State Tax Return. New Texas Tax On Margin Of Limited Partnerships And Other Businesses Tied To Property Tax Relief

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1 May 2006 Volume 13 Number 5 State Tax Return New Texas Tax On Margin Of Limited Partnerships And Other Businesses Tied To Property Tax Relief Karen H. Currie Dallas (214) After years of discussion and numerous proposals, the Texas Legislature finally passed legislation 1 closing the limited partnership loophole that Texas businesses have come to know so well. Although many potential taxing regimes have been considered over the years, the Legislature settled on a gross margin based tax to be imposed on almost all legal entities, including limited partnerships, beginning with returns filed after January 1, The legislation, passed in record time with little amendment, provides a unique taxing structure that has already raised numerous issues for current and potential taxpayers. Background Although the Texas Legislature has considered amendments to the Texas franchise tax several times over the years, the need for such a change became more apparent in recent years. In Neeley v. West Orange-Cove, 2 the Texas Supreme Court set a June 1, 2006 deadline for enjoining the use of the current public school finance system after determining that such system amounted to an unconstitutional state-wide property tax. To comply with the court s order, the state was faced with the challenge of decreasing its reliance on local property taxes for purposes of funding its public school systems. This was accomplished in large part through the adoption of a gross-margin-based tax closing certain perceived loopholes allowed by the current taxing regime. Governor Perry called a special session beginning April 17, In the short time since, the Legislature enacted a record number of changes to the Texas taxing system. Five bills have passed both the House and the Senate and are expected to be signed into law by the Governor shortly. The bills are expected to collectively result in at least a temporary reduction in property taxes and a permanent net increase in franchise and other taxes. 1 At press time, the legislation has passed both the House and Senate and is waiting for signature by the Governor. Governor Perry has indicated full support for this legislation and is expected to sign it into law this week. We will keep you updated on possible changes that may occur before the legislation is signed into law. 2 See Neeley v. West Orange-Cove Consol. Independent School Dist., 176 S.W.3d 746 (Tex. Nov. 22, 2005).

2 Property Tax Relief House Bill 1 ( HB1 ) reduces local school property taxes (generally imposed at the current $1.50 per $100 valuation cap) by 17 cents in 2007 and another 33 cents in 2008 to $1 per $100 valuation. HB1 allows districts to add 4 cents of local enrichment to the tax rate by local school board approval, with access to an additional 2 cents of enrichment in Any other tax increases by local jurisdictions must be approved by voters. Teachers are to receive a $2,000 across-the-board pay raise, and districts will be permitted to create incentive plans to increase teacher performance and attract teachers to hard to staff schools, or teach understaffed subjects. The bill also implements a uniform start day of the fourth Monday in August for all public schools beginning with the school year. Revenue And Allocation Measures To pay for the property tax reduction, the Legislature passed a series of bills allocating funds and raising revenue. House Bill 2 ( HB2 ) allocates a significant portion of the new tax revenue to property tax relief. House Bills 3, 4 and 5 were each enacted to raise additional revenue, although one might have concluded otherwise from some of the clever press coverage. House Bill 3 ( HB3 ) amends Chapter 171 of the Texas Tax Code transforming the current Texas franchise tax into a tax based on gross margin. This bill is discussed in detail below. House Bill 4 ( HB4 ) strengthens the disclosure requirements upon the sale of used motor vehicles and clarifies that the motor vehicle sales tax will be based on blue book value, rather than buyer-stated value. House Bill 5 ( HB5 ) increases the tax on the sale of tobacco products. Franchise Tax Based On Gross Margin The most significant impact for companies doing business in Texas is the passage of HB3, which completely changes the current Texas franchise tax and adopts a more inclusive tax that is unlike any other state tax currently in existence. The unique makeup of this taxing regime raises numerous implementation questions that the Legislature, the Texas Comptroller and/or businesses will need to address in the near future. For now, we are limited to the language set forth in the bill, which is summarized in detail below. Regulations will be promulgated over the coming months. Under the new franchise tax, Texas retains its entity focus, but shifts from a net income base to a gross margin base. The newly-revised Texas franchise tax is imposed, on a unitary combined basis, on any taxable entity at the general rate of one percent (1%) of taxable margin, although certain retail or wholesale businesses receive a reduced rate of one-half percent (.5%) of taxable margin. A. Broader Definition Of Taxable Entity HB3 broadens the definition of businesses subject to tax to include limited partnerships, trusts, and other entities not previously subject to the Texas franchise tax. HB3 2

