A CPA firm signed a large outsourced-services contract to perform finance, accounting, and information technology functions for a client's upstream/chemical and downstream business units. Should the whole contract be treated as one nontaxable bundle of 'professional' accounting services (since the computer work is just how the firm delivers its professional advice), or does it need to be broken into individually taxable and nontaxable pieces?

Plain-English summary

A CPA firm ("Company A") signed a large outsourced-services contract with a client ("Company B") to perform finance, accounting, and information technology functions across the client's upstream/chemical business (detailed in "Schedule 1," covering order fulfillment, ownership/royalty accounting, joint venture accounting, general accounting and reporting, tax compliance, and other functions) and some downstream IT services (detailed in "Schedule 17," covering SAP host services, hardware maintenance, mainframe, and distributed host services). The firm asked whether the WHOLE contract should be treated as nontaxable "professional" accounting services — with any data processing just incidental to delivering that professional advice — or whether individual services within it should be separately assessed for tax under Tex. Tax Code § 151.0101.

The Comptroller's answer: the contract must be broken into pieces, not treated as one bundle. Rule 3.330 defines data processing broadly — data entry, data retrieval, data search, information compilation, payroll and business accounting data production, and other computerized data/information storage or manipulation — and much of what Company A does clearly fits that definition, since the information being entered, tracked, manipulated, and printed is used both by the client and by the firm itself. The rule does carve out a narrower nontaxable zone: using a computer merely to facilitate the performance of ANOTHER nontaxable service, or to apply specialized knowledge (physical sciences, accounting principles, tax law) — like a CPA using a computer to produce a financial report or prepare a tax return. But that carve-out has a limit: a CPA firm that separately states a charge for payroll processing, for instance, can't shelter that taxable data-processing charge just because the same payroll numbers also flow into a nontaxable tax return or financial statement — allowing that would give CPA and bookkeeping firms an unfair advantage over dedicated data processing companies performing the identical taxable work.

The letter also addresses the "essence of the transaction" doctrine via Comptroller's Decision No. 30,394 (1994), a case involving a demolition-and-hauling contractor. That decision held the doctrine historically applied to transactions combining a service with a transfer of tangible personal property (predating full taxation of services), and that where a taxpayer performs genuinely TWO distinct services — one taxable, one not — the correct approach is to tax each service on its own terms rather than picking a single "essence" for the whole engagement. Applying that reasoning here: since the firm is performing multiple distinct functions (some data processing, some genuinely nontaxable professional/managerial work), where a single charge bundles both taxable and nontaxable services together, the "5% rule" in Rule 3.330(d)(2) should be applied to apportion the charge, rather than defaulting to an all-or-nothing "professional services" characterization.

What this means for you

CPA firms, accounting firms, and professional-services outsourcers

Don't assume a large outsourced-services contract is automatically nontaxable just because it's delivered by licensed professionals under a "professional services" label. Break the contract down by function: genuine professional analysis/advice (tax return prep, financial statement production, management consulting) stays nontaxable when the computer work is purely incidental to that advice, but distinct data-processing functions (payroll processing, data entry/retrieval, business accounting data production) are taxable on their own, even when billed by the same firm under the same master agreement.

Businesses outsourcing finance/accounting/IT functions to a professional-services firm

Expect your vendor to apply tax to specific line items or apportioned charges (via the 5% rule) rather than treating the whole engagement as either fully taxable or fully exempt — ask for a service-by-service breakdown if your contract bundles clearly-taxable data processing with genuinely nontaxable professional advice.

Accountants and tax professionals

This is a rich, structurally important letter: it forecloses the "we're a CPA firm doing this so it's all professional services" argument, clarifies where the facilitate-vs-perform-the-data-processing-itself line sits, and directly applies the mixed-transaction 5% rule (Rule 3.330(d)(2)) with support from the "essence of the transaction" analysis in Comptroller's Decision No. 30,394.

Common questions

Q: Is an outsourced accounting/IT services contract automatically nontaxable just because a CPA firm provides it?
A: No — the Comptroller requires breaking the contract into pieces and assessing each function individually against the Rule 3.330 data processing definition.

