Texas Franchise Tax Recent Developments

Transcription

1 Texas Franchise Tax Recent Developments 2014 This teaching manual/outline provides information on general tax issues and is not intended to provide advice on any specific legal matter or factual situation. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this information without seeking professional counsel. James F. Martens ( ). All rights reserved. Last Revised 7/29/14

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3 Instructor Jimmy Martens, trial and appellate attorney is a partner with Martens, Todd & Leonard, a boutique Texas tax litigation law firm located downtown, Austin, Texas. Mr. Martens has handled the trial of federal and Texas tax cases and related appeals all the way through both the Texas Supreme Court and the U.S. Supreme Court. His recent Texas Supreme Court cases include Combs v. Roark Amusements & Vending., No , 2013 WL (Tex. 2013); and In Re: AllCat Claim Service, L.P., 356 S.W. 3d 455 (Tex. 2011). His recent Court of Appeals cases include Combs v. Newpark Resources, Inc., No CV, 2013 WL ; and Titan Transportation, LP v. Combs, No CV, 2014 WL He and other members of his law firm limit their law practices to Texas tax, multi-state, and federal tax controversies and litigation. He is board certified by the Texas Board of Legal Specialization in Tax Law and a CPA. He is a former council member of the Tax Section for the State Bar of Texas and the former chair of the CLE Committee. Mr. Martens teaches courses in Advanced Texas Franchise and Sales Tax, Texas Sales Tax for the Oilfield Services Industry, and Texas Sales & Use Tax for LAT Seminars. He also teaches the TSCPA s statewide course on Texas taxes. He received his B.B.A. and J.D. from University of Texas at Austin, both with honors. Mr. Martens may be reached by at jmartens@textaxlaw.com or by telephone at (512) Special Note: Martens, Todd & Leonard maintains a website which provides Texas tax information, links to all of the websites referenced in this manual and links to all available state revenue officers websites. The site is located at: The service is free.

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5 TABLE OF CONTENTS I. CALCULATIONS, EXEMPTIONS, RATES & APPORTIONMENT 1 ELECTION-SWITCHING: POLICY REVERSAL 1 $1 MILLION DEDUCTION 2 TEMPORARY RATE DECREASES LEGISLATIVE CHANGES 6 INSURANCE COMPANY EXEMPTION 8 SEISMIC DATA RECEIPTS APPORTIONMENT 9 THREE FACTOR APPORTIONMENT: MTC ELECTION 9 II. REVENUE EXCLUSIONS 11 FLOW-THROUGH FUNDS MANDATED BY LAW OR FIDUCIARY DUTY 11 REAL ESTATE INDUSTRY EXCLUSION 14 RECENTLY-ADDED EXCLUSIONS 17 III. COST OF GOODS SOLD DEDUCTION 23 INBOUND TRANSPORTATION COSTS 23 PIPELINE COMPANIES 23 REAL ESTATE INDUSTRY SERVICE PROVIDERS 24 PARSING OF DIRECT COSTS 26 INDIRECT COSTS 26 IV. COMPENSATION 31 NET DISTRIBUTIVE LOSSES 31 WORKING CONDITION BENEFITS 33 V. TAX CREDITS & INCENTIVES 35 RESEARCH & DEVELOPMENT CREDIT 35 CLEAN COAL PROJECTS 49 CLEAN ENERGY PROJECTS 50 HISTORIC STRUCTURE REHABILITATION CREDIT 50 MAIN OFFICE RELOCATION COSTS 51

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7 Texas Franchise Tax Recent Developments Page 1 I. Calculations, Exemptions, Rates & Apportionment Election-Switching: Policy Reversal During 2012, the Comptroller reversed her prior policy on election changes. The Comptroller now allows taxpayers to amend their Texas franchise tax reports to switch to or from the cost of goods sold ( COGS ) or compensation deductions at any time within the statute of limitations. 1 Previously, the Comptroller determined that taxpayers could not file amended reports to change their election after the due date of the report. 2 Many taxpayers believe the Comptroller s prior policy conflicted with the Texas Tax Code and the Comptroller s own tax forms and instructions. Cases Challenge Comptroller Election Policy. Two cases filed in Travis County District Court before the Comptroller s policy change concerned whether taxpayers who initially filed using the E-Z computation form may elect the cost of goods sold deduction. 3 The Comptroller s policy reversal came shortly before the August 20, 2012 jury trial scheduled in one of these cases. District Court Allows Election Change. In the first Texas revised franchise tax case tried in the Travis County District Courts, the taxpayer prevailed in proving it qualified as a temporary employment service, rather than as a professional engineering firm as alleged by the Comptroller. In her order, the trial judge ruled that the taxpayer was entitled to claim the compensation deduction for the wages and benefits of the unassigned workers. The taxpayer had previously claimed the COGS deduction. 4 The district court decided this case prior to the Comptroller s policy change. 1 Texas Comptroller of Public Accounts, Important Information Concerning Cost of Goods Sold (COGS) and Compensation Deduction Elections available at 2 See, E.g., Comptroller Hearing No. 105,037 (Nov. 15, 2011). 3 Bigham Bros., Inc. v. Combs, No. D-1-GN Martens, Todd & Leonard represented the plaintiff. Sunbelt Custom Mineral, LLC v. Combs, No. D-1-GN Martens, Todd & Leonard represented the plaintiff. 4 Taylor & Hill v. Combs, No. D-1-GN , 53rd District Court, Travis County, Texas, July 7, James Martens and Lacy Leonard with Martens, Todd & Leonard tried this case.

8 Page 2 Texas Franchise Tax Recent Developments Example Up until 2013, ABC Oil Company had prepared its Texas franchise tax reports electing to report under the compensation method. It was unaware that the Comptroller treated oil & gas wells as real property and that it would also qualify to elect to report under the COGS method. In March of 2013, ABC Oil Company realized its mistake. As a result of the election switching policy change of 2012, ABC Oil Company was entitled amend its reports to claim COGS deductions (and resulting refunds of overpaid franchise tax) for all reports years then open under the four (4) year statute of limitations. $1 Million Deduction For reports due on or after January 1, 2014, the franchise tax calculation now incorporates the $1 million small entity exemption as a $1 million deduction. An entity s taxable margin is now the lesser of (A) 70% of total revenue or total revenue less $1 million; or (B) total revenue less the greater of (1) $1 million, (2) COGS, or (3) compensation. 5 A taxable entity is not required to pay any franchise tax if the amount of tax computed for the taxable entity is less than $1, As compared with the 30% deduction method, the breakeven point is $3,333,333 of total revenue. At this total revenue amount, the deduction for 30% of revenue equals $1 million. Comment: How do the new $1 million deduction and the tiered reporting rules interrelate? 5 Texas Tax Code (a) eff. Jan 1, Texas Tax Code (d)(1).