3 specifically excludes certain other entities from the tax. The new list of taxable and excluded entities is set forth below. 1. Taxable Entities Pursuant to HB3, the new franchise tax is imposed on the following taxable entities : a. Partnerships Except General Partnerships Owned By Natural Persons The new Texas franchise tax is imposed on all partnerships except general partnerships that are entirely owned by natural persons. Pursuant to HB3, all limited partnerships and limited liability partnerships are considered taxable entities subject to tax, as are any general partnerships with entity ownership. b. Corporations As before, the definition of taxable entity includes a corporation. A corporation that is subject to the current franchise tax will continue to be subject to the franchise tax under the new legislation. c. Limited Liability Companies Pursuant to HB3, the definition of taxable entity includes a limited liability company. Limited liability companies will continue to be subject to the franchise tax as a separate legal entity regardless of whether they are characterized as a corporation, partnership, or disregarded entity for federal income tax purposes. d. Business Trusts Business trusts are included in the definition of taxable entity subject to the new Texas franchise tax. Historically, business trusts were not included in the definition of corporation and thus, were not previously subject to the franchise tax. e. Professional Associations Professional associations are included in the definition of taxable entity subject to the new Texas franchise tax. The term professional association is not defined in the Texas Tax Code. f. Banking Corporations A banking corporation is a specifically enumerated taxable entity according to HB3. The term banking corporation is defined as a state, national, domestic or foreign bank, whether organized in Texas, another state, another country or pursuant to federal law. Included in the definition of a banking corporation is any limited banking association or Edge Act corporation. Bank holding companies, as defined under the Bank Holding 3

4 Company Act of 1956, are specifically excluded from the definition of a banking corporation. g. Savings And Loan Associations A savings and loan association is a taxable entity subject to the revised Texas franchise tax. Savings and loan association is defined as a savings and loan association or savings bank, whether organized in Texas, another state, another country, or under federal law. h. Business Associations Pursuant to HB3, business associations are also subject to the new franchise tax. Historically, business associations were not included in the definition of corporation and thus, were not previously subject to the franchise tax. The legislation does not define the term business association. i. Joint Ventures In general, joint ventures are included in the definition of taxable entity subject to the new franchise tax. Although the term joint venture is not specifically defined, the legislation sets forth certain specific joint ventures that are excluded from the definition of a taxable entity. The term joint venture for purposes of determining a taxable entity does not include joint operating or co-ownership arrangements that meet the requirements of Treas. Reg (a)(3) and elect out of federal partnership treatment as provided by Section 761(a) of the Internal Revenue Code. Treas. Reg (a)(3) requires that the participants own the property as co-owners in fee or under lease, reserve the right separately to take in kind or dispose of their shares, and do not jointly sell services or the property produced. j. Joint Stock Companies Join stock companies are included in the definition of taxable entity subject to the new Texas franchise tax. The legislation does not define the term joint stock company. k. Holding Companies Pursuant to HB3, a holding company is a taxable entity. HB3 does not specifically define the term holding company. HB3 provides an exemption for certain passive entities, discussed in Section 2c below. Presumably certain holding companies may qualify for the passive entity exemption. However, it is important to note that the holding of assets, including royalties, patents, trademarks, and other intangible assets used in the active trade or business of a related entity is not considered a passive activity. Thus, traditional intangible holding companies will generally be considered taxable entities for purposes of the new tax. 4

5 l. REITs Holding Interests In Real Property A real estate investment trust ( REIT ) that directly holds real estate, other than real estate it occupies for business purposes, is a taxable entity. A limited partnership or other entity that directly holds real estate may also be a taxable entity, regardless of whether a REIT holds an interest in it. m. Other Legal Entities Not Specifically Excluded HB3 includes a catch all provision in the definition of a taxable entity for other legal entities. It is unclear as to what this provision is intended to include. It is likely that any entity not otherwise enumerated as taxable or exempt would be subject to the new tax under this provision. 2. Entities Specifically Excluded From The Revised Texas Franchise Tax Pursuant to HB3, the following entities are expressly excluded from the definition of taxable entity. a. Sole Proprietorships A sole proprietorship is excluded from the definition of taxable entity. Thus, sole proprietorships will continue to be exempt from the Texas franchise tax. b. General Partnerships Owned Directly By Natural Persons A general partnership, the direct ownership of which is entirely composed of natural persons, is excluded from the definition of taxable entity. To qualify for the exclusion, all partners must be natural persons. To the extent the general partnership has even one owner that is a corporation, limited liability company, or other type of legal entity, the partnership will be subject to tax. To the extent the partnership is a limited partnership or limited liability partnership it will be a taxable entity under the new franchise tax. Only a general partnership owned entirely by natural persons will be exempt. c. Passive Entities (Other Than Typical Intangible Holding Companies) Pursuant to HB3, a passive entity is not a taxable entity for purposes of the revised Texas franchise tax. To qualify as a passive entity, the entity must be a general or limited partnership or trust, other than a business trust, for which at least ninety percent (90%) of the entity s federal gross income consists of passive income. Although a passive entity is excluded from the tax, the owners of a passive entity must include in their calculation of total revenue the revenue of the passive entity. Thus, in most instances, the revenue of a passive entity will continue to be subject to tax as part of a combined group. Alternatively, a combined group may elect to treat a passive 5

