Texas Franchise Tax: Still Changing After All These Years

• Key issues surrounding the application of the Texas franchise tax present new challenges and opportunities for taxpayers conducting business within the state.
• Taxpayers should review their Texas positions and consider the impact of the most recent hearing decisions and policy changes.

​​The current version of the Texas franchise tax has been in effect since 2008, but clearing up gray areas surrounding the levy remains a work in progress. Emerging questions regarding key aspects of the tax include those related to apportioning receipts from services, calculating the cost of goods sold, deducting compensation, and qualifying for the reduced franchise tax rate. Several seminal court decisions offer insights on interpreting and applying these provisions. These cases, as well as other contributing factors have resulted in policy changes by the Texas Comptroller’s office (Comptroller). It is important for taxpayers to consider these changes and weigh their impact on their Texas tax positions.

Apportionment

Apportionment seeks to fairly measure a company’s tax base in a state based on its activities within the jurisdiction. Three-factor apportionment formulas (property, payroll and sales/receipts) were the norm for a long time. Eventually, most states transitioned to a more heavily weighted sales factor and some adopted a single-sales factor. Texas has used a single-receipts factor for this purpose for many years, even before the current version of the franchise tax. Sourcing receipts from sales of tangible personal property is relatively straightforward, with a few exceptions. However, the sourcing of receipts from services can be more complex. The Texas tax code states that the apportionment factor numerator is determined based on the sum of the taxable entity’s receipts from each service performed in Texas. The Texas Administrative Code clarifies further that receipts from a service are apportioned to the location where the service is performed. If services are performed both inside and outside of Texas, then such receipts are Texas receipts on the basis of the fair market value of the services that are rendered in Texas.

While sourcing receipts from services based on the fair market value of services rendered in Texas seems somewhat simple, complexities have emerged when applying this rule to receipts from service transactions in which the deliverable is received electronically by customers. To make these determinations, Texas has applied a concept described as the end product act. This concept can be traced back to a hearing in 1980 that addressed the sourcing of revenue from television stations’ broadcast time. The result was that the services were sourced based on the location of the broadcast towers. In contrast, there was a 2013 hearing decision that sourced revenue from satellite television services to the subscribers’ addresses because that was where the signal was descrambled. More recently, the Comptroller issued a letter ruling in 2018 that sourced revenue from an airport parking reservation service to the location of the parking spaces rather than the location of the employees that operated the software, or the location of the servers where the software resides.

Then, in 2018, the satellite radio subscription service, Sirius XM Radio (Sirius), was assessed additional tax after the Texas Comptroller’s office determined that the company improperly apportioned its tax base. The Comptroller contended the company’s subscription receipts should have been apportioned to Texas based on the locations where the satellite transmissions were received by subscribers. Sirius argued that the receipts should instead be apportioned based on the location where the services were produced. In doing so, Sirius presented two expert witnesses who explained the methodology used to determine the percentage of Sirius’s value-producing activities within the state, versus those outside of Texas.

Ultimately, the court found the experts’ testimony to be credible and held that Sirius correctly apportioned its subscription receipts based on where its production and distribution activities occurred and the fair value of the services provided. The court discussed the end product act test, which looks at the taxpayer’s receipt-producing activities and the location in which the activities are performed. Here, Sirius’ end product act was the production and distribution of its subscription content, both of which occurred outside of Texas. Thus, the court held Sirius’ method of apportionment was valid, and accurately accounted for the fair value of services performed in Texas.

The end product act test has been brought up by Texas auditors over the last couple of years, especially with services where the deliverable is received electronically by customers. The cases have shown that applying this concept can lead to different conclusions depending on the specific aspects of the transactions producing the taxpayer’s service receipts. Taxpayers should be prepared to analyze the technical details of the transactions underlying their service receipts and challenge audit results if the auditor’s conclusions seem unreasonable.

Cost-of-Goods-Sold Deduction

The cost-of-goods-sold (COGS) deduction also made headlines in recent years with respect to a subsidiary’s eligibility to take a COGS deduction in computing its franchise tax within the context of a combined group’s overall business. The qualification for COGS was expanded to include certain types of companies that invest labor into improving or modifying real property.