9 Texas Franchise Tax Recent Developments Page 3 Example Lower Tier partnership (LT) is owned 50/50 by Corporations A and B (both qualifying upper tier entities). LT generates $4 million in total revenue. Corporations A and B have no financial activity. If LT elects to pass up $2 million up to each of Corporation A and B, would each be entitled to claim the $1 million deduction? If so, it would appear that by making the election the group is doubling the deduction from $1million at the lower tier level to $2 million at the upper tier level. 7 A request for an answer was submitted to the Comptroller s Franchise Tax Policy Division. Temporary Rate Decreases For Report years 2014 and 2015, the Legislature changed the tax rates for four of the five reporting methods. The tax rate changes apply to both the retailer/wholesaler rate and the regular tax rate. The tax rate for EZ filers did not change. It remains.575%. Regular Rates. The regular rates were changed as follows: Method COGS.975%.95% 1% Compensation.975%.95% 1% 30% of Revenue.975%.95% 1% $1 Million.975%.95% 1% The reduced rates for 2015 will apply only if the Comptroller certifies that the state tax collections exceeded her estimates. The retailer/wholesaler rates were correspondingly reduced for these same years. 7 Martens, Todd & Leonard recognizes Annette Goodson, CPA with ATKG in San Antonio for noting this issue.

10 Page 4 Texas Franchise Tax Recent Developments Retailer Rates. The retailer rates where changed as follows: Method COGS.4875%.4750%.5% Compensation.4875%.4750%.5% 30% of Revenue.4875%.4750%.5% $1 Million.4875%.4750%.5% Retailers typically sell merchandise for household or personal consumption and may render services incidental to the sale of goods. Retailers generally sell to the public. They buy merchandise for sale, in contrast with manufacturers who create their own products. 8 The Standard Industrial Classification Manual classifies retailers according to the commodities they sell (e.g., grocery stores, hardware stores, etc.) or according to their usual trade designations (e.g., drug stores, cigar stores, etc.). Most retailers sell primarily to the general public, but stores that also sell to businesses (e.g., lumber yards; paint, glass, and wallpaper stores; gasoline service stations; etc.) may also be retailers. 9 Apparel rental activities qualify as retail or wholesale trade for purposes of the ½% tax rate. 10 Other entities, which we normally think of as retailers for sales tax purposes are actually wholesalers for purposes of the revised franchise tax. This includes entities that sell such merchandise as plumbing equipment, electrical supplies, used auto parts and office furniture. Also, farmers who sell only their own produce at or from the point of production are not retailers, even if they sell primarily to the general public Office of Management and Budget s Standard Industrial Classification Manual Division G: Retail Trade. 9 Office of Management and Budget s Standard Industrial Classification Manual Division G: Retail Trade. 10 Texas Tax Code (12)(B) (as amended by SB1, 82nd Legislature, 1st Called Special Sess. 2011). This change is effective for reports due on or after January 1, Id.

11 Texas Franchise Tax Recent Developments Page 5 Wholesalers sell merchandise to retailers or other wholesalers. Wholesalers may sell to industrial, commercial, institutional, farm, construction contractors or professional business users. They may also act as agents or brokers buying merchandise for or selling merchandise to wholesalers or retailers. 12 Examples include drop shippers, truck distributors, retailer cooperative warehouses, terminal elevators, sales branches and sales offices, merchandise or commodity brokers, and commission merchants. 13 A commission merchant is a merchant that transacts business in its own name. Commission merchants physically control the goods consigned to them and negotiate their sale. Comment: Commission merchants and sellers of consigned goods are not permitted to take the cost of goods sold deduction because they do not own the goods that they sell. 14 Nevertheless, even though these entities cannot take the cost of goods sold deduction, these type of entities appear to qualify for the.5% rate. Primarily Retail or Wholesale. The total revenue from the taxable entity s retail and wholesale activities must be greater than the total revenue from its activities other than retail and wholesale trade. 15 As a result, a retailer or wholesaler may sell services or engage in other non-retail or wholesale businesses, so long as it does not generate more revenue than selling goods. To determine if a combined group qualifies as an entity primarily engaged in retail or wholesale trade, the combined group should classify the revenue stream, of the entire combined group, after eliminations. 16 Likewise, the reporting entity of the combined group should report a SIC code based on the primary business activity of the combined group as determined by the revenue stream after elimination Office of Management and Budget s Standard Industrial Classification Manual Division F: Wholesale Trade. 13 Id. 14 Texas Tax Code (i). 15 Texas Tax Code (c)(1). 16 Comptroller s FAQs Combined Reporting, No Comptroller s FAQs Combined Reporting, No. 13.

12 Page 6 Texas Franchise Tax Recent Developments 2014 Legislative Changes Retailer Rate Businesses Expanded. The 2013 Texas Legislature qualified several business categories as eligible for the retailer rate. The changes are effective for 2014 reports: Auto Repairs Shops. 18 This category includes the following types of automotive businesses: o Top, body & upholstery repairs shops o Paint shops o Tire retreading & repair shops o Automotive glass replacement shops o Automotive transmission repair shops o General automotive repair shops o Automotive repair shops, not elsewhere classified 19 Rental-purchase Agreement Activities 20 Tool Rentals 21 Party & Event Supplies Rentals 22 Furniture Rentals 23 Heavy Construction Equipment Rentals Texas Tax Code (12)(C) (as amended by HB 500, 83nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group House Research Organization, Bill Analysis to CSHB 500 (5/7/2013). 20 Texas Tax Code (12)(D) (as amended by HB 500, 83nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, Texas Tax Code (12)(E) (as amended by HB 500, 83nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group Texas Tax Code (12)(E) (as amended by HB 500, 83nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group Texas Tax Code (12)(E) (as amended by HB 500, 83nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group 7359.

13 Texas Franchise Tax Recent Developments Page 7 Utility-Provider Exception. Generally, a taxable entity cannot sell retail or wholesale utilities and qualify for the half-percent rate. This includes telecommunications, electricity, and gas. 25 Combined Group Exception. The 2013 Texas Legislature added an important exception to the utility provider disallowance rule. 26 A taxable affiliate that provides electric utilities may not join in the filing of a combined report if the utility provider s revenue from selling electricity is less than 5% of the combined group s revenue and if the utility provider would otherwise cause the entire combined group to fail the utility provider test. Example A, B, C & U are affiliated entities engaged in a unitary business. A, B & C sell products at retail. For report year 2014, their total revenues equal $100 million. U sells electricity. For report year 2014, U generated revenues of $2 million from selling electricity. In the absence of the exception, U would be required to join in the filing of a combined report and in doing so the entire combined group of A, B, C & U would not be eligible for the retailer s rate (1/2%) due to the inclusion of member U in the combined group. The exception avoids this result by requiring U to file a separate report from the combined group of the remaining members A, B & C. Important Note. The utility-provider exception for combined group members only applies to an affiliate that sells electricity. The language of the statute does not extend to providers of natural gas or telecommunications services. 24 Texas Tax Code (12)(F) (as amended by HB 500, 83nd Legislature, Regular Sess. 2013). This change is effective for reports due on or after January 1, It applies to SIC Industry Group Texas Tax Code (c)(3). 26 See Texas Tax Code (j)(2). Eff. Jan. 1, 2014.