6 entity as a taxable entity, in which case the owner will not be required to include such revenue in its return. Passive income is defined as: (1) dividends, interest, foreign currency exchange gain, periodic and nonperiodic payments with respect to notional and principal contracts, option premiums, cash settlement or termination payments with respect to a financial instrument and income from a limited liability company; (2) distributive shares of partnership income; (3) gains from the sale of real property, commodities traded on an exchange and securities; and (4) royalties, bonuses, or delay rental income from mineral properties. Specifically excluded from the definition of passive income is rent and certain income received by a non operator from mineral properties where the operator of such properties is a member of the affiliated group. An entity that receives more than ten percent (10%) of its federal gross income from conducting an active trade or business will not qualify as a passive entity. An entity is considered to be conducting an active trade or business if the activities carried on include: (1) active operations that form a part of the process of earning income or profit; or (2) active management and operational functions. For purposes of this active trade or business test, activities of independent contractors will be deemed performed by the entity to the extent the activities are performed on behalf of the entity and constitute all or part of the entity s trade or business. However, an entity will not be conducting an active trade or business if the entity s activities are limited to payment of compensation to employees or independent contractors for financial or legal services reasonably necessary for the operation of the entity. HB3 provides specific guidance with respect to intangible holding companies. An entity is conducting an active trade or business if royalties, patents, trademarks or other intangible assets held by the entity are used in the active trade or business of a related entity. Thus, an intangible holding company will generally be considered a taxable entity for purposes of the new tax. 6

7 d. Otherwise Exempt Entities An entity that is exempt from taxation under Subchapter B is also excluded from the definition of taxable entity. Subchapter B of Chapter 171 of the Texas Tax Code relates to a number of pre-existing franchise tax exemptions, including insurance companies that pay premium taxes, nonprofit organizations, and cooperative associations. 3 For the most part these exemptions have remained unchanged by the legislation. Insurance organizations, title insurance companies, title insurance agents authorized under the Insurance Code, and nonadmitted insurance organizations paying the gross premium tax will continue to be exempt from tax. The other provisions of Subchapter B also remain unchanged. The exemptions set forth in Subchapter B have been extended to noncorporate entities. Pursuant to HB3, an entity that is not a corporation but that, because of its activities, would qualify for a specific exemption under Subchapter B if it were a corporation, will qualify for the exemption purposes of the new franchise tax. e. Certain Passive Family Limited Partnerships A family limited partnership that is a passive entity will be excluded from the definition of taxable entity if at least eighty percent (80%) of the interest in the partnership is held, directly or indirectly, by members of the same family. f. Grantor Trusts Where Beneficiaries Are Natural Persons Or Charitable Organizations When all of the beneficiaries of a grantor trust, as defined by the Internal Revenue Code, are either natural persons or charitable entities, the trust will generally be excluded from the new Texas franchise tax. The one exception to this general rule is that any trust that elects to be taxable as a business entity pursuant to Treas. Reg (b) will be considered a taxable entity for purposes of the Texas franchise tax as well. g. REITs That Do Not Hold Interests In Real Property Certain REITs and qualified REIT subsidiaries are excluded from the definition of taxable entity under the new Texas franchise tax provided that the REIT does not directly own any real estate other than real estate it occupies for business purposes. A REIT is a taxable entity to the extent any amount of its assets are direct holdings of real estate, other than real estate it occupies for business purposes, as opposed to holdings of interests in limited partnerships or other entities that directly hold real estate. To the extent a limited partnership or other entity directly holds real estate, the entity is not exempt under this subdivision, regardless of whether a REIT holds an interest in it. 3 Tex. Tax Code through