Q: When is a computer's use by a professional firm considered nontaxable?
A: Only when the computer merely facilitates the performance of another nontaxable service or the application of specialized professional knowledge (e.g., preparing a tax return or financial report) — not when the computer work IS the taxable data processing service itself (e.g., payroll processing).

Q: Can a CPA firm avoid tax on payroll processing just because the same data feeds into a nontaxable tax return?
A: No — that would give CPA/bookkeeping firms an unfair advantage over dedicated data processing companies doing the same taxable work.

Q: How should a single combined charge covering both taxable and nontaxable services be handled?
A: Apply the 5% rule under Rule 3.330(d)(2) to apportion the charge, rather than treating the whole thing as taxable or nontaxable.

Q: Can I rely on this letter for my own outsourced-services contract?
A: No. This opinion is based on the facts presented, and additional or different facts may change the opinion; it can be relied on only by the taxpayer it was issued to.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.0101 (list of taxable services, including data processing)
• 34 Tex. Admin. Code Rule 3.330 (data processing services; Rule 3.330(d)(2) is the "5% rule" for mixed taxable/nontaxable single charges)
• Comptroller's Decision No. 30,394 (1994) (guidance on the "essence of the transaction" test for mixed-service transactions)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9912947L

Original ruling text

December 27, 1999

Dear **:

Thank you for your recent letter concerning issues discussed in our meeting of
November l0, l999.

You asked that I review the additional information presented and determine
whether the services contained within the contract should be viewed as
professional accounting services, with data processing functions being
performed for Company A's benefit (necessary to provide the professional
services), or whether the contract services should be viewed individually by
service with taxability determined at that level.

Facts: A contract agreement for outsourced services has been developed between
Company A (a CPA firm) and Company B. Overall, the contract provides that
Company A will perform finance, accounting and information technology services
in accordance with terms as outlined in the contract. Company A will provide
the referenced services for the upstream and chemical portion of Company B's
business. In addition, Company A will provide some limited downstream
information technology services for Company B's downstream business. Many
functions associated with Company B's downstream business have been outsourced
to a third provider, and the services that Company A will be providing will be
for the benefit of Company B and the third party service provider.

The main process areas covered by the contract are referred to as Service Level
Agreements (SLA's). There is a direct reference to these activities (Schedule l
and Schedule 17) in the contract. Schedule l contains detailed information on
the specific process area job functions primarily associated with the upstream
and chemical functions and Schedule l7 describes downstream information
technology services to be provided.

The following represents a brief summary of the process areas associated with
Schedule l (SLA's):

l) Order Fulfillment - This function includes establishing and maintaining the
required data to derive production reports, report transactions, and file
regulatory reports with the appropriate jurisdictional agencies.

2) Ownership Function - This function includes activities to determine,
establish, and maintain property and ownership data. It also entails processing
disbursements of royalties, monitoring and processing legal suspense accounts
and preparing suspense reports.

3) Joint Venture Accounting - This group is responsible for the creation of
master records in SAP relating to Joint Venture Accounting. This includes
monthly processing, accounts receivable and collections, customer inquiry,
business unit support, billing processing, and special projects. Outside
operated functions include master data maintenance, monthly processing,
business unit support, outside operated audit coordination, and payroll
activities.

4) General Accounting and Reporting - This group is responsible for financial
processing, cash management, controlling master data, financial reporting, tax
reporting and future financial reporting.

Other accounting functions - Other accounting functions include managing,
processing, and supporting the procurement function, capital assets, energy
accounting, lease accounting, subsidiary accounting, international accounting
support and accounts receivable marketing.

Tax Compliance - This function includes preparing and filing state and local
sales and use tax returns, maintaining taxability tables, and handling tax
authority disputes with respect to tax audits.

Information Technology Support - This function includes SAP production support,
desktop support services, computer hardware maintenance, software support,
operational support services, and technical upgrade planning.

Business Solutions (Mergers, Acquisitions and Divestments) - This group
coordinates accounting services, performs contract reviews and due diligence,
and consults on issues related to pursuing property acquisitions, divestments
and joint ventures.

