valid tax-included contract.41
2011 Update. Texas law prohibits sellers from stating that they will absorb or refund sales taxes. Comptroller Letter No. 201101944L (January 21, 2011) states that the sales tax is a transaction tax that must be collected on each sale of a taxable item. Every Texas seller must collect sales taxes on anything shipped to another resident of the state, and the amount of the sales tax must be written on the bill or the customer must receive a written notice that the amount includes the sales tax.
12. “Seller” or “Retailer”
Texas Tax Code Sec. 151.008 defines a “seller” or “retailer” as “a person engaged in the business of making sales of taxable items of a kind the receipts from the sale of which are included in the measure of the sales or use tax imposed.” A seller or retailer includes the following:
a. a person in the business of making sales at auction of tangible personal property owned by the person or by another;
b. a person who makes more than two sales of taxable items during a 12- month period, including sales made in the capacity of an assignee for the benefit of creditors or receiver or trustee in bankruptcy;
c. a person regarded by the Comptroller as a seller or retailer under Section 151.024 of this code;
d. a hotel, motel, or owner or lessor of an office or residential building or development that contracts and pays for telecommunications services for resale to guests or tenants; and
e. a person who engages in regular or systematic solicitation of sales of taxable items in this state by the distribution of catalogs, periodicals, advertising flyers, or other advertising, by means of print, radio, or television media, or by mail, telegraphy, telephone, computer data base, cable, optic, microwave, or other communication system for the purpose of effecting sales of taxable items.
2011 Update. The 2011 legislature revised the definition of “retailer engaged in business” to include:
- a retailer that holds a substantial ownership interest in, or is owned in whole or in substantial part by, a person who maintains a business location in Texas, provided certain conditions are met; and
- a retailer that holds a substantial ownership interest in, or is owned in whole or in substantial part by, a person who maintains a distribution center, warehouse or similar location in Texas and who delivers property sold by the retailer to consumers.42
This provision does not necessarily seek to require sales tax collection by all online retailers, but only those with substantial ownership interests. This bill is specifically designed to address large retailers, such as Amazon.com, which has a distribution facility in North Texas. Around the time the change was made, Amazon was challenging an assessment of around $269 million in sales and use tax.43 The legislative revisions include an entity that holds a substantial ownership interest in, or is owned in whole or substantial part by, a person who maintains a business location in Texas if:
- The retailer sells the same or substantially similar line of products under a business name that is the same as or substantially similar to the entity with nexus; or
- The facilities or employees of the entity with a location in Texas are used to (1) advertise, promote or facilitate sales by the out-of-state retailer; or (2) perform any other activity of the retailer intended to establish or maintain a marketplace in Texas, such as receiving or exchanging returned merchandise.
They also include as “doing business in Texas” an entity that holds a substantial ownership interest in, or is owned in whole or substantial part by, a person who:
- Maintains a distribution center, warehouse or similar location in Texas; and
- Delivers property sold by the retailer to consumers.
The legislative changes defined “ownership” to include: direct ownership, common ownership, and indirect ownership through a parent entity, subsidiary or affiliate. Ownership is treated as “substantial” if there is at least 50% ownership of the total combined voting power of all classes of stock for a corporation or the beneficial ownership of stock of the corporation. For trusts, the measure is at least 50% direct or indirect beneficial interest in the trust corpus or income. For LLCs, it is measured by at least 50% direct or indirect membership interest or beneficial interest. For other entities, such as partnerships or associations, the measure is at least 50% direct or indirect interest in the capital or profits of the entity.
13. “In This State”
Texas Tax Code Sec. 151.004 defines “in this state” to include all locations within the exterior limits of Texas.
Federal land located within the boundaries of Texas is considered “in this state” for Texas sales and use tax purposes. This includes all territory ceded to or owned by the United States within the State of Texas. Examples include military bases or other land ceded to the Federal government.
Receipts from transactions occurring in Texas waters are also Texas receipts. The dividing line between Texas waters and international waters is established at 10.359 statute miles (nine nautical miles) from the Texas coastline.
