2017 Legislative Session

Transcription

1 RECENT DEVELOPMENTS IN TEXAS TAX: POTENTIAL TROUBLE, DISAPPOINTMENT AND OPPORTUNITIES FOR TAXPAYERS Presented By: David E. Colmenero, J.D., LL.M., CPA 901 Main Street, Suite 3700 Dallas, TX fax Copyright Meadows, Collier,Reed,Cousins,Crouch & Ungerman, L.L.P. All rights reserved Dallas Bar Association December 5 th, 2016 Dallas, Texas 2017 Legislative Session Convenes January 2017 Things to keep an eye out for: Texas Comptroller s budget for the Legislature: Expect the next session to have a tighter budget; Property Tax Reform: Many legislators campaigned on the promise to do away with or reform the Texas property tax system. However, any meaningful reform may be constrained by anticipated budgetary concerns; Expect a Texas Comptroller technical corrections bill. 2 1

2 Franchise Tax: Apportionment Hallmark Marketing Company, LLC v. Hegar, 2016 LEXIS 314 (Tex. Sup. Ct April 15, 2016) Facts: For 2008, Hallmark generated $4,516,155,458 in gross receipts and $628,243,514 in losses on sales of investments and capital assets. For apportionment purposes, Hallmark excluded the loss amount from the denominator. Following an audit, the Comptroller assessed additional tax claiming that the denominator should be reduced by the loss amount. Issue: At issue is Section (b) which states that, [i]f a taxable entity sells an investment or capital asset, the taxable entity s gross receipts includes only the net gain from the sale. 3 Franchise Tax: Apportionment Hallmark Marketing Company, LLC, cont d: Court of Appeals: The term net gain is ambiguous. It could refer to the particular gain or loss that results from each individual sale or it may instead refer to the taxpayer s cumulative gain or loss on its various investment and capital asset sales. Under the former, losses resulting from individual sales would not be deducted, but under the latter, they would. Citing to the Third Court of Appeals prior holding in Calver v. Electro-Science Investors, Inc., 509 S.W.3d 700, 702 (Tex. Civ. App. Austin, 1974, no writ), the court found that the Texas Comptroller s interpretation was reasonable. Note: The statutory language at issue in Calvert read, [A]s to the sale of investments and capital assets, the term total gross receipts of the corporation from its entire business shall include only the net gain from such sales. 4 2

3 Franchise Tax: Apportionment Hallmark Marketing Company, LLC, cont d: Texas Supreme Court Holding (April 15, 2016): Citing the plain language of Section (b), the Texas Supreme Court held that Hallmark was not required to reduce the denominator of its apportionment factor by net losses generated from the sale of investments of the Texas Tax Code which states that only net gain from the sale of an investment or capital asset is included in the denominator. While noting that it was not bound by the decision in Electro-Science, the Court stated that it did not have to relitigate that issue as Hallmark did not generate a net gain under any calculation. 5 Franchise Tax: Apportionment Hallmark Marketing Company, LLC, cont d: Texas Supreme Court: Our goal in interpreting any statute is to ascertain and give effect to the legislature s intent as expressed by the language of the statute. We presume the legislature chose a statute s language with care, including each word chosen for a purpose while purposely omitting words not chosen.if a statute is unambiguous, we adopt the interpretation supported by its plain language unless such interpretation would lead to absurd results. The Hallmark decision carries significant implications for any taxpayers that generate losses from the sale of investments and capital assets. Any taxpayer that has generated such losses in the recent past will want to review its Texas franchise tax reports in light of this decision 6 3

4 Franchise Tax: Apportionment Graphic Packaging, Inc. v. Combs, Cause No CV (Third Ct. of Appeals, July 28, 2015): Apportionment/MTC Three-Factor Facts: Taxpayer claims that it should be entitled to use the 3-factor apportionment formula provided for under the Multi-State Tax Compact. The trial court denied Graphic s motion for partial summary judgment and granted the Comptroller s cross-motion concluding that Graphic was not entitled to apportion its tax base under the Compact formula. Held: On July 28, 2015, the Third Court of Appeal held there the three-favor apportionment formula does not apply to the Texas franchise tax because the Texas franchise tax is not an income tax. According to the Court, none of the alternative ways of computing the franchise tax results in taxing net income. 7 Franchise Tax: Apportionment Section of Tax Code: [A] taxable entity s margin is apportioned to this state by multiplying the margin by a fraction, the numerator of which is the entity s gross receipts from business done in this state and the denominator of which is the entity s gross receipts from its entire business Section of MTC: The Multistate Tax Compact is adopted and entered into with all jurisdictions Article III, Section 1: Any taxpayer subject to an income tax whose income is subject to apportionment and allocation for tax purposes pursuant to the laws of the party state may elect to apportion and allocate in accordance with Article IV. Article IV, Section 8: All business income shall be apportioned to this state by multiplying the income by a fraction, the numerator of which is the property factor plus the payroll factor plus the sales factor, and the denominator of which is three. Article IV, Section 1(a): Business income means income arising from transactions and activity in the regular course of the taxpayer s trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer s regular trade or business operations. 8 4