Schedule 17 addresses downstream information technology services. These
services will focus on the following:

• SAP host services

• SAP production hardware maintenance/facilities

• Mainframe services

• Distributed host services

Issues: Would the performance of the aforementioned process area services
(Schedule 1 and Schedule 17) be considered "professional" services in total and
therefore, not be subject to Texas sales and use taxes or would certain
specified services contained within the process areas be considered data
processing and thus individually taxable pursuant to Texas Tax Code 151.0101?

Response: It appears that you have two contentions. The first is that data
processing is being performed, however; it is performed by your firm for its
own use in carrying out nontaxable managerial or accounting functions. The
second is that an "essence of the transaction" test applies and that the total
charge is one nontaxable service. The alternative view is that the firm is
providing both taxable and non-taxable services.

There appears to be little question that data processing services are
performed. Data processing services include data entry, data retrieval, data
search, information compilation, payroll and business accounting data
production, and other computerized data and information storage or
manipulation. Rule 3.330, which addresses data processing, defines the service
as "the processing of information for the purpose of compiling and producing
records of transactions, maintaining information, and entering and retrieving
information." It appears that the information entered, tracked, manipulated,
and printed at issue are the property of and are used by the client company as
well as the provider of the services.

The rule also provides that data processing does not include the use of a
computer by a provider of other services when the computer is used to
facilitate the performance of the service or the application of the knowledge
of physical sciences, accounting principles, and tax laws (i.e.; use of a
computer by a CPA firm, enrolled agent, or bookkeeping firm to produce a
financial report, prepare federal income tax, state franchise or sales tax
returns). Obviously, there is overlap here. A CPA firm that separately states a
charge for payroll services will use the expenses associated with the payroll
computations in completing the Income Tax Return or financial statements. This
cannot serve to exempt the payroll services provided. This would give any CPA
or bookkeeper an unfair advantage in providing these services in lieu of data
processing firms.

The issue of the applicability of the "essence of the transaction" doctrine, as
it relates to services was addressed in Comptroller's Decision No. 30,394
(1994). Though the cited decision does not involve data processing services, it
does provide guidance on how to approach a case that considers mixed-services.

In that administrative hearing the Tax Division argued that the cases involving
the "essence of the transaction" test involved controversies that arose prior
to taxable services, which gave rise to the so called "5% rule" to address
transactions involving a mix of taxable and non-taxable services. The
Administrative judge agreed that the "essence of the transaction test" involved
instances where transactions included both the provision of a service and the
transfer of tangible personal property prior to the imposition of sales tax on
taxable services. The judge continued, stating that "when mixed services are
performed, the agency has adopted a rule that provides a reasonable method for
addressing the taxability of 'mixed-service' transactions in a consistent and
efficient manner." The judge also states; "(s)econdly, even if the 'essence of
the transaction' test were applicable to 'mixed-service' transactions, it does
not seem to be helpful to Petitioner's case, since (at least on its face) it
appears that Petitioner was hired for the dual purposes of demolishing the
buildings and hauling away of the demolished remains." Therefore, the essence
of the transaction seems twofold. In short, Petitioner was hired to perform two
services. One is taxable. One is not." In the case at hand, it appears that
your firm is performing multiple services.

You are correct in stating that this office generally does not tax
"professional" services performed by a CPA. In addition, tax is not due when
you are performing a nontaxable service (i.e., preparation of income tax return
or management consultation services) and the data processing involved is for
your own purposes of performing the nontaxable service. However, the processing
of payables, payroll, and other taxable data processing services are taxable,
even when performed by a professional that also performs nontaxable services
for the client. In these cases, the 5% rule, as explained in enclosed Rule
3.330 (d)(2), should be applied when taxable and nontaxable services are
performed for a single charge.

This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change. You may call me toll free at
1-800-531-5441, ext. 5-0613. The direct line is 512/475-0613. You may also
write to Tax Policy Division, Comptroller of Public Accounts.

Sincerely,

Kevin Koller
Tax Policy Division