C. Use Tax
Texas imposes use tax on the storage, use, or other consumption in this state of a taxable item purchased from a retailer for storage, use, or other consumption in this state. The tax is at the same percentage rate as is provided by the sales tax provisions on the sales price of a taxable item.44
1. Purpose of the Use Tax
According to the Third Court of Appeals in May Department Stores v. Strayhorn:45“’A use tax is a tax on the enjoyment of that which was purchased,’46 and complements the sales tax.47 The use tax is designed to tax sales not reached by sales tax and thus reaches use or consumption in the state of property purchased outside of it.48 The purpose of the use tax is ‘to more evenly distribute the tax burden among all consumers by imposing a tax on the fruits of an interstate purchase as well as on the sale of property in the State.’49 A use tax serves to prevent ‘avoidance of a state’s sales tax by the purchase of goods in another state, and to place retailers in the state upon equal footing with out-of-state competitors, who are not obligated to collect and remit sales tax.’”50
In theory, a use tax aids Texas businesses by ensuring consumers cannot obtain a tax benefit by purchasing items outside of the state for use in Texas. In reality, it is very difficult for the Comptroller to monitor and enforce compliance with the use tax, particularly when the transactions are small or when the purchasers are individuals, rather than businesses.
2. “Use” of Tangible Personal Property
For use tax purposes, the “use” of tangible personal property is the exercise of a right or power incidental to the ownership of tangible personal property. Manufacturers purchasing items for their own use must pay tax on those items. The exercise of a right or power over tangible personal property includes the exercise of a right or power over tangible personal property (other than printed material) that has been processed, fabricated, or manufactured into other property or attached to or incorporated into other property transported into this state.
In 2003, the legislature added the requirements regarding tangible personal property purchased out of state and incorporated into other property transported into this state in order to repeal the Third Court of Appeals decision in Sharp v. Morton Buildings.51 In that case, the court determined a manufacturer of corrugated steel buildings did not owe use tax on building components it manufactured out of state from raw materials purchased out of state. The building components were temporarily stored in Texas before being incorporated into real property in Texas. The customer did not pay tax on the building components because the contractor was selling and the customer was purchasing real property, which is not subject to Texas sales or use tax.
3. Tangible Personal Property Incorporated Into Real Estate
Manufacturers who install manufactured goods onto real estate such that the items become incorporated into the real estate are considered to be contractors for such projects. The “use” of tangible personal property includes the incorporation of tangible personal property into real estate or into improvements of real estate, regardless of whether or not the real estate is subsequently sold. The tax is imposed on the consumer.
Generally, the contractor is considered the consumer of items purchased to be incorporated into real property under a lump-sum contract for the sale of real estate.52 The contractor will therefore pay sales or use tax on the purchase of those materials and the customer, who is purchasing a building, will not owe sales or use tax. This differs from projects in which the manufacturer is not considered a contractor.
Separated contracts are treated differently. Texas tax law considers a contractor to be the seller of tangible personal property the contractor furnishes and incorporates into the customer’s property.53 The contractor shall collect tax from the customer if the contract between the contractor and the customer is a “separated contract” (i.e., one that contains separate amounts for the performance of the service and the cost of the necessary materials).54
4. “Use” of a Taxable Service
The Tax Code defines the “use” of a taxable service as “the derivation in this state of direct or indirect benefit from the service.” Consistent with this definition, and as discussed further in the Taxable Services and Exemptions chapters, certain services won’t be taxable to customers located in Texas because they are purchased to benefit out of state locations.
Taxable “storage” is defined as the “keeping or retaining for any purpose in this state of tangible personal property sold by a retailer.” “Storage” does not include the keeping or retaining of tangible personal property held for sale in the regular course of business (e.g. inventory). Items purchased for resale are not subject to sales and use tax because an exemption applies.
6. Items Held for Transportation or Manufacturing
Neither “use” nor “storage” includes the exercise of a right or power over or the keeping or retaining of tangible personal property for the purpose of:
a. transporting the property outside the state for use solely outside the state; or
b. processing, fabricating, or manufacturing the property into other property or attaching the property to or incorporating the property into other property to be transported outside the state for use solely outside the state.