8 h. REMICs A real estate mortgage investment conduit ( REMIC ), as defined by the Internal Revenue Code, is excluded from the definition of taxable entity for purposes of the new Texas franchise tax. Thus, a REMIC will continue not to be subject to the revised Texas franchise tax. 3. A Combined Group Is A Taxable Entity The definition of taxable entity specifically includes a combined group. The term combined group is defined as taxable entities that are part of an affiliated group engaged in a unitary business and are required to file a group report.... Whenever the term taxable entity is used throughout the revised statutes, the term refers to the unitary combined group as a whole, rather than a specific entity. The extent of joint liability for a combined group remains somewhat unclear. B. Unique Unitary Provisions HB3 requires an affiliated group of entities engaged in a unitary business to file a combined report including all taxable entities in the group. A taxable entity is included in the combined group regardless of whether the entity has nexus with Texas. In some respects, the Texas unitary combined group is broader than in other states (e.g., includes most partnerships, LLCs and business trusts). In other respects, the Texas unitary combined group is narrower than in other states (e.g., limited to 80% or more common ownership). As described below, the new legislation incorporates a unique definition of a unitary business. 1. Limited Partnerships And Disregarded LLCs Are Included Because HB3 expands the definition of taxable entity to include limited partnerships, limited liability partnerships, disregarded limited liability companies, and business trusts, all of these entities will be included in the combined group. Thus, the combined group will have a unique composition that is different from any other combined or consolidated return. 2. Limited To Entities With 80% Ownership The combined group is limited to an affiliated group of taxable entities engaged in a unitary business. An affiliated group is defined as a group of one or more entities in which a controlling interest is owned by a common owner or owners, either corporate or non corporate, or by one or more of the member entities. A controlling interest means eighty percent (80%) or more of the direct or indirect beneficial ownership held by a common owner of a corporation or other entity. Unlike other states that determine a unitary group based on fifty percent (50%) ownership, Texas has a more limited ownership structure. 8

9 3. Water s-edge Combination Texas adopted a water s-edge type of combination, excluding those companies that are primarily outside of the United States. Pursuant to HB3, excluded from the definition of a combined affiliated group are those entities in which eighty percent (80%) or more of the entity s property and payroll are assigned to locations outside the United States. If the entity does not have any payroll or property, it will be excluded if eighty percent (80%) of the entity s sales are outside of the United States. 4. Special Definition Of Unitary Business Two or more entities that are taxable entities and meet the definition of affiliated group, will be required to file a combined report only if they are engaged in a unitary business. A unitary business is defined as a single economic enterprise that is made up of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts. In determining whether a unitary business exists, HB3 provides that the Comptroller consider any relevant factor, including whether: (1) the group members are in the same general line of business, such as manufacturing, wholesaling, retailing of tangible personal property, insurance, transportation, or finance; (2) the activities of the group members are steps in a vertically structured enterprise or process; and (3) the members are functionally integrated through the exercise of strong centralized management. 5. Method Of Unitary Filing Aggregate Separate Company Revenue An affiliated group of taxable entities engaged in a unitary business will be treated as a single taxable entity for purposes of the filing of a tax return. An exempt entity that is a part of an affiliated group engaged in a unitary business will not generally be included in the combined return. However, a combined group may elect to include an exempt entity and treat it as a taxable entity. The combined group determines its total revenue by calculating the revenue on a separate entity basis then adding the total revenue of the member entities together. Once the total revenue is determined, the combined group subtracts, to the extent included in separate company revenue, any items of total revenue received from a member of the combined group. Once total revenue is determined, a combined group must make an election to deduct either cost of goods sold or compensation. The election between the cost of goods sold or compensation applies to all members in the combined group. For a group that elects to subtract the costs of goods sold, the subtraction is calculated by determining costs of goods sold on an individual entity basis, adding the deduction for each separate member together, then subtracting out items received from a member of the combined group. The compensation deduction is calculated in a similar manner. 9

10 C. Tax Is Based On Total Revenue Pursuant to HB3, an entity s gross margin is based on the lesser of (a) seventy percent (70%) of the taxable entity s total revenue from its entire business or (b) the entity s total revenue from its entire business with a deduction for either cost of goods sold or compensation. 1. Total Revenue Defined For corporations, total revenue is based on gross receipts per line 1c of the federal return 4 including dividends, interest, gross rents and royalties, capital gain net income, net gain from Form 4797, and other income per lines 4 through 10 of the federal 1120 return. Taxpayers are then allowed to subtract: (1) bad debt, to the extent the debt corresponds to items of income included in the tax base; (2) to the extent included in revenue, foreign royalties and foreign dividends, including amounts determined under Section 78 or Section of the Internal Revenue Code; (3) net distributive income of partnerships, trusts, limited liability companies treated as partnerships for federal income tax purposes and corporations or limited liability companies treated as S corporations if the income was included in the total revenue; (4) expenses related to dividend income as reported on Form 1120 Schedule C; and (5) income attributable to a disregarded entity to the extent included in total revenue. Corporations that file as part of a federal consolidated return are required to compute the total revenue as if the corporation had filed on a separate company basis for federal income tax purposes. HB3 provides identical provisions for the calculation of total revenue for partnerships. For taxable entities other than partnerships or corporations, HB3 requires that the entities use a substantially similar method to calculate total revenue on a separate 4 Note that federal return is defined to include all variations of the federal return regardless of which actual form the taxpayer files. In addition, even though HB3 specifically provides the line number from Form 1120 and not the actual term, a separate provision in HB3 states that the equivalent amount should be used if the taxpayer does not file on an actual Form