14 Page 8 Texas Franchise Tax Recent Developments Insurance Company Exemption Insurance companies, sureties, guaranty corporations, title insurance companies, title insurance agents, or fidelity companies are exempt because they are already taxed under the gross-receipts tax provisions of the insurance code. 27 However, the exemption is not available to any entity that operates at any time during the year in violation of an order issued by the Texas Department of Insurance under Insurance Code (b). The Comptroller s former position was that only insurance companies that paid the Texas gross premiums taxes qualified for this exemption. 28 The Texas Legislature amended the Texas revised franchise tax statute in 2013 to provide that the exemption applies when the non-admitted insurance company is subject to an occupations tax, privilege tax or gross premiums tax in another state. 29 The legislative amendment adopts the position advanced by Atlantic Casualty Insurance Co. in its suit against the Comptroller. Settled Litigation. A surplus lines carrier recently settled its lawsuit challenging the Comptroller s position that only insurance companies that pay Texas gross premiums taxes qualify for the exemption. 30 Texas imposes a tax on gross premiums for surplus lines insurance, and surplus lines carriers typically pay gross premiums taxes to states in which they hold certificates of authority. Atlantic Casualty argued that the payment of a gross premiums tax to another state (besides Texas) was sufficient to invoke the franchise tax exemption. The revised franchise tax statute has now been amended to comport with the result sought by Atlantic Casualty s lawsuit. 27 Texas Tax Code Ann (Vernon Supp. 1995). This also includes nonadmitted captive insurance companies if they pay a gross premium receipts tax during the same year they re requesting the franchise tax exemptions. 28 Comptroller Letter No L (Sept. 30, 2011). 29 Texas Tax Code Ann (a) eff. Jan. 1, 2014). 30 Atlantic Casualty Insurance Company v. Combs, et al., No. D-1-GN Martens, Todd & Leonard represented Atlantic Casualty.

15 Texas Franchise Tax Recent Developments Page 9 Seismic Data Receipts Apportionment Receipts from seismic data arise from the sale of intangible assets and must be apportioned based upon the location of payor rule. 31 In TGS-NOPEC Geophysical Co. v. Combs, the taxpayer gathered, interpreted and marketed seismic and geophysical data of underground terrain. It acquired the data using sophisticated seismic equipment and software technology. It created a master library in which it stored this data. The taxpayer sold the data by granting licenses for its use. Its customers used the data, not the licenses. As a result, the court determined that the location of payor rule applied to source the receipts. Under the location of payor rule, receipts are sourced based upon the legal domicile of the customer (who pays for the data). The legal domicile of a corporation is its state of incorporation. Three Factor Apportionment: MTC Election May a Texas franchise taxpayer may elect to apportion the margin tax base using a three-factor formula instead of the single gross receipts factor formula? Texas became a member of the Multistate Compact and our legislature enacted Chapter 141 of the Texas Tax Code pursuant to that agreement. Chapter 141 provides that a taxpayer who is subject to an income tax, as defined in Chapter 141, may elect to apportion the tax base using a factor based upon sales, payroll and property. So, the ultimate question is whether the Texas revised franchise tax constitutes an income tax, as defined by Chapter 141. The Comptroller has rejected all refund claims filed by taxpayers electing to use of the three-factor formula, alleging that the revised franchise tax is not imposed on net income. Graphic Packaging argued and lost cross-motions for summary judgment in state district court challenging the Comptroller s refusal to allow the use of the three-factor formula. 32 Graphic Packaging filed its Notice of Appeal on April 2, TGS-NOPEC Geophysical Co. v. Combs, Texas Supreme Court, No , May 27, Graphic Packaging Company v. Combs, No CV. Martens, Todd & Leonard represents Graphic Packaging.

16 Page 10 Texas Franchise Tax Recent Developments The following example illustrates the potential impact of the three-factor formula as contrasted with the single factor of gross receipts: Example XYZ Company manufactures furniture outside the state of Texas. XYZ Company sells furniture to buyers located throughout the United States, including Texas. During 2013, XYZ Company generated taxable margin of $100 million. XYZ s relative sales, payroll and property are (in the millions): Sales Payroll Property Texas Everywhere 1,000 1,000 1,000 Under the single factor gross receipts formula, XYZ would apportion $30 million of its margin tax base to Texas. If XYZ is allowed to elect the MTC three-factor formula, XYZ would apportion $10 million of its margin tax base to Texas. Is it a net income tax? Texas Tax Code Chapter 141 Article II, Paragraph 4 defines income tax as follows: Income tax means a tax imposed on or measured by net income including any tax imposed on or measured by an amount arrived at by deducting expenses from gross income, one or more forms of which expenses are not specifically and directly related to particular transactions.

17 Texas Franchise Tax Recent Developments Page 11 II. Revenue Exclusions The revised franchise (margin) tax calculation begins with determining the entity s revenue. We determine a taxable entity s revenue by referring to amounts reportable on specific lines of the federal income tax forms. IRS instructions accompany the federal forms and instruct taxpayers which specific accounts for income (a/k/a revenue in the margin tax) and deductions are grouped and reported on the corresponding lines. We then reduce the total derived above by the reductions and exclusions provided in the Texas Tax Code. During the 2013 regular legislative session, we saw numerous additional provisions enacted, largely as a result of various industry groups who sought the changes so that their franchise tax liabilities would be computed consistently with other industries. Note: Exclusions from revenue tend to benefit taxpayers more than if the excluded item was a component of the deductions for COGS or compensation. The reason is that the exclusions reduce federal revenue to arrive at reportable revenue (which the Comptroller labels Total Revenue ). Total Revenue serves as the benchmark for determining the qualification for the E-Z computation. Flow-through Funds Mandated by Law or Fiduciary Duty The statute allows taxable entities to reduce revenue by the amount of funds that the taxpayer must distribute to others as a result of a fiduciary or statutory duty. These excluded funds include sales taxes and other so-called trust fund taxes that are included in revenue. 33 For sales tax, this provision appears to apply only when sales tax is included in the sales price of a contract and is booked as a direct component of the sales price. 34 The provision may also apply to the motor fuels taxes. Comptroller representatives have stated that they believe this exclusion applies only to collected taxes. However, the scope of the statutory language appears much broader. Since the enactment of the Texas revised franchise tax, there have been two cases filed which addressed the scope of this exclusion. 33 Texas Tax Code (f). 34 cf. Texas Sales Tax Rule

18 Page 12 Texas Franchise Tax Recent Developments Freight Brokers. The first case, which is still pending, addresses whether this provision allows a freight broker that serves as a limited agent for its customers to exclude the customer payments it flows through to haulers. 35 Oil & Gas Producers. The second case addressed whether this provision allows a taxpayer that owns working interests in oil and gas leases and sells a net profits interest to another entity to exclude the net profits distributions it makes. 36 The Texas statutes impose a duty on oil & gas operators that should be sufficient to qualify for this revenue exclusion. Specifically, Texas Natural Resources Code (a) requires operators to distribute to the non-operating interest holders their respective shares from the oil & gas leases. It states: The proceeds from the sale of oil or gas production from an oil or gas well located in [Texas] must be paid to each payee by payor on or before 120 days after the end of the month of first sale of production from the well. After that time, payments must be made to each payee on a timely basis according to the frequency of payment specified in a lease or other written agreement between the payee and payor. The Texas Natural Resources Code defines the terms payor and payee for the purposes of Texas Natural Resources Code (a) as follows: Payee means any person or persons legally entitled to payment from the proceeds derived from the sale of oil or gas from an oil or gas well located in this state. Payor means the party who undertakes to distribute oil and gas proceeds to the payee, whether as the purchaser of the production of oil or gas generating such proceeds or as operator of the well from which such production was obtained or as lessee under the lease on which royalty is due. 35 Seltex, Inc. v. Combs, No. D-1-GN , Travis County District Court. Martens, Todd & Leonard represents the plaintiff. 36 BASA Resources, Inc. v. Combs, No. D-1-GN , Travis County District Court. Martens, Todd & Leonard represents the plaintiff. Case settled in 2013.