5 Franchise Tax: Apportionment Graphic Packaging, Inc. v. Combs, Cause No CV (Third Ct. of Appeals, July 28, 2015): Apportionment/MTC Three-Factor This case is on appeal to the Texas Supreme Court. In Gillette v. California Franchise Tax Board, 62 Cal. 4th 468 (Dec. 31, 2015) which involves the same issue for California franchise tax purposes, the California Supreme Court held that the MTC is not binding on the State of California and that the state could adopt a different apportionment factor that the elective one prescribed by the MTC. On October 11, 2016, the U.S. Supreme Court denied certiorari in the Gillette case. On October 20, 2016, Kimberly-Clark Corp. filed pet. for rev. with the U.S. Supreme Court on the same issue appealing the Minnesota Supreme Court decision in Kimberly-Clark Corp. v. Comm r of Rev., 880 N.W.2d 844 (Minn. June 22, 2016.) 9 Franchise Tax: Apportionment American Airlines, Inc. v. Hegar, Cause No. D-1-GN , (pending in Travis County D. Ct) Plaintiff, an airline company, claims that the Texas franchise tax violates the Federal Anti-Head Tax Act, which prohibits a state from assessing a tax, fee, head charge, or other charge on an individual traveling in air commerce; the transportation of an individual traveling in air commerce; the sale of air transportation; or the gross receipts from that air commerce or transportation. 49 U.S.C (b). Plaintiff cites to Graphic Packaging and the Comptroller s arguments for the proposition that the franchise is more akin to a gross receipts tax. As such, Plaintiff argues that the franchise tax violates the Federal Anti-Head Act. 10 5

6 Franchise Tax: Apportionment Siruis XM Radio, Inc. v. Hegar, Cause No. D-1-GN , (pending in Travis County D. Ct.) Facts: According to the lawsuit, Sirius XM Radio, Inc. ( SXM ) provides a satellite radio service that, among other things, transmits music, sports, talk, entertainment, traffic and weather channels to subscribers throughout the U.S., including subscribers in Texas. Issue: The Comptroller claims that the apportionment factor should be based on where the signal is descrambled using a percentage of customers located in Texas applied to against everywhere receipts. SXM argues that all revenues should be sourced outside of Texas because the location of SXM s headquarters, satellite equipment and production facilities are all outside of Texas. 11 Franchise Tax: Apportionment Hearing No. 107,606 (July 28, 2014): Facts: Taxpayer was a foreign corporation headquartered in Oklahoma that provided technical training services for the oil and gas industry. Training is offered in Texas and various other states. The training services sold in Texas were taught by instructors that were located in Texas for the benefit of attendees in Texas. 12 6

7 Franchise Tax: Apportionment Hearing No. 107,606 (July 28, 2014): Issue: The Comptroller argued that receipts from live training sessions performed in Texas should be apportioned to Texas. Taxpayer argued that revenue producing activities should take into account activities related to the creation of the training much of which occurred in Oklahoma including the development and marketing activities. Ruling: The act done that produced the revenues at issue were performed completely in Texas. The acts done at Petitioner s headquarters were merely preparatory, non-receipt producing acts. The receipts at issue were properly sourced to Texas according to the ALJ. 13 Franchise Tax: Apportionment Hearings 11, ,869 (pending): Prepaid Telephone Cards Taxpayer is a seller of prepaid telephone cards. Taxpayer seeks a refund of Texas franchise tax on the basis that (i) the sale of prepaid calling cards constitutes the sale of telephone services; (ii) calls made with the prepaid calling cards are international in nature and cannot, therefore, be sourced to Texas; (iii) Taxpayer is entitled to a cost of goods sold deduction for the cost of the prepaid calling cards; and (iv) Taxpayer is entitled to use the reduced rate available to retailers and wholesalers The Comptroller claims that Taxpayer is engaged in selling intangibles and does not, therefore, qualify to use the apportionment sourcing rules applicable to telephone service providers, the cost of goods sold deduction or the.5% rate. The Comptroller also claims that the 2008 refund year is barred by the statute of limitations. 14 7

8 Franchise Tax: Apportionment Hearings 11, ,869 (pending): Prepaid Telephone Cards Rule 3.591(e)(30): (A) Revenues from telephone calls that both originate and terminate in Texas are Texas receipts. (B) Revenues from telephone calls that originate in Texas but terminate outside of Texas or that originate outside of Texas but terminate in Texas are excluded from Texas receipts. Rule 3.591(e)(21)(B): Sales of intangibles are apportioned based on the location of the payor. 15 Franchise Tax: Apportionment Hearings 11, ,869 (pending): Prepaid Telephone Cards In a prior decision (Hearing No. 108,113 (July 9, 2013)) involving a cost of goods sold issue, the Comptroller held, the Comptroller s policy treating [the sale of] prepaid calling cards as intangible personal property is mandated by the plain language of Texas Tax Code Section Petitioner s customers are paying for the telecommunication services embedded in the calling card, and not for the card itself. (emphasis added). Query: For apportionment purposes, should the sale of Prepaid Calling Cards be treated as the sale of telephone services or intangibles? 16 8

9 Franchise Tax: Apportionment Hearings 11, ,869 (pending): Prepaid Telephone Cards The Comptroller also claims that the 2008 refund year is barred by the statute of limitations. Taxpayer filed its refund claim later than 4 years from when the report for 2008 was due, but within 4 years from when the Comptroller s assessment became final. Generally, a refund claim must be filed within 4 years from when tax was due and payable or 6 months after determination becomes final. Tax on an assessment is due and payable 10 days after it becomes final under Tex. Tax Code Sec Tax on original report is due by due date of report. Query: When is tax due and payable for purposes of triggering 4-year SOL? 17 Franchise Tax: Apportionment Hearings 11, ,869 (pending): Prepaid Telephone Cards On June 27, 2016, the ALJ issued a final Proposal for Decision ruling in favor of taxpayer for all years other than the 2008 report year. The 2008 year was denied on SOL grounds. The Comptroller issued a final decision accepting the PFD on October 13, Other Prepaid Calling Card Cases pending: Hearing No. 107,086: Taxpayer argues it is entitled to use the 3-factor apportionment formula under the MTC. I-Tel, Inc. v. Hegar (Travis County D. Ct., Docket No. D-1-GN ): Taxpayer argues it is entitled to cost of goods sold deduction. 18 9

