Sales Tax State Activity Update December 2005

ISP Plays Texas Hold’em with Use Tax on Promo Materials

The Taxpayer’s CDs and other promotional disks are manufactured and purchased outside Texas with materials such as blank disks, labels, and packaging. The Disks function as electronic promotions and membership programs for the Taxpayer’s Internet services. Consequently, the Taxpayer’s Disks are identical in function to the paper and other components the Court of Appeals ruled were exempt in the May Department Stores case.

Are the costs of the blank disks and other raw materials, such as labels, cardboard, and cellophane that are transformed into the finished Disks and offered by the Taxpayer to Texas residents subject to use tax in Texas?

Background

The Taxpayer is a corporation organized and domiciled in the United States, though not in Texas. It is an Internet service provider (“ISP”), and maintains as well as provides various content-based services to its members. Examples of the services include; financial information, news, entertainment, games, and sports features. Customers pay a monthly fee to access the Taxpayer’s services, from their own computers, through dial-up, cable, wireless, or DSL connections.

Included among the Taxpayer’s promotional materials is computer software (“Client Software”), which enables computer users who have a modem to access the Taxpayer’s services. The Taxpayer distributes these promotional materials on CDs and other computer disks (collectively, “Disks”), via U.S. Mail or in conjunction with the delivery of certain products, such as computers or computer accessories. The Disks also contain electronic order forms which permit potential customers to sign up for Taxpayer’s services. Computer users who receive the Disks are invited to insert them in their computers and, with the guidance of instructional and interactive new member programs, to access the Taxpayer’s services.

The Taxpayer supplies blank Disks to companies located outside of Texas that, from a “master” of the Client Software, replicate or duplicate the Client Software onto the blank Disks. The various replicator companies charge separately for their duplication services. The replicator organizations also attach a supplied label, which identifies the Taxpayer and the nature of the software, to each Disk. The Taxpayer acts, in effect, as a company that prints catalogs and provides the paper to its printer. In this case, the blank Disks and labels are comparable to paper.

Letter shops, also located outside of Texas, individually package the completed Disks in cardboard backing and cellophane or similar materials also supplied by Taxpayer. Only then are the Disks distributed to Texas residents, from outside Texas, either via U.S. Mail or inside the packaging in which computers, computer accessories, and other items are shipped to Texas residents.

Conclusion

Pursuant to Texas Tax Code 151.011, the Taxpayer would have to “use” the Disks in Texas by exercising “a right or power incidental to the ownership of tangible personal property over tangiblepersonal property”. Such use must have occurred “in this state” – Texas – to be taxable (Tex. Tax Code 151.101(a)). The Court of Appeals has held on more than one occasion that raw materials that are transformed outside Texas into new items that are then used in Texas are not subject to use taxation in Texas. The latter determination was the ruling in the May Department Stores case and applied to this letter ruling.

View the full letter ruling on the Texas STAR System. (Note: To visit the STAR system you must have port 8765 open on your network firewall - contact your system administrator.) (Texas Policy Letter Ruling, 200511343L, 11/1005)