19 Texas Franchise Tax Recent Developments Page 13 The payor is the first purchaser of such production of oil or gas from an oil or gas well, unless the owner of the right to produce under an oil or gas lease or pooling order and the first purchaser have entered into arrangements providing that the proceeds derived from the sale of oil or gas are to be paid by the first purchaser to the owner of the right to produce who is thereby deemed to be the payor having the responsibility of paying those proceeds received from the first purchaser to the payee. Tex. Nat. Res. Code (1)-(2). This statute creates a legal duty on the part of operators to distribute to the other interest holders their respective shares of the revenues generated from the sale of oil and gas from the lease. As a result, operators organized as taxable entities should be able to exclude the distributions to the non-operating interest holders. Example Oilfield Operator operates an oil & gas well in which it holds a 100% working interest and an 87.5% net revenue interest. Mr. Smith, the landowner, holds the remaining 12.5% net revenue interest. Oilfield Operator receives a net revenue check from the pipeline company of $10,000. Oilfield Operator pays Mr. Smith his share which equals $1,250. Oilfield Operator should be entitled to exclude the payment to Mr. Smith from total revenue. Note: The Comptroller takes the position that oil & gas operators are not entitled to claim the exclusion, alleging that the revenue exclusion for statutory duties only arises in the context of sales tax. As a result, the Comptroller alleges that oil & gas operators receiving oil & gas net revenues that are payable to other interest holders (working interest, royalties, net profits interests and so forth) must include the revenue shares of the other interest holders in the calculation of revenue, with no revenue exclusion for the amounts paid to the other interest holders. The Comptroller settled BASA Resources, Inc. v. Combs.

20 Page 14 Texas Franchise Tax Recent Developments Note: The recent appellate decision of Titan Transportation, LP v. Combs may shed light on the meaning of flow-through funds. 37 In Titan, the Third Court of Appeals rejected the Comptroller s argument that flow-through funds, as used in a different revenue exclusion, required the taxpayer to pay the other entity with the exact dollars that the taxpayer had received. The court declined to impose the Comptroller s overly formalistic segregate, wait, and trace requirement for flowthrough funds. Real Estate Industry Exclusion Real estate industry businesses are allowed to exclude certain payments made to subcontractors. The revenue exclusion applies to payments to subcontractors to provide services, labor or materials in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of boundaries of real property. 38 Comptroller s Anti-Taxpayer Policy Overturned by Courts & Legislature. Prior to 2014, the statute stated: A taxable entity shall exclude from its total revenue... only the following flow-through funds that are mandated by contract to be distributed to other entities:... (3) subcontracting payments handled by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of the boundaries of real property. For 2014 and later years, the statute states: A taxable entity shall exclude from its total revenue... only the following flow-through funds that are mandated by contract or subcontract to be distributed to other entities:... (3) subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property. 37 Titan Transportation, LP v. Combs, No CV, 2014 WL Martens, Todd & Leonard handled the trial and the appeal of this case. 38 Texas Tax Code (g)(3).

21 Texas Franchise Tax Recent Developments Page 15 Titan Transportation Wins on Appeal. 39 On March 14, 2014, the Third Court of Appeals in Austin, Texas held that Titan Transportation was entitled to claim a revenue exclusion under the real property activities provision for the payments it made to independent contractor drivers. In doing so, the court rejected the Comptroller s position imposing conditions on taxpayers not found in the clear words of the statute. As a result of a desk audit, the Comptroller had denied Titan s claim for the revenue exclusion alleging: (1) Titan was not a construction company; (2) Titan s customer contracts did not reference its fee-splitting agreement with the independent haulers, and (3) Titan did not pay its independent haulers with the actual dollars that Titan received from its customers. The Third Court of Appeals rejected each of these arguments. First, the court explained that the real property service revenue exclusion is not limited to construction companies. The court stated that a taxpayer must simply have some reasonable nexus between the real property services delineated in the statute and the service, labor, or materials for which the subcontractors receive payment. Titan had the requisite nexus because its services (hauling and depositing aggregate on construction sites) were logically and reasonably connected with the construction of real property improvements. Second, the court held that Titan s independent hauler agreements satisfied the statute s mandated by contract language. Titan did not need a contract with its customer stating that a portion of the labor would be subcontracted out. Third, the court rejected the Comptroller s segregate, wait, and trace requirement for flow-through funds as overly-formalistic and inconsistent with the statute s plain language. Titan employed sufficient procedures to ensure that its independent haulers were paid from gross receipts attributable to the work they performed. The statute s flow-through requirement did not require Titan to pay its independent haulers with the actual dollars that Titan received from its customers. 39 Titan Transportation, LP v. Combs, No CV, 2014 WL Martens, Todd & Leonard handled the trial and the appeal of this case.

22 Page 16 Texas Franchise Tax Recent Developments The Comptroller s deadline to appeal Titan Transportation to the Texas Supreme Court expired on April 28 th but may be extended until May 13 th. As of the date of this discussion, the Comptroller has not indicated whether her office will seek review by the Texas Supreme Court. Note: Due the similarity in language of the revenue exclusion under Texas Tax Code (g)(3) and the COGS eligibility provision under Texas Tax Code (i), taxpayers should always review both provisions and assert alternative claims for both, where appropriate. Pending Litigation: Several cases currently pending in Travis County district courts also address the scope of this revenue exclusion. 40 Allcat Claims Service, L.P. v. Combs, et al. 41 This case addresses: (1) whether claims adjusters may exclude payments to independent contractor adjusters from revenue as real property subcontracting payments; or (2) in the alternative, whether claims adjusters may include payments to independent contractor adjusters in cost of goods sold. PEK, Inc. d/b/a Serviceline Transport v. Combs, et al. 42 This case addresses: (1) whether an aggregate hauler may exclude payments to independent contractor drivers from revenue as real property subcontracting payments; (2) alternatively, whether an aggregate hauler qualifies for the COGS deduction under section (i); (3) whether the Comptroller properly apportioned gross receipts of an interstate transportation company; (4) whether an aggregate hauler meets the definition of a qualified courier and logistics company ; and (5) whether the Comptroller s interpretation of the provisions allowing deductions and exclusions for the real estate industry violates constitutional requirements of equal and uniform taxation. 40 Martens, Todd & Leonard represents these plaintiffs. 41 No. D-1-GN No. D-1-GN

