TX: Physical Presence Rule Continues to Apply for Franchise Tax Purposes

The Texas Comptroller recently determined that a taxpayer did not have franchise tax nexus with Texas because it lacked a physical presence in the state. The taxpayer, a California company, operated an online platform that allowed software developers to sell digital products to consumers and allowed third-party marketers to advertise a software developer’s products. In making sales via the platform, the taxpayer would enter into a buy-sell agreement whereby the taxpayer purchased the products from the developer and agreed to resell them to consumers. However, the taxpayer did not retain a license or ownership interest in the digital products. To compensate the taxpayer for its services, the taxpayer retained a portion of the sales price of the products sold. Developers were also offered an e-commerce transaction processing and subscription management service to simplify payment. When a developer subscribed to the e-commerce transaction processing service, it received a limited, non-exclusive, non-transferable right to use the taxpayer’s software platform. The taxpayer did not employ anyone in Texas, did not send representatives to Texas, and did not own any property in Texas. The taxpayer’s only presence in Texas was when a Texas developer received a license to use taxpayer’s transaction processing and subscription management service, or when a Texas consumer purchased a product using the taxpayer’s online platform. 

The taxpayer requested a ruling as to whether it was subject to the Texas franchise tax. Under Texas law, a taxable entity is subject to franchise tax when it has sufficient contacts with the state so that subjecting it to state taxation would not violate the Commerce Clause of the U.S. Constitution. In Rylander v. Bandag Licensing Corp. (2000), a Texas appellate court held that to meet the substantial nexus requirement under the Commerce Clause, a business must have a physical presence in Texas. The Texas Comptroller observed that although the U.S. Supreme Court recently overruled the physical presence test in the South Dakota v. Wayfair case, Texas “has not moved away from the physical presence requirement for franchise tax at this time.” The Comptroller went on to provide that it will “give ample notice through various means, including the Comptroller’s website, of any change in its policy regarding the physical presence rule.” Because Texas still follows the physical presence test, the Comptroller concluded that the taxpayer did not have nexus for franchise tax purposes. Although the taxpayer retained an ownership interest in the software it licensed to developers, the Comptroller determined that ongoing rights to use software in Texas did create a physical presence for franchise tax purposes. Please contact Doug Maziur at 713- 319-3866 with questions on Texas Private Letter Ruling No. 201809005L.