7. Direct Pay Permit Holders
Manufacturers that purchase large quantities of taxable goods for their own use may qualify for direct pay permits. Direct pay permit holders accrue and remit tax on their own purchases. A direct pay permit holder may issue a special form of an exemption certificate to its vendor, shifting the sales tax accrual and remittance burden from the vendor to its customer. The customer is then responsible for accruing and remitting tax on purchases when it files its monthly sales and use tax report.
A taxpayer may apply for a direct pay permit if its annual purchases meet or exceed $800,000 of taxable items for the taxpayer’s own use. The direct pay permit applicant agrees to maintain a separate accounting of taxable and nontaxable purchases, and to submit its records at any time, upon request, to the Comptroller’s office for review. The advantage of the direct pay permit is that it allows a taxpayer to make an election regarding the timing of the use tax payment – when an item is first purchased and stored, or when it is removed for use. However, effective November 11, 2012, local use tax “is due to the jurisdictions where the item is first stored regardless of which election is chosen.”55
8. Use of Printed Materials
In Southwestern Bell Yellow Pages v. Combs,56 the Third Court of Appeals considered whether the phone book company had appropriately paid use tax on out-ofstate printing of telephone directories that were subsequently distributed in Texas. The case considered a legislative revision to the use tax made in 2003 to overturn the outcome of the Morton Buildings57 case. In Morton Buildings, the Third Court of Appeals determined that raw materials purchased out of state, assembled into a new item, and then brought into Texas, are not put to a taxable use in Texas because the original materials no longer exist.
The Court, in a somewhat confusing analysis, concluded that the exclusion for printed materials applied only to printed material that serves as a component of some other finished product. Under the revised use tax statute, “use” means the exercise of a right or power over goods, including “tangible personal property other than printed material that has been processed, fabricated, or manufactured into other property or attached to or incorporated into other property transported into this state.”58 The concurring opinion pointed out that it would have been simpler for the Court to take the position that the legislative changes did not alter the tax on printed materials. The minority would have followed the May Department Stores case. In May Department Stores v. Strayhorn,59 the court determined that May Department Stores owed tax on printed advertising materials manufactured outside Texas and delivered to prospective customers in Texas. The same issue appears to have applied to Southwestern Bell Yellow Pages, even though the majority opinion used a different analysis in coming to its conclusion that use tax was due.
1 See Business Dictionary, available online at: http://www.businessdictionary.com/definition/manufacturing.html#ixzz2MJxiBNeI.
2 See Comptroller Pub. 94-124, Manufacturing Exemptions, April 2003, available online at: http://www.cpa.state.tx.us/taxinfo/taxpubs/tx94_124.html.
3 Comptroller Rule 3.300(a).
4 Comptroller Rule 3.300(a).
5 See Comptroller Letter No. 9506L1351F01.
6 Comptroller Hearing No. 100,858, SOAH Docket No. 304-09-1713.26 (2009).
7 Houston Wire & Cable Co. v. Combs, 2008 WL 678540 (Tex. App.-Austin 2008, pet. denied).
8 Tex. Tax Code § 151.318(d).
9 Comptroller Rule 3.346 (proposed 10/29/2010; adopted 02/04/2011).
10 The Rule was also amended, in part, to implement a statutory change to Tax Code, §151.011 by House Bill 2425, 78th Legislature, 2003, which provides that the use tax extends to tangible personal property transported into this state that has been processed, fabricated, or manufactured into other property, or has been attached or incorporated into other property.
11 Tex. Tax Code § 151.051(b).
12 Tex. Tax Code § 151.101. The tax rate for use tax is at the same percentage rate as is provided by the sales tax provisions on the sales price of the taxable item.
13 There is an exception for used property, if the beginning of the lease term falls within the last 25% of the total estimated economic life of the lease property.
14 See, e.g., Day & Zimmerman, Inc. v. Calvert, 519 S.W.2d 106 (Tex. 1975); Gifford-Hill & Co. v. State, 442 S.W.2d 320 (Tex. 1969).