11 company basis. The income of a passive entity that is not included in a group report is includable in the total revenue of the taxable entity owner to the extent the net income of the passive entity was not generated by the margin of any other taxable entity. In determining total revenue, HB3 provides a deduction for flow-through funds mandated by law or fiduciary duty to be distributed to other entities. Similarly excluded are flow-through funds mandated by contract. Examples of such funds include taxes collected and remitted to the taxing authority, sales commissions to non-employees, the tax basis of securities underwritten, and subcontracting payments to provide services, labor, or materials in connection with the design, construction, remodeling, or repair of improvements on real property. To the extent any of these deductions arose out of payments to other members of the affiliated group, the deductions will be disallowed, to avoid a double exclusion/deduction. HB3 also provides that dividends and interest received from federal obligations may be deducted to the extent included in revenue. 2. Deduction For Cost Of Goods Sold Or Compensation The tax base for the new franchise tax is the lesser of (1) seventy percent (70%) of the total revenue or (2) total revenue minus either cost of goods sold or compensation. a. Cost Of Goods Sold For purposes of determining cost of goods sold pursuant to HB3, goods is defined as real or tangible personal property sold in the ordinary course of business. Tangible personal property includes personal property that can be seen, weighed and measured as well as films, sound recordings, videotapes and other similar property and computer programs. Tangible personal property does not include intangible property or services. Where not otherwise provided, an entity shall determine cost of goods sold pursuant to the federal statutes and regulations. HB3 provides that cost of goods sold, for purposes of computing the new Texas franchise tax, includes all direct costs of acquiring or producing the goods, including: (1) costs for labor; (2) costs of materials that are an integral part of specific property produced or are consumed in the ordinary course of performing production activities; (3) handling costs, including costs attributable to processing, assembling, repackaging, and inbound transportation; (4) storage costs; (5) depreciation, depletion, and amortization; 11

12 (6) the costs of renting or leasing equipment, facilities, or real property; (7) repair and maintenance; (8) costs attributable to research, experimental engineering, and design; (9) geological and geophysical costs incurred to identify and locate potential mineral producing property; (10) taxes paid in relation to acquiring or producing any material or in relation to services that are a direct cost of production; (11) costs of producing or acquiring electricity sold; and (12) a contribution to a partnership in which the taxable entity owns an interest that is used to fund activities, the costs of which would otherwise be treated as cost of goods sold of the partnership, to the extent those costs are related to goods distributed to the taxable entity as goods-in-kind in the ordinary course of production rather than being sold. Production is defined to include construction, installation, manufacture, development, mining, extraction, improvement, creation, raising, or growth. In addition to those costs relating to the acquisition of production of goods, cost of goods sold also includes the following costs of the taxable entity s goods: (1) deterioration; (2) obsolescence; (3) spoilage and abandonment; (4) costs allocable to the property, including costs of purchasing, storage, and handling; (5) insurance on a plant, facility, machinery, equipment, or materials directly used in the production of goods; (6) insurance on produced goods; 12

13 (7) costs of utilities directly used in the production of goods; (8) quality control costs, including replacements of parts, inspection, and repair and maintenance; and (9) licensing or franchise costs. HB3 sets forth certain costs that are excluded from cost of goods sold. Excluded costs include: (1) facilities, equipment, and land not used in the production of goods; (2) selling costs; (3) advertising; (4) distribution and outbound transportation costs; (5) interest and financing costs; (6) officers compensation; (7) compensation to an undocumented worker; and (8) income and franchise taxes based on income. In addition to those items discussed above, a taxable entity is allowed to deduct as part of cost of goods sold the indirect or administrative overhead costs to the extent allocable to the acquisition or production of goods. The deduction for indirect or administrative overhead costs may not, however, exceed four percent (4%) of the taxable entity s total indirect or administrative overhead costs. Included in indirect or administrative overhead costs are all mixed service costs, such as security services, legal services, data processing services, accounting services, personnel operations, and general financial planning and financial management costs. An entity is allowed to subtract costs for cost of goods sold only if the entity owns such goods. Ownership is determined based on all the facts and circumstances including various benefits and burdens of ownership vested with the entity. A taxable entity that is subject to Section 263A, 460, or 471 of the Internal Revenue Code must capitalize its costs of goods in the same manner and to the same extent that the taxable entity is required or allowed to capitalize costs in accordance with federal law, except as specifically provided in accordance with the Texas provisions. 13