23 Texas Franchise Tax Recent Developments Page 17 Recently-Added Exclusions During the 2011 and 2013 legislative sessions, the Texas Legislature enacted numerous, industry-specific revenue exclusions in an attempt to mitigate the harsh effect of the revised franchise tax on certain industries. New revenue exclusions were added for several industries. Crop Dusters. An agricultural aircraft operation 43 may exclude the cost of labor, equipment, fuel, and materials used to provide agricultural aircraft services. These services include spraying for pest control and fertilization. Pharmacy Cooperatives and Networks. Pharmacy Cooperatives may exclude rebates from wholesalers that are distributed to shareholders. 44 Pharmacy networks may exclude reimbursement for payments to pharmacies in the network. 45 Destination Management Companies. Businesses that qualify as destination management companies may exclude from their total revenue payments they make to others for services, labor, or materials in connection with providing their destination management services. 46 To qualify as a destination management company ( DMC ), a business must meet the following requirements: The DMC must be formed as a corporation or limited liability company; 80 percent or more of the DMC s revenue must come from providing or arranging 6 of the 9 statutorily-listed destination management services. These services generally involve transportation management, shuttling services, airport meet & greet services, managing entertainers, coordinating tours, and event management and staffing; The DMC must have a permanent, non-residential office with three or more full-time employees; 80 percent of the DMC s client contracts must be for clients located outside Texas or where out-of-state program attendees; C.F.R defines agricultural operations to include: (1) dispensing any economic poison, (2) dispensing any other substance intended for plant nourishment, soil treatment, propagation of plant life, or pest control, or (3) engaging in dispensing activities directly affecting agriculture, horticulture, or forest preservation, but not including the dispensing of live insects.. 44 Texas Tax Code (g-4). 45 Texas Tax Code (g-4). Eff. Jan 1, Texas Tax Code (g-6).

24 Page 18 Texas Franchise Tax Recent Developments The DMC must maintain a general liability insurance policy with a limit of at least $1 million; The DMC, nor an affiliate, may not own equipment it uses to provide its services, such as limousines, lighting, dance floors, podiums, and catering equipment; The DMC may not provide wedding services; The business may not own a venue for which it provides its services; and The DMC, nor an affiliate, may prepare or serve beverages, meals, or other food products. 47 Live Entertainment Event Promotion Companies. Qualified live entertainment event promotion companies may exclude from revenue payments made to certain categories of entertainers. 48 Qualified live entertainment event promotion companies. To qualify, the company must meet several conditions: 49 It must receive at least 50% of its annual revenues from arranging or providing its live event promotion services to three or more live events; It must employ at least 10 or more full-time employees; It must provide its services from a permanent location that is not a residence; It cannot provide services for weddings and carnivals; and It cannot be a movie theatre. Live Event Promotion Services. This includes promoting, coordinating, operating, managing live entertainment events and includes services relating to staff provided and scheduling and promoting the artists who perform or entertain at the event Texas Tax Code Texas Tax Code (g-5). 49 Texas Tax Code (11-b). 50 Texas Tax Code (10-b).

25 Texas Franchise Tax Recent Developments Page 19 Aggregate Haulers. For reports originally due before to 2014, aggregate haulers may rely on the Titan Transportation case to exclude from revenue the amounts paid to independent contractors. For reports originally due on or after January 1, 2014, aggregate haulers are entitled to exclude from revenue the amounts paid to independent contractors per a new statutory revenue exclusion. 51 In order to qualify, the aggregate hauler must meet these conditions: It must be primarily engaged in the business of transporting aggregates. 52 We presume this means that the majority of revenues earned by the taxable entity must arise from transporting aggregates, It must make subcontracting payments to independent contractors for the performance of delivery services on behalf of the taxable entity, 53 It must haul aggregates, which means any commonly recognized construction material removed or extracted from the earth, including dimension stone, crushed or broken limestone, crushed or broken granite, other crushed and broken stone, construction sand and gravel, industrial sand, dirt, soil, cementitious material, and caliche. 54 Barite Haulers. For reports originally due before to 2014, barite haulers should be entitled to exclude from revenue the amounts paid to nonemployee agents under the Titan Transportation case. For reports originally due on or after January 1, 2014, barite haulers are entitled to exclude from revenue the amounts paid to nonemployee agents per a new statutory revenue exclusion. 55 Barite is the powered substance used to make drilling mud. In order to qualify, the aggregate hauler must meet these conditions: It must be primarily engaged in the business of transporting barite. 56 We presume this means that the majority of revenues earned by the taxable entity must arise from transporting barite, 51 Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-8). Eff. Jan. 1, Texas Tax Code (g-10). Eff. Jan. 1, Texas Tax Code (g-10). Eff. Jan. 1, 2014.

26 Page 20 Texas Franchise Tax Recent Developments It must make subcontracting payments to nonemployee agents for the performance of transportation services on behalf of the taxable entity, 57 It must haul barite, which means barium sulfate (BaSO4), a mineral used as a weighing agent in oil and gas exploration. 58 Landman Services. Often companies that provide landman services subcontract work out to independent landmen to whom they issue IRS Forms For reports originally due on or after January 1, 2014, a business primarily engaged in performing landman services may exclude from revenue the subcontracting payments made to independent landmen who perform landman services on behalf of the business. 59 Landman services means: 1. performing title searches to determine the ownership of or curing title defects related to oil, gas, or other related mineral or petroleum interests; negotiating for mineral rights to explore, develop, or produce oil, gas, or other related mineral or petroleum interests; 61 or 3. negotiating agreements relating to the ownership of mineral interests in order to explore, develop, or produce oil, gas, or other related mineral or petroleum interests. 62 Example Landman Services Co. hires independent landmen as subcontractors. The independent landmen perform title searches and negotiate oil leases on behalf of the Landman Services Co. Under the new revenue exclusion, Landman Services Co. may exclude the payments it makes to the independent landmen from its calculation of revenue. 57 Texas Tax Code (g-10). Eff. Jan. 1, Texas Tax Code (g-10). Eff. Jan. 1, Texas Tax Code (g-11). Eff. Jan. 1, Texas Tax Code (g-11)(1). Eff. Jan. 1, Texas Tax Code (g-11)(2). Eff. Jan. 1, Texas Tax Code (g-11)(3). Eff. Jan. 1, 2014.