15 Comptroller Rule 3.300(a)(2).
16 See Comptroller Rule 3.323(C)(3) (dealing with exports).
17 Tax Policy News, March 2012, available online at: http://www.window.state.tx.us/taxinfo/taxpnw/tpn2012/tpn1203.html#issue6
19 See Comptroller Rule 3.347; See also Tax Policy News, March 2012, available online at: http://www.window.state.tx.us/taxinfo/taxpnw/tpn2012/tpn1203.html#issue6
20 See e.g., Comptroller Letter No. 200105276L (Al Van Allen, May 29, 2001) (stating that “charges for computer programs downloaded from Texas servers to a location outside Texas are exempt under Tax Code Section 151.330.”).
21 Id. at *4.
22 ___ S.W.3d ____ (Tex. App.–Amarillo 2013).
24 311 S.W.3d 676 (Tex. App.–Austin 2010, pet. denied) (original opinion dated August 31, 2009, withdrawn).
30 See, e.g., Comptroller Letter No. 200005359L (Barbara Truesdale, May 30, 2000).
31 See, e.g., Comptroller Letter No. 200812241L (December 16, 2008).
32 See Comptroller Letter No. 200805095L (Lia Edwards, May 28, 2008).
33 See, e.g., Comptroller Letter No. 200204996L (Al Van Allen, April 19, 2002).
34 ___ S.W.3d ___, 2010 WL 2218662, Cause No. 03-08-00561-CV (Tex. App.–Austin 2010, pet. denied), reh’g denied Jan. 14, 2011.
35 Id. at *4.
36 Id. at *1.
37 Id. at *1.
38 Tax Policy News, April 2009 (STAR No. 200904585L).
39 Comptroller Letter No. 200009663L (Al Van Allen, September 7, 2000).
40 Comptroller Hearing No. 33,136 (1995) (contract stating “the contractor shall assume full responsibility for and pay all taxes…” was held to be too ambiguous to constitute a “tax included” contract); Comptroller Hearing No. 32,994 (1995) (contract stating “price includes entire amounts due for…taxes…” was not a sufficient statement); Comptroller Hearing No. 32,994 (1995) (contract stating “the sub-contractor (seller), shall pay all taxes required by law…” was insufficient); Comptroller Hearing No. 32,248 (1997) (contract stating “the contractor shall pay all sales consumer and use taxes…” was not “tax included” language).
41 See, e.g., Perry Homes v. Strayhorn, 108 S.W.3d 444, (Tex. App.–Austin 2003, no pet.).
42 82nd Legislature, 1st C.S., S.B. 1, Art. 30 (2011).
43 News reports indicate that Amazon tried to make a deal with the legislature for a safe-harbor provision by promising to add 6,000 jobs and $300M capital investment, but its negotiations apparently did not provide the legislature sufficient incentive to prevent this provision. Governor Perry vetoed a bill with a similar provision during the regular legislative session on the grounds that such a bill risked significant unintended consequences.
44 Tex. Tax Code § 151.101.
45 2004 WL 1898244 (Tex. App.–Austin 2004).
46 McLeod v. J.E. Dilworth Co., 322 U.S. 327, 330 (1944).
47 Bullock v. Lone Star Gas Co., 567 S.W.2d 493, 497 (Tex. 1978).
48 Bullock v. Foley Bros. Dry Goods Corp., 802 S.W.2d 835, 838 (Tex. App.–Austin 1990, writ denied).
49 Lone Star Gas Co., 567 S.W.2d at 497.
50 Foley Bros., 802 S.W.2d at 838.
51 953 S.W. 2d 300 (Tex. App.–Austin 1997, pet. denied).
52 See Tex. Tax Code §§ 151.056(a), (d).
53 Tex. Tax Code § 151.056(b).
55 Comptroller Rule 3.346(g).
56 2009 WL 211633 (Tex. App.-Austin 2009, pet. denied) (mem. op.) (construing 2003 amendment to section 151.011(a), which added language nearly identical to language in section 151.011(f)(2), as excluding from taxation only printing materials that are components of finished product, not cost of printing services provided out-of-state for products distributed in Texas).
57 953 S.W.2d 300 (Tex. App.–Austin 1997, pet. denied).
58 Tex. Tax Code § 151.010(a) (emphasis added).
59 2004 WL 1898244 (Tex. App. –Austin 2004).