10 Franchise Tax: Apportionment Empty Miles : Internal Memo, Access No L(Sept. 8, 2016) Issue: May a taxable entity include empty miles in the apportionment formula for transportation services. Rule (e)(32): Transportation companies must report Texas receipts from transportation services in intrastate commerce by: (A) the inclusion of revenues that are derived from the transportation of goods or passengers in intrastate commerce within Texas; or (B) the multiplication of total transportation receipts by total mileage in the transportation of goods and passengers that move in intrastate commerce within Texas divided by total mileage everywhere. 19 Franchise Tax: Apportionment Empty Miles : Internal Memo, Access No L(Sept. 8, 2016) Ruling: A taxable entity may either include empty miles in both the numerator and denominator or exclude such miles from both. A taxable entity may not exclude empty miles from the numerator but include such miles in the denominator. The exclusion of empty miles from the numerator but not the denominator skews the percentage for apportionment, does not accurately reflect receipts from intrastate transportation in Texas, and results in a disproportionate percentage from that calculated when using revenue to apportion transportation receipts. Note: Apparently, this memorandum was issued to address a reporting position that empty miles should be included in the denominator but not the numerator

11 Franchise Tax: Combined Reporting Owner versus Owners Scenario: Section (1): Affiliated group means 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. Comptroller Rule 3.590(a)(1): Affiliated group Entities in which a controlling interest is owned by a common owner, either corporate or noncorporate, or by one or more of the member entities. Query: Should entities with common owners that collectively meet the controlling interest test be treated as an affiliated group for combined reporting purposes? 21 Franchise Tax: Combined Reporting Individual A Individual B Individual A Individual B 50% 50% 50% 50% Corporation A Corporation B 22 11

12 Franchise Tax: Combined Reporting Owner versus Owners Scenario: A SOAH Proposal for Decision in Hearing No. 109, ,673 was issued on June 2, 2014 ruling that two entities with multiple owners who collectively owned more than 50% of both entities were an affiliated group. On August 12, 2014, the ALJ rejected exceptions filed by the State upholding PFD as originally issued. Comptroller issued a final decision adopting the PDF on June 23, Franchise Tax: Combined Reporting Hearing No. 111,577 (Oct. 22, 2015): Unitary Business Facts: Petitioner and Co. A were owned by Individual A. The two entities were engaged in separate lines of business, were operated by separate individuals, and had only one common vendor. Individual A provided accounting services to both entities including paying bills, collecting accounts, balancing statements, and other similar activities. The Comptroller argued that Individual A s activities constituted created a unitary business because it represented centralized management. Note: Under the Comptroller Regulations, a unitary relationship is presumed where an affiliated group exists

13 Franchise Tax: Combined Reporting Hearing No. 111,577 (Oct. 22, 2015): Unitary Business Held: Centralized management is not enough to create a unitary relationship. It must be strong centralized management. Individual A s activities were not sufficient to create unity. Both entities operate independently of each other with respect to their more critical functions such as the delivery of their mutual services; the hiring, firing, and management of personnel; the direct purchasing of goods and services; and their marketing activities. The regulatory presumption of unity was rebutted in this case. 25 Franchise Tax: Combined Reporting Note: Combined Reporting May Be More Beneficial Than Separate Reporting Where: A large number of intercompany transactions exist; One or more entities in the combined group have no nexus with Texas; or One or more entities have a significant out of state presence

14 Franchise Tax: Cost of Goods Sold American Multi-Cinema, Inc. v. Combs (Tex. App. Austin, Texas April 30, 2015): Movie Theaters Facts: Taxpayer is engaged in the movie theater business. It claims that it is entitled to include the cost of exhibiting movies and other content to its customers. Taxpayer also claims that it is engaged in producing TPP and therefore costs of the entire auditorium are costs that may be included in cost of goods sold. Held: On April 30, 2015, the Third Court of Appeals agreed with Taxpayer. The court held that the exhibition of movies by Taxpayer constitutes the production of personal property for which a cost of goods sold deduction could be claimed. The cost of exhibiting movies and other content to paying customers could be included in cost of goods sold. In addition, costs associated with the square footage of its auditoriums were also direct costs of production. 27 Franchise Tax: Cost of Goods Sold Cost of Goods Sold: American Multi-Cinema, Inc. v. Combs (Tex. App. Austin, Texas April 30, 2015): Cost of Goods Sold/Movie Theaters Motion for rehearing filed still pending Query: What other items might there be that qualify for cost of goods sold deduction under the Court s opinion? If an item or service is considered tangible personal property for franchise tax cost of goods sold purposes, should it be considered the same for sales tax purposes? 28 14

15 Franchise Tax: Cost of Goods Sold Hegar v. CGG Veritas Services (US), Inc., 2016 Tex. App. LEXIS 2439 (Third Ct App. Austin, March 9, 2016): Cost of Goods Sold Taxpayer sells audio and visual representations of the earth s subsurface to oil and gas well drillers and producers. The oil and gas well drillers and producers use Taxpayer s product to construct oil and gas wells. Taxpayer stores the audio and visual recordings in a library and makes them available to customers for purchase. Issue: Taxpayer claims that it is entitled to claim a cost of goods sold deduction. District Court agreed with the taxpayer. The D.Ct. found in part that CGG s seismic services and products were an integral, essential, an direct component of the drilling process. 29 Franchise Tax: Cost of Goods Sold Hegar v. CGG Veritas Services (US), Inc., 2016 Tex. App. LEXIS 2439 (Third Ct App. Austin, March 9, 2016): Cost of Goods Sold The Court of Appeals upheld the District Court s decision. Citing to Newpark, the Court held, Finally, given the common definition of the term labor, which encompasses a wide range of activities, including expenditure of physical or mental effort especially when fatiguing, difficult or compulsory, we concluded that the legislature intended section to permit taxable entities to deduct a wide range of labor expenses, including those associated with activities that might also be described as a service