In Combs v. Newpark Resources, Inc., the court stated that each member of a combined group’s business should be viewed in the context of the combined group’s business as a whole, as opposed to treating each member as if it were a stand-alone company. The court clarified that to hold otherwise would “lead to the absurd result that a company that had no subsidiaries could take all the COGS deductions allowable, but if that same company created subsidiaries it could potentially lose substantial COGS deductions because each subsidiary might not sell goods in the ordinary course of its business.” Additionally, the Comptroller had argued that the company’s subsidiary should not be eligible for a COGS deduction because the subsidiary provided only a service. The court, however, viewed the combined group as a single taxable entity for purposes of the application of the franchise tax.

The case also expanded the qualification for COGS for companies that invest labor into improving or modifying real property. The Texas tax code limits which entities can claim the COGS deduction, restricting it to those that actually own the goods they sell. However, an exception applies to entities that furnish labor or materials to certain projects related to real property and are “considered to be an owner of that labor or materials and may include the costs, as allowed by this section, in the computation of [COGS].” In deciphering the legislature’s meaning of as allowed by this section, the court concluded this subsection means that the party that supplies labor or materials to the construction, improvement, remodeling, repair, or industrial maintenance of real property can deduct its labor or material expenses as a COGS, assuming those expenses would qualify as the cost of selling real property. The Comptroller had previously been more restrictive on the entities and costs that qualified for the COGS deduction. In fact, Texas’ initial stance on COGS was that COGS for Texas would never be the same as federal COGS.

Employer’s Compensation Deduction

Another noteworthy change in recent years is that the employer’s deduction for compensation is now interpreted to include employee benefits. A well-known Texas-based law firm sued the Comptroller for a refund for taxes it paid in protest. The Comptroller had assessed the tax as a result of the taxpayer’s claimed deductions for employee benefits, which included parking, attorney occupation taxes and continuing education fees.

In general, the franchise tax compensation deduction includes both a wages and cash compensation component, and a benefits component. Accordingly, the taxpayer argued the meaning of benefits in the Texas tax code. The court held the rule invalid to the extent that it does not allow a taxpayer to deduct as compensation the cost of all benefits it provides to its officers, directors, owners, partners, and employees that are deductible for federal income tax purposes. As such, the court held that the taxpayer could deduct the employee benefits.

Reduced Franchise Tax Rate

Taxpayers primarily engaged in retail or wholesale trade may qualify to pay tax at one-half of the regular franchise tax rate. For a taxpayer to be considered primarily engaged in retail or wholesale trade, the Texas tax code lists several requirements. One of the requirements to qualify for the reduced rate is that less than 50% of a taxpayer’s revenue comes from the sale of products it produces or products that are produced by an entity that is part of an affiliated group. Texas Tax Code Sec. 171.0001 defines an affiliated group as one or more entities in which a controlling interest is owned by a common owner or owners, either corporate or noncorporate, or by one or more of the member entities. Noticeably absent from this definition is clarification on whether or not an affiliated group includes entities that are not included in a Texas combined return. The Comptroller’s position is that foreign affiliates are considered for this test even though foreign affiliates are not allowed to be included in a combined Texas return.

In a recent hearing decision, the Comptroller held that a prescription eyeglass distributor did not qualify for the reduced rate because the distributor’s activity was predominantly production and manufacturing as opposed to retailing. Further, the Comptroller determined that 100% of the eyeglasses the distributor sold included lenses that the taxpayer itself manufactured. Because more than 50% of the distributor’s total revenue came from the sale of its manufactured lenses, the distributor was considered a manufacturer of eyeglasses (rather than a retailer) for Texas franchise tax purposes. Thus, the taxpayer was prohibited from using the reduced rate.

One fact pattern to consider is companies that have historically been considered manufacturers but in more recent years have moved to outsource their manufacturing to unrelated third parties. In these situations the company may qualify for the reduced rate as long as the 50% test is met. Also, energy companies that have commodity trading operations should review their facts to see if they can meet the 50% test. Trading operations generally create a large volume of receipts and much of that may be related to commodities that were purchased from counterparties outside the group.

The Takeaway

Much has changed since Texas enacted the current version of the franchise tax. These changes present new challenges and opportunities for taxpayers conducting business within the state. As such, we encourage taxpayers to proactively review their Texas tax positions and consider the impact of these recent hearing decisions and policy changes. Andersen has the resources to assist clients in reviewing their current Texas franchise tax position and evaluating opportunities for tax planning in light of these changes from the Texas Comptroller’s office.