Texas Tax Talk: Sales Tax Sourcing and Court Access Issues
Law360 recently published an article by Baker Botts Partners Matt Larsen and Renn Neilson, and Associate Ali Foyt.
With the Texas Legislature in full swing, taxpayers have a lot to keep their eye on.
In this issue of Texas Tax Talk, we focus on two consequential tax policy developments from this legislative session: (1) potential legislative intervention responsive to a controversial local sales tax sourcing rule adopted by the Texas Comptroller of Public Accounts, and (2) how changes to state administrative appeal procedures will modify taxpayers' options in appealing a comptroller assessment.
A version of this piece can be read in Law360, here.
Legislative Responses to Comptroller's Controversial Local Sales Tax Sourcing Regulation
Comptroller's Rule Change
Texas taxpayers should brace for disruptions to local sales tax sourcing under a revision to the Comptroller's Rule 3.334.1
The comptroller's amendment proposes to change sales tax sourcing rules for orders that are not "received by sales personnel" — i.e., internet orders.
This amendment, set to take effect Oct. 1, if the Legislature does not act to override it, could threaten common tax incentive agreements with localities, would require many taxpayers to change their local tax collection and payment systems, and is expected to significantly alter the local sales tax revenue stream of cities, counties and other municipal jurisdictions across the state.
“Place of Business” Designation for Local Sourcing
Subject to a few exceptions, sale transactions in Texas are sourced to the local jurisdiction in which a seller's “place of business” is located.2 As such, sales by vendors with a qualifying Texas place of business are sourced at the origin of the sale, rather than at the destination.
In contrast, sales made by out-of-state vendors or other vendors with no qualifying place of business in the state are generally sourced to the destination: the place where the order was shipped or delivered.3
This means the city of the buyer collects sales tax on the transaction if the seller is from out-of-state or has no qualifying place of business in Texas. But the city of the seller collects sales tax if the seller has an established place of business in the local jurisdiction from which the order was received or fulfilled.
Numerous local economic development packages — drafted to incentivize the creation of jobs and new investment across the state — have been structured around these local sales tax sourcing rules for Texas businesses. For example, agreements authorized under Chapters 380 and 381 of the Local Government Code allow a city or county to offer local sales tax rebates in negotiations with businesses looking to build or relocate in Texas.
Pursuant to these local economic development arrangements, a municipality may offer a temporary sales tax rebate in negotiations to incentivize a company to establish a place of business in the jurisdiction. In exchange, companies agree to make certain capital investments and to offer jobs. The newly-established place of business itself also generates additional local sales tax revenue for the municipality.
Sourcing Rule 3.334, effective October 1, 2021
Amendments to Rule 3.334 eliminate the place of business designation for certain Texas businesses, and thereby disrupt long-established business practices and resulting local sales tax revenue streams.
A “place of business,” for purposes of the sourcing rules, is defined by Rule 3.334 as a location where a seller “receives” — or after Oct. 1 under the comptroller's amendment, where “sales personnel of the seller receive” — three or more orders for taxable items during a calendar year.4 Under the new rule, orders placed through an online portal or software application will not qualify as received at a place of business of the seller.5
Accordingly, a seller cannot create a place of business for local sales tax sourcing purposes if the only orders received by that location are internet orders, although the location could still qualify as a place of business under the new rule if it receives at least three other orders at that location via other mediums — e.g., phone, mail or walk-in orders.
To date, the comptroller has provided little guidance as to how the change would shift local sales tax revenue currently received by local taxing units, but it might substantially impact some cities and counties.
Taxpayers may also be significantly affected — and not just those who have entered into the incentive agreements discussed above — particularly given the ubiquity of online portals and software applications. For example, if a business processes intercompany orders using a software application or a website, the location that receives those orders may no longer qualify as a place of business under the new rules.
Businesses would need to reevaluate and perhaps modify billing procedures for certain business locations where such internet orders are received, particularly for locations that do not receive orders via any other medium.
Proposed Legislation Unlikely to Address Concerns
Following significant pushback from numerous municipalities and taxpayers, Texas Comptroller Glenn Hegar delayed the effective date of his controversial sourcing amendment until Oct. 1 to allow for legislative buy-in. But Texas lawmakers appear to be stalled in responding to this call.