16 Franchise Tax: Cost of Goods Sold Autohaus LP, LLP v. Combs (Tex. Dist. Ct. April 29, 2015): Cost of Goods Sold/Installation Activities Facts: Taxpayer is an automobile dealer in the business of selling and repairing automobiles. At issue were labor costs associated with the installation of automobile parts in the repair business. Issue: Taxpayer claimed these labor costs were includable in cost of goods sold under the plain language of Tex. Tax. Code as the definition of production in (a)(2) included installation. Comptroller argued that production was defined by Texas Admin. Code (b)(7) and thus only included installation during the manufacturing or construction process. 31 Franchise Tax: Cost of Goods Sold Autohaus LP, LLP v. Combs (Tex. Dist. Ct. April 29, 2015): Cost of Goods Sold/Installation Activities The District Court granted Plaintiff s Motion for Summary Judgment in its entirety, granting the deduction and associated refund, along with declaring that Tex. Admin. Code 3.588(b)(7) is invalid because it conflicts with Tex. Tax. Code (a)(2). Final Judgment entered April 29, The District Court also awarded taxpayer attorneys fees. The case is on appeal to the Third Court of Appeals in Austin, Texas. Oral arguments scheduled for January 11,

17 Franchise Tax: Cost of Goods Sold Definition of Production: Section (c): Cost of goods sold includes all direct costs of acquiring or producing goods. Section (a)(2): Production includes construction, installation, manufacture, development, mining, extraction, improvement, creation, raising, or growth. Comptroller Rule 3.588(a)(7): Production Construction, manufacture, installation occurring during the manufacturing or construction process, development, mining, extraction, improvement, creation, raising, or growth. Query: Should installation labor be included in cost of goods sold regardless of whether related to manufacturing or construction? 33 Franchise Tax: Cost of Goods Sold Amicus Brief: Filed: August 25, 2016 Amici argues that the starting point in computing cost of goods is the federal cost of goods sold amount. This amount is reduced for items that are not fully deductible under Section Section (h) states: A taxable entity shall determine its cost of goods sold, except as otherwise provided by this section, in accordance with the methods used on the federal income tax return on which the report under this chapter is based. This subsection does not affect the type or category of cost of goods sold that may be subtracted under this section. Query: Does reference to methods in Section (h) include the amount of federal cost of goods sold? How much deference is the Comptroller entitled to in construing this term? 34 17

18 Franchise Tax: Cost of Goods Sold NTS Communications v. Combs: Do telephone, cable and Internet access services qualify for the cost of goods sold deduction? "Goods" means real or tangible personal property sold in the ordinary course of business of a taxable entity. "Tangible personal property includes personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner. Mixed Transaction Rule: If a transaction contains elements of both a sale of tangible personal property and a service, a taxable entity may only subtract as cost of goods sold the costs otherwise allowed by this section in relation to the tangible personal property sold. 35 Franchise Tax: Cost of Goods Sold Hearing No. 110, 776 (July 16, 2015): Aquarium Facts: Taxpayer operates an aquarium. Its primary source of income is from admission charges. Taxpayer argued that it was entitled to a cost of goods sold deduction related to its operations claiming that the husbandry of animals constitutes goods for cost of goods sold purposes. Taxpayer also argued that its aquarium exhibits constitute goods. Ruling: Taxpayer does not qualify for a cost of goods sold deduction. Taxpayer does not sale the animals and the exhibits do not constitute goods

19 Franchise Tax: Cost of Goods Sold Hearing No. 108,066 (May 12, 2015): Guidebooks Facts: Taxpayer was engaged in the publication of a guidebook that listed residential properties for sale. The guidebook was distributed at no cost to the general public. Advertisers paid a fee for advertising space. Ruling: The ALJ ruled that Taxpayer was not entitled to a cost of goods sold deduction because the guidebook was not sold in the normal course of business. Taxpayer s customers purchased a service not a product or good. 37 Franchise Tax: Cost of Goods Sold Contractors: Internal Memo (June 30, 2016) Supersedes June 10, 2014 Memo (g)(3): Subcontracting payments that are mandated by contract to be distributed to others and have a reasonable nexus to the actual or proposed design, construction, remodeling, or repair of improvements to real property or the location of boundaries of real property may be excluded. A payment is mandated by contract to be distributed to other entities if the taxable entity has a contract with its customer providing that a subcontractor may be used and requiring payment to the subcontractor, or by a written contract between the taxable entity and the subcontractor where the payment is based on the funds paid to the taxable entity by the taxable entity s customers (e.g., subcontract requires payment based on percentage received from customer). Timing of payment does not determine if payment qualifies as flow-through