14 b. Employee Compensation Compensation includes (i) all wages and cash compensation paid by a taxable entity to its officers, directors, owners, partners, and employees; and (ii) the cost of all benefits provided to officers, directors, partners, owners, and employees, including workers compensation benefits, health care, contributions to health savings accounts, and retirement to the extent deductible for federal income tax purposes. Wages and cash compensation is specifically defined as the amount entered in the Medicare wages and tips box of the Internal Revenue Service Form W-2 or similar form. The amount of wages and cash compensation deducted may not exceed $300,000 for any single person (owner or employee). There is no cap on the deduction for benefits. Compensation includes payments a taxpayer makes to a staff leasing company for wages and benefits of leased employees but does not include any administrative fee charged by the staff leasing services company. Companies may not deduct wages paid to an undocumented worker. 3. Special Industry Provisions a. Small Businesses HB3 provides an exemption from tax for a taxable entity with total revenue not exceeding $300,000 or a tax liability of less than $1,000. Currently, the small business exemption is available to businesses with gross receipts less than $150,000. HB3 provides a mechanism for adjusting the amount of the exemption every other year beginning in 2009 based on the consumer price index. b. Staff Leasing Services Companies Staff leasing services companies 5 are allowed to exclude from their total revenue the payments received from a client for wages, payroll taxes on wages, employee benefits and workers compensation benefits. In determining its compensation deduction, a staff leasing services company may not deduct payments for sales commissions or payments made to a sales representative by a principal to the extent such payments have been excluded from total revenue, to avoid a double exclusion/deduction. c. Lending Institutions Lending institutions are allowed to deduct from total revenue the principal repayments of loans, to the extent the repayments are not received from a member of the affiliated group. Pursuant to HB3, a lending institution that offers loans to the public may subtract as cost of goods sold an amount equal to the lender s interest expense on its debt. 5 A company is a staff leasing services company if it is meets the definition of staff leasing services company set forth in Section of the Texas Labor Code. Pursuant to Section of the Texas Labor Code, a company is a staff leasing services company if it provides staff leasing services. Staff leasing services can only be provided by companies that hold a license to provide such services. 14

15 A lending institution is defined as an entity that makes loans and is regulated by the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Texas Department of Banking, the Office of Consumer Credit Commissioner, the Department of Savings and Mortgage Lending, the Credit Union Department or any comparable regulatory body. d. Banks And Savings And Loans A bank or savings and loan may deduct interest expense from total revenue as part of cost of goods sold. e. Management Companies Management companies may subtract from total revenue reimbursements of specified costs incurred in the conduct of the active trade or business of a managed entity. Wages and cash compensation may be included in the amounts subtracted. To avoid a double deduction, a management company may not include such amounts in computing its compensation deduction. Deductible wages and compensation will include only the amounts that are not reimbursed by a managed entity. A managed entity may treat reimbursements made to the management company as wages and compensation for purposes of computing its compensation deduction. f. Legal Service Companies An entity that provides legal services may exclude (i) reimbursement of expenses incurred in prosecuting a matter that are not general operating expenses and (ii) actual out-of-pocket expenses of an attorney not to exceed $500 for providing pro bono legal services. g. Health Care Providers And Health Care Institutions A health care provider that is not a health care institution may exclude from total revenue the payments received under the Medicaid, Medicare, Indigent Health Care and Treatment Act, and the Children s Health Insurance programs. Such health care providers may also exclude from revenue the payments for professional services provided in relation to workers compensation claims, to beneficiaries under the TRICARE military health system and actual cost to the health care provider for any uncompensated care for auditing purposes. A health care institution is allowed a similar exclusion limited to fifty percent (50%) of such payments. A health care institution is defined as an ambulatory surgical center, licensed assisted living facility, emergency medical services provider, home and community support services agency, hospice, hospital, hospital system, intermediate care facility for the mentally retarded, birthing center, nursing home or a licensed end stage renal disease facility. 15