27 Texas Franchise Tax Recent Developments Page 21 Marine Transport Companies. 63 Waterway transport companies my exclude from revenue the direct costs of providing the transportation service. This provision applies to both intrastate and interstate transportation. The excluded direct costs are the equivalent of the COGS that an entity that sells goods would qualify to claim. In order to qualify for the exclusion, the waterway transport company must: 1. be primarily engaged in the business of transporting goods by waterways, and 2. not subtract cost of goods sold in computing its taxable margin. 64 This provision will significantly benefit the barge transport companies that travel on the intercoastal waterway. Registered Motor Carriers. A motor carrier registered under Chapter 643 of the Texas Transportation Code is entitled to exclude flow-through revenue derived from taxes and fees. 65 Qualified Courier & Logistics Companies. These entities may exclude from revenue the payments they make to their subcontractors to perform delivery services. 66 To qualify, the company must meet these conditions: The company must earn 80% of its revenues from two of these sources: Expedited, same-day delivery of an envelope, package, parcel, roll of architecture drawings, box or pallet; 2. Temporary storage and delivery of another s property, including an envelope, package, parcel, roll of architecture drawings, box or pallet; 3. Brokering the same-day or expedited courier and logistics services to a person or entity under a contract that contains a provision requiring the company to pay the person or entity. 63 Texas Tax Code (v). Eff. Jan. 1, Texas Tax Code (v). Eff. Jan. 1, Texas Tax Code (x). Eff. Jan. 1, Texas Tax Code (g-7). 67 Texas Tax Code (g-7)(1)(A)-(C).

28 Page 22 Texas Franchise Tax Recent Developments The company must be registered as a motor carrier under Chapter 643 of the Texas Transportation Code; 68 It must maintain automobile liability insurance with combined coverage of $1 million per occurrence; 69 It must maintain cargo insurance of at least $25,000; 70 It must maintain a permanent location that is not a residence; 71 It must employ at least 5 full-time employees; 72 It cannot be engaged in any of the following activities: Livery service 2. Floral delivery 3. Taxicab 4. Building supply delivery 5. Water supply delivery 6. Fuel/energy supply service 7. Restaurant supply service 8. Commercial moving & storage 9. Overnight delivery service It cannot be in the business of delivering items that it or an affiliate owns Texas Tax Code (g-7)(2). 69 Texas Tax Code (g-7)(3). 70 Texas Tax Code (g-7)(4). 71 Texas Tax Code (g-7)(5). 72 Texas Tax Code (g-7)(6). 73 Texas Tax Code (g-7)(7). 74 Texas Tax Code (g-7)(8).

29 Texas Franchise Tax Recent Developments Page 23 III. Cost of Goods Sold Deduction Inbound Transportation Costs The Comptroller s current position is that construction businesses may include the cost of transporting materials to the job site in cost of goods sold as inbound transportation costs, but may not include the cost of transporting equipment and laborers to the job site. It is unclear whether a court would rule that the revised franchise tax statute supports the Comptroller s position. Pipeline Companies Since pipeline companies provide a service and generally don t sell goods, they did not qualify for the COGS deduction under the statute as it was originally written. For reports originally due on or after January 1, 2014, pipeline companies may subtract as a cost of goods sold its depreciation, operations, and maintenance costs allowed by the COGS section. 75 Qualification. In order to qualify for the COGS deduction, the pipeline company must: 1. own or lease and operate the pipeline that transports products for others. The COGS deduction authorized by this provision applies only to the product owned by others. Presumably, to the extent the pipeline company owns it own product, it would qualify for the COGS deduction as the owner of goods; and 2. be primarily engaged in gathering, storing, transporting, or processing crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids, except for a refinery installation that manufactures finished petroleum products from crude oil. 76 Processing means the physical or mechanical removal, separation, or treatment of crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids after those materials are produced from the earth. The term does not include the chemical or biological transformation of those materials Texas Tax Code (k-2). Eff. Jan. 1, Texas Tax Code (k-2). Eff. Jan. 1, Texas Tax Code (k-3). Eff. Jan. 1, 2014.

30 Page 24 Texas Franchise Tax Recent Developments Real Estate Industry Service Providers Taxable entities that provide services to the real estate industry may qualify for the COGS deduction under a special provision that treats them as the owner of the labor and materials that they furnish to real estate projects. 78 The special provision applies to the following types of work: Construction. Improvement. Remodeling. Repair. Industrial Maintenance. Example 1 A general contractor hires a wiring subcontractor to install wiring in a building the general contractor is constructing. The real estate industry services provision treats the wiring subcontractor as the owner of the installation labor and wiring materials it furnishes to the building. As a result, the wiring contractor is eligible for the COGS deduction. Newpark Resources, Inc. s Victory Affirmed on Appeal. 79 In Combs v. Newpark Resources, Inc., the Third Court of Appeals held that Newpark an integrated oilfield services company and combined group for Texas franchise tax reporting purposes was entitled to include the expenses of its drilling mud waste disposal division ( NES ) in its COGS deduction. The Court rejected the Texas Comptroller s argument that eligibility for the COGS deduction must be made separately for each member of the group. Instead, the Court held that NES s eligibility to claim the deduction should be determined by examining Newpark s combined business. After determining that the COGS analysis applied at the combined group level, the Court then determined that NES s waste disposal service qualified for the COGS deduction as labor furnished to a project for the construction or improvement of real property under Texas Tax Code (i). The Court held so because NES s 78 Texas Tax Code (i). 79 Combs v. Newpark Resources, Inc., No CV, 2013 WL Martens, Todd & Leonard handled the trial and the appeal of this case.

31 Texas Franchise Tax Recent Developments Page 25 transportation and disposal of drilling waste constituted labor furnished to a project for the construction and improvement of an oil and gas well (real property). The testimony at trial established that drilling mud waste removal was an essential and direct component of the drilling process. The Court did not reach Newpark s alternative argument that it could exclude from total revenue NES s flow-through payments to certain real property subcontractors (a component of NES s COGS deduction), which spurred Chief Justice Jones to author a concurring opinion. In his opinion, Chief Justice Jones agreed with the judgment affirming Newpark s trial court victory, but felt that the Court should have addressed Newpark s revenue exclusion argument before taking up the COGS deduction. The Comptroller filed a Motion for Rehearing, in which she urged the Third Court of Appeals to reconsider its decision and limit (i) to those who work on and effect a physical change to the real property. The Court denied the Motion for Rehearing. In Titan Transportation, LP v. Combs, 80 issued by the Third Court of Appeals shortly after the Newpark decision, the Court explicitly rejected the Comptroller s attempt to add a physical change requirement to the revenue exclusion found in Texas Tax Code (g)(3), which contains similar but not identical language to (i). The Comptroller s deadline to appeal the Newpark case to the Texas Supreme Court has expired. The opinion is now final. Seismic Data Costs. In CGGVeritas Services (U.S.) Inc. v. Combs 81, the trial court found for the taxpayer and ordered a full refund of the franchise taxes paid under protest. CGG s petition alleged: (1) that CGG qualified under the real estate activities provision 82 to claim the COGS deduction for costs incurred in producing custom-ordered seismic recordings and images that it sold to oil & gas well drillers and producers; and (2) that CGG qualified under media definition of goods 83 to include the costs of its seismic data library in its COGS deduction. As of the date of these materials, the Comptroller s deadline to appeal the decision has not yet expired. 80 Titan Transportation, LP v. Combs, No CV, 2014 WL Martens, Todd & Leonard handled the trial and the appeal of this case. 81 Cause No. D-1-GN Texas Tax Code (i), third sentence. 83 Texas Tax Code (a)(3)(A).