20 Franchise Tax: Cost of Goods Sold Contractors: Internal Memo (June 30, 2016) (i): No longer required to actually physically touch the property or make a change to the property to qualify for the COGS deduction. The policy changes are similar for both Sections (g)(3) and (i), but with one slight difference. Both permit industries such as transportation companies delivering aggregate and other similar materials to a construction site, waste removal companies, demolition companies, and inspectors, among others, to claim either a COGS deduction or an exclusion from revenue provided the transaction meets the contractual requirement of flow-through funds as described above. The one slight difference is that Section (g)(3) uses the term proposed absent from Section (i) which may permit costs for activities performed by architects and engineers to qualify as exclusions from revenue, without regard to whether construction occurs. (emphasis added). 39 Franchise Tax: Cost of Goods Sold Vendor Funded Incentives Internal Memorandum L (Aug. 11, 2016) Provided that the following VFIs are not treated as an offset to cost of goods sold: (i) Advertising; (ii) Coupon Program-Handling Fees; (iii) Product Demos; (iv) Product Placement; (v) Shows/Seminars. The following are considered sales-based incentives and, if not reported as revenue, are included in COGS calculation as a contra-expense (i) Coupon Program Face Value; (ii) Depletion Allowance/Volume Incentive; (iii) Mark Down Funding; (iv) New Item Allowances; (v) Sales Based Incentives; (vi) Temporary Price Reductions

21 Franchise Tax: Cost of Goods Sold Research and Related Costs Internal Memo L (April 23, 2015) Revises existing tax policy to permit a taxable entity that is eligible for a COGS deduction to claim as COGS all research, experimental, engineering, and design activity costs, including all research or experimental expenditures described in Section 174 of the IRC, regardless of whether the taxable entity is the producer of the good. Under prior Comptroller policy, these deductions were available only to those entities that produced the goods at issue. 41 Franchise Tax: Total Revenue Hearing No. 107,916 (May 7, 2013): Reimbursements Taxpayer was a forwarding agent. On its 2008 and 2009 franchise tax reports, TP deducted out-of-pocket costs from total revenue and later sought to amend it s federal tax returns to exclude the reimbursements from gross receipts. Comptroller agreed that the federal income tax returns could be amended to report gross receipts by excluding reimbursed expenses. If amended, total revenue could also be reduced. Petitioner amended two returns but stated that he could not amend the third because of the federal statute of limitations. It is not clear why Petitioner believed federal law precluded amending federal returns: 3-year statute of limitations for federal tax purposes applies to refund claims. See IRC Sec. 6511(a)

22 Franchise Tax: Total Revenue Hearing No. 107,457 (Dec. 4, 2014): Reimbursements Facts: Taxpayer transports freight on a contract basis. It charged its customers a fuel surcharge to account for fluctuations in fuel prices. The surcharge was essentially an estimate based on industry standards that sought to recover excess fuel costs on a dollar-for-dollar basis and was billed separately on customer invoices. Taxpayer initially included its fuel surcharge amounts in its gross receipts amount for federal purposes. Subsequently, TP amended its FIT returns to exclude the surcharge from gross receipts and sought a corresponding refund of Texas franchise tax.. Issue: Whether Taxpayer could exclude the fuel surcharge amounts from Total Revenue for franchise tax purposes. The auditor argued that the charges were for the provision of transportation services rather than reimbursements. 43 Franchise Tax: Total Revenue Hearing No. 107,457 (Dec. 4, 2014): Reimbursements Held: The judge held that the fuel surcharge amounts could be excluded from total revenue. Citing to federal tax authority, the judge concluded that the fuel surcharges were excludable from federal income tax gross receipts because they would otherwise be deductible under IRC Section 162 and there was a right or expectation of reimbursement at the time the expenditure occurred. The right of reimbursement does not have to be absolute under Fifth Circuit authority. The judge noted that (i) Taxpayer paid for fuel upfront with the expectation that it would be substantially repaid by client; (ii) clients were routinely invoiced for the fuel and were required to pay within 15 days; and (iii) less than 1% of fuel surcharges billed were written off

23 Franchise Tax: Total Revenue Hearing No. 111, 251 (Feb. 26, 2016): Home Health Care Agencies: Facts: Taxpayer provided healthcare professional services for around-the-clock care, including registered nurses, licensed vocational nurses, certified aides, social workers, and therapists. Taxpayer excluded Medicare and Medicaid payments from total revenue under Section (n)(1)(A), which permits a health care provider to exclude those payments from total revenue. The Comptroller argued that Taxpayer could only exclude 50% of those payments from total revenue because it was a health care institution as defined in Section (p)(2). Taxpayer was registered as a home and community support services agency with the Texas Department of Aging and Disability Under Section (n)(1), health care providers may exclude payments from Medicare and Medicaid from total revenue. However, health care providers that are health care institutions may only exclude 50% of those payments from total revenue. A healthcare institution is defined to include a home and community support services agency.. 45 Franchise Tax: Total Revenue Hearing No. 111, 251 (Feb. 26, 2016): Home Health Care Agencies: Held: Taxpayer was a home an community support services agency. The ALJ relied heavily on the fact that the taxpayer was registered as such with DADS and was also listed in the current agency directory published by DADS. The ALJ also noted that a health care institution is defined to include a home and community support services group under the Texas tort reform legislation (Chapter 74 of the Texas Civil Practice and Remedies Code)

24 Franchise Tax: Temporary Credit Hearing No. 109,446 (June 24, 2015): Sale of combined group member Facts: Claimant was the reporting entity of a combined group. On April 1, 2011, the group was acquired by another entity. For the 2012 short report year, the original combined group claimed the full amount of an unused temporary credit available for use that year. The Comptroller disallowed the credit. Ruling: The plain language of Section (d) prohibits a taxable entity that changes combined groups from claiming its temporary credits on the report for the partial year during which it was still part of its original combined group. 47 Franchise Tax: Exemptions New Comptroller Rule 3.574: Veteran Owned Business (proposed Aug 10, 2016) Implements rules for new Veteran Owned Business Exemption enacted by SB 1049 in Generally provides that new veteran owned businesses (as defined) are exempt from tax for the first 5 years of existence. Proof of exempt status required: Must submit a Letter of Verification of Veteran s Honorable Discharge from the Texas Veterans Commission for each owner of the business and Comptroller Form to the Secretary of State or the Comptroller along with a franchise tax questionnaire if the entity is not required to file a certificate of formation with the Secretary of State. Query: Might there be planning opportunities utilizing veteran owners under this new exemption? 48 24