16 h. Entities Operating Certain Facilities On Behalf Of The Federal Government Entities that operate a facility on land leased or owned by the federal government, where the facility is used primarily to house members of the armed forces, are entitled to a deduction for revenue that is directly derived from such operations. Entities that manufacture or produce goods under a contract with the federal government are deemed to own the goods being manufactured or produced under such contract for purposes of computing allowable cost of goods sold. i. Oil And Gas Production Companies Stripper Wells Companies that receive revenue from the production of oil and gas may deduct such revenue to the extent the revenue is from an oil or gas well designated by the Railroad Commission of Texas as producing less than ten barrels per day. j. Motor Vehicle Rental Or Leasing Companies In computing cost of goods sold, motor vehicle rental or leasing companies that pay the new Texas franchise tax may subtract as part of cost of goods sold the costs related to the tangible personal property rented or leased in the taxpayer s ordinary course of business. k. Railcar Rolling Stock Rental Or Leasing Companies In computing cost of goods sold, railcar rolling stock rental or leasing companies may subtract as part of cost of goods sold the costs related to the tangible personal property rented or leased in the taxpayer s ordinary course of business. l. Heavy Construction Equipment Leasing Or Renting Companies In computing cost of goods sold, heavy construction equipment leasing or renting companies may subtract as part of cost of goods sold the costs related to the tangible personal property rented or leased in the taxpayers ordinary course of business. m. Intercompany Transactions A company that files a combined return is entitled to subtract from the total revenue of the combined group, items of total revenue received from a member of the combined group. Thus, most intercompany transactions will be eliminated. n. Tiered Partnerships HB3 provides that a tiered partnership arrangement is an ownership structure in which all of the interests in a partnership, trust, or limited liability company that is treated as a 16

17 partnership for federal income tax purposes (an upper-tier partnership ) are owned by one or more other taxable entities (a lower-tier entity ). Thus, for Texas purposes the owner is considered to be the lower-tier entity. A lower-tier entity is allowed to pay tax on the taxable margin of a higher-tier partnership (in addition to the tax it is required to pay on its own taxable margin) provided the higher-tier partnership files a report showing the amount of taxable margin each lowertier entity should report. To the extent the lower-tier entity is not a taxable entity, the higher-tier partnership is liable for tax on its taxable margin. D. Apportionment 1. In General Pursuant to HB3, the tax base will continue to be apportioned using a single gross receipts factor. The throwback rule is repealed. a. Apportionment Calculation Texas gross receipts will continue to include receipts from (i) the sale of tangible personal property delivered or shipped to a buyer in this state, (ii) services performed in this state, 6 (iii) the use of a patent, copyright, trademark, franchise, or license in this state, (iv) sales of real property in this state, (v) rental of property situated in the state, and (vi) other business done in this state. Total gross receipts will continue to be the sum of the taxable entity s sales of tangible personal property, services, rents, royalties and other business. Any receipts excluded from total revenue will also be excluded for Texas receipts factor purposes. b. Combined Apportionment For a combined group, only those receipts from taxable entities that are members of the combined group and have nexus with Texas will be included in the numerator of the apportionment factor. 7 Because most intercompany receipts will be excluded from total revenue, such receipts will be excluded for apportionment purposes, as well. However, receipts from the sale of tangible personal property to a member of a combined group where the buying member lacks sufficient nexus with the state will be included in the Texas and everywhere factors to the extent that the non-nexus member resells the tangible personal property, without modification, to a purchaser in Texas. Total gross receipts for a combined group will include the total receipts from the group s sales of tangible personal property, services, rentals, royalties, and other business. 6 HB3 proposes an amendment to the general rule relating to the sourcing of services for real estate loan services. Pursuant to HB3, real estate loan services will be sourced to the state where the real property is located. 7 HB3 does not change the existing provisions relating to the determination of whether a company has nexus with Texas for franchise tax purposes. 17

18 Receipts from every taxable entity must be included in the denominator regardless of nexus. Any receipts excluded from total revenue will also be excluded for total receipts factor purposes; thus, most intercompany receipts will be excluded. 2. Special Apportionment Provisions a. Servicing Of Loans Pursuant to HB3, receipts derived from the servicing of loans secured by real property will be included in the numerator if the real property is located in Texas. b. Food And Medicine Receipts The pre-existing special apportionment rules for food and medicine receipts are repealed by the new legislation. c. RICs/Employee Retirement Plan Service Companies HB3 leaves in place the sourcing provisions for RICs and entities that service employee retirement plans, with the sole modification of replacing the term corporation with taxable entity so that such provisions will be extended to all types of legal entities. d. Banking Corporations HB3 provides no changes to the sourcing rules for banking corporations. Banks will continue to exclude interest earned on federal funds and interest earned on securities sold under an agreement to repurchase, where such securities are held in Texas. Note that the new provision dealing with the servicing of loans secured by real property discussed in Section 2a above may have an impact on a banking corporation. E. Tax Rate 1. Generally 1% Of Taxable Margin The new franchise tax is imposed on taxable margin at the rate of one percent (1%) per year of privilege period for most companies. A separate lower rate is available to those entities primarily engaged in retail or wholesale trade. 2. Retail Or Wholesale Businesses Taxed At.5% Pursuant to HB3, taxable entities primarily engaged in retail or wholesale trade will be taxed at the rate of one-half percent (.5%) per year of privilege period. With limited exception for eating and drinking establishments, a taxable entity is primarily engaged in retail or wholesale trade only if: (1) the total revenue from retail or wholesale trade is greater than total revenue from activities in other trades; (2) less than fifty percent (50%) of the total revenue from activities in retail or wholesale trade comes from the sale of 18