At least half a dozen bills were introduced in the state Legislature that propose a range of actions to preserve or amend current local sales tax sourcing rules in response to the Comptroller's amendments to Rule 3.334. As of the date of this article, only one responsive bill has received a hearing in committee and even it still has a long road ahead before it could be adopted into law.
The one bill that has any traction, H.B. 4072 introduced by chairman of the House Ways and Means Committee, Rep. Morgan Meyer, R-Dallas, would be even more disruptive to local tax sourcing than the comptroller's proposed rule. The bill proposes to shift all sales transactions to destination sourcing. This total overhaul of sourcing goes much further than the comptroller's amended rule.
As H.B. 4072 is drafted now, the sourcing change would not take effect until Jan. 1, 2023, allowing time for taxpayers to adapt business practices and accommodate the change — at least more time than if the comptroller's amendment is allowed to go into effect Oct. 1.
Meyer’s bill is not responsive, however, to requests from local municipalities for the comptroller to conduct a study on the fiscal impacts of the new sourcing rule. The bill also does not preserve certain economic development agreements, such as those provided under Chapters 380 and 381, which rely on origin-based sourcing for tax incentive benefits.
If Texas lawmakers fail to override the comptroller's regulation, or if they go further to adopt Meyer's destination sourcing bill, Texas taxpayers and municipalities will need to prepare for significant sales tax sourcing changes.
Changes to Administrative Appeal Procedures May Affect Texas Taxpayers' Access to Court
Two bills that promise to substantially modify taxpayer appeal avenues have been speeding through the Texas Legislature and are expected to pass later this session.
H.B. 2080, if adopted, would require taxpayers to seek administrative relief before appealing a disputed tax assessment to district court.
Currently, taxpayers have two options to dispute a comptroller assessment. Put simply, taxpayers may either (1) skip the administrative hearing process altogether, pay the entire amount — both disputed and undisputed — under protest, and then sue in district court, or (2) go through the administrative hearing process, which does not require prepayment of disputed tax, and then appeal an unfavorable ruling for de novo review in district court.
Under the changes proposed by H.B. 2080, taxpayers would be required to engage in the full administrative procedure, either on the front end with an initial assessment or on the back end if an account is audited, before suing in court.
Also, the bill would require taxpayers to pay any undisputed — but not disputed — tax amounts to the comptroller before bringing suit and would limit claims for attorneys fees except for sanctions for frivolous pleadings and motions.
S.B. 903, if adopted, would modify the foregoing proposed legislation by allowing a taxpayer to waive a hearing with the State Office of Administrative Hearings as part of an administrative appeal, as long as the taxpayer agrees to a conference about the appealed assessment should the comptroller request one.
Together, these two legislative changes to administrative procedure compel taxpayers to exhaust administrative procedures but allow taxpayers to bypass a full-blown administrative hearing and to also only pay undisputed portions of the assessment before bringing suit for de novo review in district court.
The new laws could slow down taxpayer access to relief. Some tax disputes or refund claim administrative proceedings take over a year, or even multiple years, to complete. The ability to waive a hearing under S.B. 903 could mitigate this concern, but taxpayers would still be required to jump through potentially lengthy procedural hurdles before being able to exercise waiver.
Further, because a taxpayer could be delayed with administrative proceedings, others could get to court and argue the issue before a judge first. If those other taxpayers have less favorable facts or less effective representation, those behind them in administrative appeal would face additional challenges to overcome the negative precedent.
Both H.B. 2080 and S.B. 903 appear poised to pass later in this legislative session. As such, taxpayers will likely need to budget for additional time and resources in some cases to shepherd disputed tax assessments through administrative appeals, which could alter strategic considerations when disputing an assessment.
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Matthew Larsen and Renn Neilson are partners, and Ali Foyt is an associate, at Baker Botts LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
1 34 Tex. Admin. Code § 3.334.
2 Tex. Tax Code §§ 321.203, 321.205.
3 Id. § 321.203(e); 34 Tex. Admin. Code § 3.334(h)(3)(D).
4 34 Tex. Admin. Code § 3.334(a)(16), (b)(5) (2020).
5 Id. § 3.334(b)(5) (2020). ("Orders not received by sales personnel, including orders received by a shopping website or shopping software application. Effective October 1, 2021, these orders are received at locations that are not places of business of the seller.")
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