25 Franchise Tax: Tax Rate Under Section , a reduced tax rate applies to entities primarily engaged in retail or whole sale, defined as: 1) the total revenue from its activities in retail or wholesale trade is greater than the total revenue from its activities in trades other than the retail and wholesale trades; 2) except as provided by Subsection (c-1)(certain eating and drinking places), less than 50 percent of the total revenue from activities in retail or wholesale trade comes from the sale of products it produces or products produced by an entity that is part of an affiliated group to which the taxable entity also belongs; and 3) the taxable entity does not provide retail or wholesale utilities, including telecommunications services, electricity, or gas. 49 Franchise Tax: Tax Rate Proposed Amendments to Rule For purposes of applying the 50% production test: I.A taxable entity produces the product that it sells if the taxable entity acquires the product and makes modifications to the product that increase the sales price of the product by more than 10%. II.A taxable entity produces the product that it sells if the taxable entity manufactures, develops, or creates tangible personal property that is incorporated into, installed in, or becomes a component part of the product that it sells. For example: i. A taxable entity produces an electronic device that it sells when the taxable entity produces a computer program, such as an application or operating system, that is installed in the device, even if the device is manufactured by an unrelated party. ii. iii. A taxable entity produces a drug that it sells when the taxable entity produces the active ingredient in the drug, even if the drug is manufactured by an unrelated party. A taxable entity does not produce a product that it sells if the product is manufactured by an unrelated party to the taxable entity's specifications

26 School Finance Texas Taxpayer & Student Fairness Coalition, et al v. Williams (Travis County District Court, Cause No. D-1-GN )(Aug. 28, 2014): At issue: Art VII, 1: A general diffusion of knowledge being essential to the preservation of the liberties and rights of the people, it shall be the duty of the Legislature of the State to establish and make suitable provision for the support and maintenance of an efficient system of public free schools. Art VIII, 1-e: No State ad valorem taxes shall be levied upon any property within this State. Holding/Status: District Court Judge Dietz declared the Texas school finance system unconstitutional claiming that it is inequitable, inadequate and constitutes a statewide property tax. The case was appealed directly to the Texas Supreme Court. 51 School Finance Morath, et al v. Texas Taxpayer & Student Fairness Coalition, et al, 2016 Tex. LEXIS 374 ( Tex. May 13, 2016) Texas Supreme Court holding: Plaintiffs did not meet their burden of showing the school finance system was inadequate, noting an extremely deferential standard in favor of the State. The Plaintiffs also failed to show the school system was unsuitable. The current school finance system does not impose a statewide ad valorem tax

27 Sales Tax Southwest Royalties, Inc. v. Combs, 2014 WL (Tex. App. Austin, Aug. 13, 2014). Facts: Southwest Royalties argues that equipment used for the extraction or mining of oil and natural gas as well as services pertaining to that equipment qualifies for the manufacturing exemption. In particular: Issue: Southwest Royalties sought exemption for casing, tubing, pumps and related parts as well as for services pertaining to that equipment. The Comptroller argued that the Legislature did not intend for the manufacturing exemption to apply to the extraction of oil and gas. Held: The boundaries intended by the Legislature regarding what qualifies as property or services used during actual manufacturing, processing, or fabrication are not clear from the statute. The Comptroller s interpretation is not plainly erroneous or inconsistent with the language of the statute. A petition for review was filed with the Texas Supreme Court. 53 Sales Tax Southwest Royalties, Inc. v. Combs, (No )(June 17, 2016). Texas Supreme Court: The Supreme Court focused heavily on the meaning of the term processing ultimately accepting the Comptroller s regulatory definition which defines the term as [t]he physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property. Rule 3.300(a)(10). According to the Court, while the equipment unquestionably was both used in and necessary to the efficient recovery of hydrocarbons there is no evidence that the equipment acted upon the hydrocarbons to modify or change their characteristics. The changes in the substances were caused not by the application of equipment and materials to them, but by he natural pressure and temperature changes that occurred as the hydrocarbons traveled from the reservoir through the casing and tubing to the surface

28 Sales Tax Southwest Royalties, Inc. v. Combs, (No )(June 17, 2016). Despite the taxpayer loss, is there a silver lining to the Southwest Royalties decision? Can the State continue to argue that equipment used in extraction does not per se qualify for the manufacturing exemption? What if the equipment directly makes a change to or modifies the hydrocarbons, such as by adding pressure, changing temperature, separating, etc? Can the State continue to argue that activities which occur before the manufacturing process has begun do not qualify for the manufacturing exemption? 55 Sales Tax Southwest Royalties, Inc. v. Combs, (No )(June 17, 2016). Motion for Rehearing: On September 6, 2016 Petitioners filed a motion for rehearing asking court decide whether the equipment at issue qualifies for the exemptions under Section (a)(5) (pollution control process) or Section (a)(10)(public health). Petitioners argue that neither of these sections require that the equipment at issued be directly used or consumed in the manufacturing, processing or fabrication of tangible personal property as is required under Section (a)(2)