19 products it produces or products produced by an affiliate; and (3) the taxable entity does not provide retail or wholesale utilities (i.e., telecommunications, electricity, gas). For purposes of determining whether a business is engaged in retail or wholesale trade, retail trade and wholesale trade are defined as the activities described in Divisions F and G of the 1987 Standard Industrial Classification ( SIC ) Manual. Thus, in determining whether an entity qualifies for the reduced rate, the entity must first qualify under the appropriate SIC code. To the extent the entity falls within the appropriate classification, it should apply the above three-part test to determine the sufficiency of those activities. An exception to the limitation against selling products produced by retail business is provided in HB3 for companies in Major Group 58 of the SIC Manual (eating and drinking places). Such entities may qualify for the one-half percent (.5%) tax rate if they are in Major Group 58 of the SIC Manual, i.e., if the total revenue from retail or wholesale trade is greater than total revenue from activities in other trade, and the entity does not provide retail or wholesale utilities. F. Credits And Business Loss Carryovers 1. Credits And Credit Carryforwards Taxable entities that have accrued pre-existing unused credits against earned surplus prior to the effective date of the new law may claim those credits against the margin tax under the terms and conditions existing at the time accrued. No new credits will be generated under the new franchise tax unless a written agreement existed before June 1, 2006 between the state and the taxpayer. Any incentive agreements allowing tax credits entered into prior to January 1, 2006 will continue to be in effect and will continue to accrue in the manner provided in the agreement. 2. Texas Business Loss Carryforwards Are No Longer Available Pursuant to HB3, any business losses or business loss carryforwards generated pursuant to the existing franchise tax may not be used to offset the new franchise tax. Because the new franchise tax is based on gross receipts, rather than net income, a company that is currently generating losses may have a significant Texas franchise tax liability beginning in Temporary Credit For Certain Federal Net Operating Losses HB3 provides for a one-time credit against the franchise tax that can be carried forward to 2026 for certain federal net operating losses ( NOLs ) incurred to date. The amount of credit is based on the difference, as of the last day of its taxable year ending in 2006, between (i) an entity s deductible temporary differences and NOL carryforwards, net of related valuation allowance amounts stated on its books and records, and (ii) the entity s taxable temporary differences stated on its books and records. The amount of 19

20 other net deferred items may be less than zero. In calculating the other net deferred tax items, any credit carryforwards (to the extent included the entity s deductible temporary differences, net of the valuation allowance) allowed against the tax shall be excluded from the amount of deductible temporary differences. The one-time temporary credit amount is apportioned based on the apportionment factor for the entity on the first report due after January 1, The apportioned amount is then multiplied by ten percent (10%) and then multiplied by the applicable tax rate to determine the credit. To preserve the right to use the temporary credit, a taxable entity must notify the Comptroller no later than March 1, 2007 of its intent to utilize the credit. The credit will be available until earlier of when the entity revokes its election or The election is not assignable or transferable to another entity and is lost if the entity is purchased by another entity. G. Public Law Not Applicable HB3 specifically provides that the new franchise tax is not an income tax and thus companies will not be afforded protection pursuant to Public Law H. Effective Date The gross margin tax applies to reports originally due on or after January 1, For a calendar year taxpayer, regular annual returns are due May 15 th for the current privilege period, based on financial data from January 1 st through December 31 st of the previous calendar year. Thus the first return will be due on May 15, 2008 based on receipts from January 1, 2007 through December 31, A fiscal taxpayer will use its fiscal year ending in 2007; however, the fiscal year start date is adjusted under certain provisions of HB3. HB3 provides that margin or gross receipts occurring before June 1, 2006 will not be considered for purposes of determining taxable margin or apportionment. Thus, if the company has an accounting period that ends between January 1, 2007 and June 1, 2007, the beginning date for the taxable period will be June 1, Conclusion The new Texas franchise tax provisions will almost certainly require corrections and clarifications. A proposed technical corrections bill, Senate Bill 6, was introduced but not addressed in time for action during the special session. We will continue to update you as further guidance, clarification and corrections become available. 20

21 This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent developments in state and local tax. Requests for a subscription to the State Tax Return or permission to reproduce this publication, in whole or in part, or comments and suggestions should be sent to Susan Ervien (214/ or shervien@jonesday.com) in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas Jones Day All Rights Reserved. No portion of the article may be reproduced or used without express permission. Because of its generality, the information contained herein should not be construed as legal advice on any specific facts and circumstances. The contents are intended for general information purposes only.