32 Page 26 Texas Franchise Tax Recent Developments Note: Due the similarity in language of the revenue exclusion under Texas Tax Code (g)(3) and the COGS eligibility provision under Texas Tax Code (i), taxpayers should always review both provisions and assert alternative claims for both, where appropriate. Parsing of Direct Costs Recently, the Comptroller has begun to require taxpayers under audit to parse their COGS deduction into costs associated with the COGS-qualifying activity (e.g., production) and throw-out the remaining costs. This position appears to be inconsistent with the rulings in Newpark Resources and CGGVeritas Services (U.S.) Inc., as well as the statutory language. Texas Tax Code does not appear to contain any requirement that taxpayers divide, allocate, and limit their COGS deductions in this manner. Indirect Costs Taxable entities may subtract indirect or administrative overhead costs as costs of goods sold. The indirect costs must be allocable to the acquisition or production of goods. The indirect cost component of the COGS deduction is limited to 4% of total overhead and administrative costs. The Comptroller recently amended COGS Rule The rule amendments favor taxpayers and appear to be applied retroactively. Labor Costs. The amended rule allows taxpayers to treat all labor costs, except those classified as service costs, as 100% deductible for COGS. Labor costs include Form W-2 wages, Form 1099 payments for labor, temporary labor expenses, payroll taxes, pension contributions, and employee benefits expenses, including health insurance and per diem payments for travel to the extent these expenses are deductible under the federal income tax rules. 85 Service Costs. The COGS rule defines service costs as:... indirect and administrative overhead costs that can be identified specifically with a service department or function, or that directly benefit or are incurred by reason of a service department or function The rule became final on June 5, Comptroller Rule 3.588(d)(1)(A).

33 Texas Franchise Tax Recent Developments Page 27 Service Departments. The COGS rule goes on to define a service department to include: Security Services. This includes payments for providing security for the business. Costs allocable to production would include, for example, fees paid for security services to guard a facility where goods are being produced or stored in inventory. Legal Services. This includes the cost of the legal department. Costs allocable to production would include, for example, fees a manufacturing plant incurs for legal services in connection with environmental cleanup litigation. Data Processing Services. This includes the cost of the data processing department. Costs allocable to production would include, for example, fees incurred for data processing services for inventory maintenance and the allocable portion of accounts payable and payroll processing. Accounting Services. This includes accounts payable, disbursements and payroll. Costs allocable to production would include, for example, the cost of accounting services related to manufacturing or inventory operations, such as cost accounting. Personnel. This includes the cost of the personnel department. Costs allocable to production would include, for example, the costs of recruiting, hiring, relocating, assigning and maintaining employee personnel records for employees involved in manufacturing operations. General Financial Planning Costs. Costs allocable to production would include, for example, financial planning costs incurred in connection with planning for manufacturing or inventory operations. General Financial Management Costs. Costs allocable to production would include, for example financial management costs incurred in connection with cost accounting for manufacturing or inventory operations.

34 Page 28 Texas Franchise Tax Recent Developments 4% Limitation. The COGS rule treats only the allocable portion of the service costs as indirect costs subject to the four percent (4%) limitation of the taxable entity s total indirect or administrative overhead costs, including all mixed service costs. Any costs specifically excluded from the cost of goods sold deduction may not be subtracted as an indirect cost. 86 There are two issues with the 4% indirect cost limitation: Does the 4% limitation include the costs excluded under Texas Tax Code (e), such as interest, selling costs, and advertising? By Rule, the Comptroller says no: If a cost is excluded from the COGS deduction it may not be included in the overhead base against which the 4% limit is applied. 87 Does a combined group calculate the 4% limitation on a separate company basis or on a combined basis? Comptroller Rule 3.590(d)(2)(A)(i) requires combining entities to compute cost of goods sold as if the member was an individual taxable entity. Combined Group Overhead Limitation Calculation. In Newpark Resources, Inc. v. Combs, a taxpayer recently won a case that involved combined reporting issues. 88 One of the grounds the suit raised was whether a combined group should calculate its 4% limitation for indirect costs based upon the total indirect administrative costs incurred by all members of the group. Although the Third Court of Appeals opinion did not expressly address indirect costs, it did confirm that COGS should be calculated as a combined group and that the members should not be viewed in isolation. 86 Comptroller Rule 3.588(f)(3). 87 Comptroller Rule 3.588(f)(2). 88 Combs v. Newpark Resources, Inc., No CV, 2013 WL Martens, Todd & Leonard handled the trial and the appeal of this case.

35 Texas Franchise Tax Recent Developments Page 29 Example Frack, Flow and Repair are members of a combined group. Frack provides fracturing services to oil producers and operators. Flow provides flowback recycling services in which waste frac water is cleaned-up with portable recycling equipment and then injected back into the ground. Repair operates a machine shop where it repairs portable recycling equipment primarily for third-parties, but occasionally for Flow. During 2014, Frac, Flow and Repair incurred the following costs: Description Frack Flow Repair Total Direct COGS Service Costs: Alloc Service Costs: NonAlloc ,000 9,700 Total Service Costs 1,000 1,000 8,000 10,000 OH Cap % 4% 4% 4% 4% OH Cap (Separate Co) OH Cap (Combined)

36 Page 30 Texas Franchise Tax Recent Developments Notes.

37 Texas Franchise Tax Recent Developments Page 31 IV. Compensation The deduction for wages and cash compensation paid to a qualified individual is a sum of the individual s Medicare wages and tips reported on the Form W-2, net distributive income, and the value of stock awards and stock options. This deduction is capped at a certain amount per individual. For reports, the cap equals $350,000 ($320,000 for the 2010 and 2011 report years and $330,000 for the 2012 and 2013 report years). Net Distributive Losses In late 2008, the Comptroller amended its Rule on Compensation to state that wages and compensation included net distributive income, regardless of whether it is a positive or negative amount. Therefore, if an entity has a net distributive loss, it may be forced to reduce its compensation by the loss if the entity otherwise meets the requirements to include net distributive income in the wages and cash compensation calculation. 89 Net Distributive Income. The margin tax has made allowances for service businesses such as law firms and accounting firms that compensate their partneremployees in whole or in part through partnership distributions. Therefore, Wages and Cash Compensation also includes net distributive income if the income meets two requirements: First, the direct recipient of the income must be a natural person, which is defined as a human being or the estate of a human being not a purely legal entity, like a corporation, LLC, partnership or trust. 90 Second, net distributive income is only includable as wages and cash compensation for three types of entities, depending on their federal tax classification: Taxable entities treated as partnerships for federal income tax purposes; 91 LLCs and corporations treated as S corporations for federal income tax purposes, and Comptroller Rule 3.589(b)(9)(B). 90 Comptroller Rule 3.589(b)(4). 91 Texas Tax Code (a)(1). 92 Texas Tax Code (a)(2).