29 Sales Tax Combs v. Health Care Service Corp., 401 S.W.3d 623 (Tex. June 7, 2013): Sale for Resale Exemption: Equipment Purchased for Transfer to U.S. Government Facts: Taxpayer purchased equipment for use in providing non-taxable administrative services under a contract with the federal government. Title to the equipment but not possession passed immediately to the federal government. Issue: At issue was Section which defines a sale for resale to include TPP or a taxable service to a purchaser who acquires the property or service for the purpose of reselling it with or as a taxable item in the normal course of business in the form or condition in which it is acquired or as an attachment to or integral part of other tangible personal property or taxable service. Taxpayer argued that the purchase of equipment qualified as an exempt purchase for resale. The Texas Comptroller argued that the equipment did not qualify as a purchase for resale because the primary purpose for the purchase was not to resell it but to use it in providing a service and also because care, custody and control of the equipment did not pass to the federal government. 57 Sales Tax Combs v. Health Care Service Corp., 401 S.W.3d 623 (Tex. June 7, 2013): Sale for Resale Exemption: Equipment Purchased for Transfer to U.S. Government Held: Citing the plain language of the statute, the Texas Supreme Court held that the equipment qualified for the resale exemption because those items were purchased for the purpose of being resold to the federal government in the form or condition in which they were acquired. The Court noted that the definition of sale includes the transfer of title even if care, custody or control is not transferred. The statute does not say (or even intimate) that the primary purpose of the sale must be for a particular kind of sale

30 Sales Tax Footnote Re Economic Realities: Health Care Services (footnote 8) states: We recently noted that in the area of tax law, like other areas of economic regulation, a plain-meaning determination should not disregard the economic realities underlying the transactions in issue, and cited federal and Texas tax cases referencing economic realities or the essence of the transaction. Combs v. Roark Amusement & Vending, L.P., S.W.3d, & n. 14, 2013 WL (Tex. 2013). However, we also made clear that if the statute does not impose, either explicitly or implicitly, the extra-statutory requirement urged by the Comptroller, we decline to engraft one-revising the statute under the guise of interpreting it. Id. at. We did not suggest that, in the guise of considering the economic realities or essence of the transaction, courts were authorized to impose an entirely new requirement for a tax exemption that simply is not found in the language of the statutory exemption. (emphasis added). 59 Sales Tax DTWC Corporation v. Combs, 400 S.W.3d 149 (Tex. App. Austin, April 11, 2013): Sale for Resale Exemption: Property transferred as part of Non-taxable Hotel Services Facts: The Taxpayer was a hotel operator that purchased several consumable items which were transferred to hotel customers as part of their hotel stay or at least made available to them to take or consume (e.g., soaps, shampoos, conditioners, notepads, mouthwash, etc.). Taxpayer argued that the purchases qualified for the resale exemption citing in part the definition of a sale, which includes a transfer of title or possession of tangible personal property when done or performed for consideration. Issue: Taxpayer argued that it could purchase the hotel consumables tax-free under Section which defines a sale for resale to include TPP or a taxable service to a purchaser who acquires the property or service for the purpose of reselling it with or as a taxable item in the normal course of business in the form or condition in which it is acquired or as an attachment to or integral part of other tangible personal property or taxable service. The Texas Comptroller argued in part that the resale exemption did not apply because (i) the items purchased were not transferred as part of a taxable transaction; (ii) the transfer to customers lacked consideration; and (iii) the hotel was not in the business of selling hotel consumables

31 Sales Tax DTWC Corporation v. Combs, 400 S.W.3d 149 (Tex. App. Austin, April 11, 2013): Sale for Resale Exemption: Property transferred as part of Non-taxable Hotel Services Held: The Court agreed with the Taxpayer holding that under the plain language of the statute, purchases of the hotel consumables qualified for the resale exemption. The consumables were TPP that the hotel acquired to put, in the form or condition in which the hotel acquired them, in the hotel rooms for guests to use, not use or take. Guests paid a fee (i.e., consideration) to use the rooms and its amenities, including the hotel consumables. The items were also acquired and transferred in the normal course of business. Note: The Texas Comptroller has begun to allocate a portion of the hotel charge to the consumables in order to arrive at a deemed sales price attributable to the consumables. 61 Sales Tax Fitness International, LLC v. Hegar, 2016 Tex. App. LEXIS 6337 (Third Ct. App. Austin, June 16, 2016) Fitness International, LLC (Fitness) owns and operates health clubs in Texas that sell memberships granting access to the facilities. Fitness argued that the purchase of items such as personal sanitation consumables (e.g., body wash, shampoo and hand sanitizer), towels, basketballs and work out equipment, including cardio machines, abdominal machines, stretch machines, arm/shoulder equipment, leg equipment, weight racks, scales and promotional flyers qualified for the resale exemption. The trial court held in favor of Fitness on all items except the equipment and promotional flyers. On appeal, the Comptroller did not challenge the trial court s holding in favor of Taxpayer but continued to argue that the work-out equipment did not qualify for the resale exemption

32 Sales Tax Fitness International, LLC v. Hegar, 2016 Tex. App. LEXIS 6337 (Third Ct. App. Austin, June 16, 2016) At issue was Section (a)(3) which states that a sale for resale includes a sale of tangible personal property to a purchaser who acquires the property for the purpose of transferring it as an integral part of a taxable service. Citing the dictionary meaning of the terms transfer and resell, the Court concluded that Fitness did not purchase the equipment and other items at issue for the purpose of (i) reselling them, (ii) transferring (i.e. legally conveying) them; (iii) transferring legal possession of them (so as to make members property rights equal to or superior to Fitness s rights) or (iv) offering them for lease or rental. Fitness therefore could not purchase these items tax free under the sale for resale exemption Amendment following the Health Care Services Decision The definition of a sale for resale in Section was amended in 2011 to state: A sale for resale does not include the sale of tangible personal property or a taxable service to a purchaser who acquires the property or service for the purpose of performing a service that is not taxed under this chapter, regardless of whether title transfers to the service provider s customer, unless the tangible personal property or taxable service is purchased for the purpose of reselling it to the United States in a contract, or a subcontract of a contract, with any branch of the Department of Defense, Department of Homeland Security, Department of Energy, National Aeronautics and Space Administration, Central Intelligence Agency, National Security Agency, National Oceanic and Atmospheric Administration, or National Reconnaissance Office to the extent allocated and billed to the contract with the federal government

