Is the merchandise a security company buys during secret (mystery) shopping taxable, and how should it be billed alongside the taxable security service?

Plain-English summary

A security company ("Company X") that provides taxable security services — surveillance, polygraphs, and secret (mystery) shopping to detect shoplifting and monitor employees — asked how to treat the merchandise it buys during secret shopping.

The Comptroller explained that the merchandise a mystery shopper buys would ordinarily be an expense of Company X subject to sales tax. But because Company X returns the items to the client and the client refunds Company X, no sales tax is due — the transaction is a return of merchandise.

The catch is in how it's billed. The purchase and return of merchandise must be treated as transactions separate from the taxable surveillance and polygraph services. The invoice must contain a separate line entry for the merchandise returned, so that the purchases and returns offset each other — leaving only the surveillance, polygraphs, and other expenses as the taxable charge for the security service. If Company X fails to offset the merchandise purchases this way, those purchases will be taxed as an expense directly related to and incurred while providing the taxable security service, under section (i)(3) of Rule 3.333 (Security Services).

What this means for you

Security and mystery-shopping firms

Merchandise your shoppers buy and then hand back to the client for a refund does not have to be taxed — but only if your invoice shows the purchase and the return as separate, offsetting entries. Get the paperwork right and the merchandise washes out of your taxable base.

The billing mechanics matter

Under Rule 3.333(i)(3), expenses you incur while providing a taxable security service are part of the taxable charge. The only reason the mystery-shopping merchandise escapes tax is that it is bought and returned and shown as an offsetting line item. Bury it in the service charge, or omit the return entry, and it becomes a taxable expense of the service.

Common questions

Q: Is merchandise a mystery shopper buys taxable in Texas?
A: It would be a taxable expense, but if Company X returns the items to the client and is refunded, it is treated as a return of merchandise and no tax is due — provided the invoice offsets the purchase and return.

Q: How must the invoice show it?
A: With a separate line entry for the merchandise returned, so the purchases and returns offset, leaving only the surveillance, polygraphs, and other expenses as the taxable security-service charge.

Q: What happens if the purchases aren't offset?
A: They are taxed as an expense directly related to and incurred while providing the taxable security service, under Rule 3.333(i)(3).

Q: Are the surveillance and polygraph services themselves taxable?
A: Yes. Those are taxable security services; the ruling addresses how to keep the reimbursed merchandise out of that taxable charge.

Q: Can I rely on this 1988 letter for my own business?
A: Treat it as guidance only. It is based on the specific facts presented and can change with different facts; on the STAR system it binds the Comptroller only as to the taxpayer it was issued to and may no longer reflect current policy.

Citations and references

Rules:

• 34 Tex. Admin. Code Rule 3.333(i)(3) (security services; reimbursed expenses incurred while providing a taxable security service)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/8809L0910F01

Original ruling text

COMPTROLLER OF PUBLIC ACCOUNTS
STATE OF TEXAS
AUSTIN, TEXAS 78774

September 23, 1988

Dear ***:

Thanks you for your letter of September 9, 1988, regarding the
taxability of merchandise purchased during secret shopping that is a part of a
security service provided by COMPANY X.

Merchandise purchased would be an expense to X and would be subject
to sales tax. However, because X returns the items purchased to the client and
the client refunds X, sales tax is not due. This is a return of merchandise.
The purchase and return of merchandise should be treated as transactions
separate from the taxable surveillance and polygraph services. The invoices
must contain another line entry for merchandise returned and the purchases and
returns offset leaving the surveillance, polygraphs, etc., and other expenses
as the taxable charges for security services. Failure to offset the
merchandise purchases will result in the purchases being taxed as an expense
directly related to and incured while providing the taxable service. See
section (i) (3) or Rule 3.333 - Security Services.

This opinion is based on the information provided. If there are
additional or different facts the opinion may change.

If you have any questions or need additional information, please
call our toll-free number 1-800-252-5555, ext. 3-4683. The regular number is
512-463-4600. You may write me at Tax Correspondence, Comptroller of Public
Accounts.

Sincerely,
Eddie C. Washington
Tax Correspondence