38 Page 32 Texas Franchise Tax Recent Developments LLCs electing to be treated as sole proprietorships for federal income tax purposes. 93 Definition. What is net distributive income? Nowhere in the statute is the term net distributive income defined. It is also undefined by the Internal Revenue Code or Regulations. The Comptroller s Rules, however, define it to be the net amount of income, gain, deduction, or loss relating to a pass-through entity or disregarded entity reportable to the owners for the tax year of the entity. 94 The Comptroller has stated that net distributive income per individual arises from the following items on the K-1 for a partnership or an S corporation: 95 Add: Ordinary business income (loss) Net rental real estate income (loss) Other net rental income (loss) Guaranteed payments (partnerships only) Interest income Ordinary dividends Royalties Net short-term capital gain (loss) Net long-term capital gain (loss) Net section 1231 gain (loss) Other income (loss) Subtract: Section 179 deduction Other deductions Foreign transactions, total foreign taxes paid 93 Texas Tax Code (a)(4). 94 Comptroller Rule 3.589(b)(5). 95 See Comptroller FAQs for Compensation, Question and Answer No. 10 ( April 23, 2008).

39 Texas Franchise Tax Recent Developments Page 33 Working Condition Benefits Taxpayers may include in the compensation deduction the amounts paid and deducted for federal income tax purposes pertaining to working condition fringe benefits, despite language in the Comptroller s rule to the contrary. In Winstead, PC v. Combs 96, the Travis County District Court addressed the scope of benefits a taxpayer may include in its compensation deduction. The taxpayer, a law firm, argues that it may include certain expenses paid on its employees behalf, including parking expenses, attorney occupation tax, and continuing legal education expenses, in its compensation deduction. The district court held that the working condition disallowance provision in Comptroller rule 3.589(e)(2)(D) is invalid to the extent that it disallows deductions that are allowed for federal income tax purposes. 96 Winstead PC v. Combs, District Court, 201st District, No. D-1-GN (Mar. 18, 2013). The Winstead law firm handled this litigation, pro se.

40 Page 34 Texas Franchise Tax Recent Developments Notes.

41 Texas Franchise Tax Recent Developments Page 35 V. Tax Credits & Incentives Research & Development Credit Summary. During 2013, the Texas Legislature enacted tax incentives aimed at encouraging companies to conduct research & development activities in Texas. Texas has now joined forty (40) other states that have enacted a research & development tax credit. The new tax incentive provides either a sales tax exemption or a franchise tax credit for qualified research & development activities. Qualifying taxpayers may claim either the sales tax exemption or the franchise tax credit, but not both. The sales tax exemption applies to depreciable tangible personal property used in qualified research if sold, leased, rented to, or stored by a person engaged in qualified research. The Comptroller is required to report to the Legislature about the exemption s effect on the amount of research & development performed in Texas and other related topics. To that end, the Comptroller has designed forms which taxpayers must complete which provide the information the Comptroller must compile and provide. When May Taxpayers Claim the Exemption or Credit? Beginning January 1, 2014, taxpayers may elect to claim either a sales/use tax exemption for the purchase of tangible personal property used for research activities or claim a research credit against the franchise tax for qualifying research expenditures. 97 The research credit may be claimed on reports originally due on or after January 1, The research credit expires on December 31, Qualified Research. Internal Revenue Code 174 defines Qualified Research. 100 Generally, to qualify, the research must be undertaken for discovering information that is technological in nature, and its application must be intended for use in developing a new or improved business component of the person or entity undertaking the research. Substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved 97 Acts of 83rd Legislature, Regular Session, H.B. 800, 2, 3, 6, Acts of 83rd Legislature, Regular Session, H.B. 800, 6, Acts of 83rd Legislature, Regular Session, H.B. 800, 2, Tex. Tax Code (f). 100 Acts of 83rd Legislature, Regular Session, H.B. 800, 2, Tex. Tax Code (a)(3).

42 Page 36 Texas Franchise Tax Recent Developments function, performance, reliability or quality. Only research performed in Texas will qualify for the exemption or credit. Qualified research does not include the following activities: research related to style, taste, cosmetic or seasonal design factors; research conducted after the beginning of commercial production of the business component; research adapting an existing product or process to a particular customer s need; duplication of an existing product or process; surveys or studies; research relating to certain internal-use computer software; research conducted outside the United States, Puerto Rico or a U.S. possession; research in the social sciences, arts or humanities; or research funded by another person or governmental entity. Sales Tax Research Exemption. The sales tax research exemption applies to the sale, storage or use of depreciable tangible personal property directly used in qualified research if the property is sold, leased, rented to or stored or used by a person who is engaged in qualified research. 101 Eligible property includes tangible personal property that: has a useful life of more than one year; and is subject to depreciation under either generally accepted accounting principles (GAAP) or Sections 167 or 168 of the Internal Revenue Code Acts of 83rd Legislature, Regular Session, H.B. 800, 2, Tex. Tax Code (b). 102 Acts of 83rd Legislature, Regular Session, H.B. 800, 2, Tex. Tax Code (a)(1).

43 Texas Franchise Tax Recent Developments Page 37 For federal income tax purposes, a depreciation deduction, generally, is a reasonable allowance for the exhaustion, wear and tear and, in some cases, for the obsolescence of certain businessrelated or income-producing property. For the purpose of the sales tax exemption, the depreciable item must be directly used in qualified research. The sales tax exemption is not available if the taxpayer claims a research credit on its franchise tax return for the period. Likewise, the sales tax exemption is not available if a member of the taxpayer s combined franchise group claims a research credit on its franchise tax return for the period. Any taxpayer who claims the sales tax exemption must complete a form annually that allows the Comptroller to report to the Legislature the amount of research activity being undertaken in Texas. 103 The sales/use tax exemption will be effective January 1, 2014, and will expire on December 31, Acts of 83rd Legislature, Regular Session, H.B. 800, 2, Tex. Tax Code (d). 104 Acts of 83rd Legislature, Regular Session, H.B. 800, 5, 7.

44 Page 38 Texas Franchise Tax Recent Developments Registration Requirement. Taxpayers must register with the Comptroller s office before claiming the exemption on qualifying purchases. Registration is done using the Comptroller s online registration system:

45 Texas Franchise Tax Recent Developments Page 39 Or, taxpayer may simply complete and file the Texas Registration for Qualified Research and Development Sales Tax Exemption (Form AP-234):

46 Page 40 Texas Franchise Tax Recent Developments

47 Texas Franchise Tax Recent Developments Page 41

48 Page 42 Texas Franchise Tax Recent Developments Once a taxpayer registers for the research exemption, the Comptroller s website reports the taxpayer s information and its status as qualified to receive the exemption. Taxpayers must certify they will not take the franchise tax credit for the same period the sales tax exemption will be claimed. After the registration is completed, the Comptroller s office will issue a Texas Qualified Research Registration Number (Registration Number). The Registration Number is eight characters beginning with RD and followed by six numbers.

49 Texas Franchise Tax Recent Developments Page 43 Sellers Responsibilities. Beginning Jan. 1, 2014, a retailer may only sell an item exempted under the sales tax research exemption when the taxpayer provides a signed and completed Texas Qualified Research Sales and Use Tax Exemption Certificate (Form ).