33 Sales Tax Hegar v. CheckFree Services v. Corp., 2016 Tex. LEXIS 4039 (Tex. Civ. App. Houston, April 19, 2016) Facts: Taxpayer contracted with several banks to provide bill pay services through the banks online banking services to bank customers. The Comptroller claimed that these services were taxable data processing services. The trial court help that the services at issue were bill pay services and not data processing services and therefore not taxable. Specifically, the Trial Court held, CheckFree has thousands of skilled and/or certified professionals who collaborate in the performance of these professional services centered around bill payment. Held: The Houston Court of Appeals agreed with the Trial Court that the services were not taxable. [T]o the extent that CheckFree provided [data processing services], they were ancillary to the professional bill pay services provided by CheckFree for the bank s customers-the electronic commerce services that the bank purchased from CheckFree. 65 Sales Tax Allstate Inc. Co. v. Hegar, 2016 Tex. App. LEXIS 1603 (Tex. App. Austin, Feb. 19, 2016, no pet. h.). Facts: Taxpayer, ( Allstate ), an insurance carrier, subcontracted with another entity, Pilot Catastrophe Services, Inc. ( Pilot ) to provide insurance claims adjusters as needed to supplement Allstate s existing staff of claims adjusters. Allstate argued that the adjusters provided by Pilot were excluded from Texas sales tax under Section (2) of the Texas Tax Code. Section states that a service performed by an employee of a temporary employment service as defined by Section , Labor Code, for an employer to supplement the employer s existing work force on a temporary basis, when the service is normally performed by the employer s own employees, the employer provides all supplies and equipment necessary, and the help is under the direct or general supervision of the employer to whom the help is furnished

34 Sales Tax Allstate Inc. Co. v. Hegar, 2016 Tex. App. LEXIS 1603 (Tex. App. Austin, Feb. 19, 2016, no pet. h.). Held: The Texas Comptroller argued that the adjusters provided by Pilot did not qualify as temporary employees because they were provided by Pilot on a continuous and ongoing basis and were therefore not temporary in nature. In support of its argument, the Texas Comptroller noted that, on any given date throughout the tax years in question, there was at least one Pilot employee, and typically more, providing adjusting services to Allstate. The Court disagreed with the Texas Comptroller s holistic view of the services provided by Pilot, holding that the temporary services exclusion must be applied on an individual employee basis. When viewed in this manner, the Court had no trouble concluding that the individual adjusters were provided by Pilot to Allstate on a temporary basis 67 DISCLAIMER The information included in these slides is for discussion purposes only and should not be relied on without seeking individual legal advice

35 David E. Colmenero Partner Mr. Colmenero practices in the areas of Federal Tax Litigation, State Tax Litigation and Wealth Transfer Tax Litigation. He represents individuals, closely held businesses, and large corporations in IRS audits, appeals, and litigation in the United States Tax Court, Federal District Courts and the United States Court of Federal Claims, U.S. Courts of Appeals and the United States Supreme Court. He also represents taxpayers in disputes with the Texas Comptroller of Public Accounts, the Texas Workforce Commission and has helped taxpayers resolve tax related controversieswith several other states as well. With respect to state tax, Mr. Colmenero was previously a tax auditor for the State of Texas and, as a lawyer, has successfully represented taxpayers in contested proceedings involving sales and use tax, franchise tax, motor fuels tax, mixed beverage tax, employment tax and others. Mr. Colmenero has expertise in representing taxpayers through contested Texas tax proceedings including audits, Independent Audit Review Conferences, administrative hearings before the State Office of Administrative Hearings and in State court litigation. With the enactment of the revised franchise tax and a corresponding increase in audits and assessments by the State of Texas, Mr. Colmenero has assisted numerous taxpayers in challenging various aspects of the Texas Comptroller franchise tax policies and assessments and in planning business structures and business transactions to mitigate exposure to the revised franchise tax. Through the course of his federal tax practice, Mr. Colmenero has represented numerous taxpayers in complex and phone (214) contentious federal tax matters through various stages of examination, appeals and litigation, some of which have toll-free (800) involved high profile taxpayers and high profile legal issues. Representative matters include constructive dividends fax (214) disputes, accumulated earnings tax assessments, hobby loss, passive activity loss and Section 465 challenges by the IRS to loss deductions, employment tax disputes involving worker classification, penalty assessments, dcolmenero@meadowscollier.com assignment of income claims by the IRS, statute of limitations disputes, trust fund assessments, partnership adjustment disputes, refund claims and voluntary disclosures to name a few. Mr. Colmenero also has expertise in representing taxpayers and partnerships in proceedings falling under the TEFRA provisions of the Internal Revenue Code. He has, in addition, advised taxpayers regarding the federal tax consequences in divorce proceedings, litigationbetween private parties and significant business transactions. Mr. Colmenero is a Certified Public Accountant and maintains active involvement in various professional legal and accounting organizations. He currently serves as the Chair of the Tax Section of the State Bar of Texas. He also serves on the Board of Directors for the Texas Society of CPAs and is a member of the Texas Comptroller s Taxpayer Advisory Group. He is the past chair of the Dallas CPA Society and past chair of both the State and Local Tax Committee and the Tax Controversy Committee of the Tax Section of the State Bar of Texas. He frequently speaks on substantive and procedural tax issues involvingboth federal and state tax matters. Mr. Colmenero was admittedto practice in Texas in