Legal Alert: Texas Poised to Replace Corporate Franchise Tax with New Margin Tax

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1 Legal Alert: Texas Poised to Replace Corporate Franchise Tax with New Margin Tax May 9, 2006 Texas Governor Rick Perry may sign legislation enacting one of the most significant tax reforms in Texas history. On April 17, 2006, the Governor called a special legislative session in response to Neeley v. West Orange-Cove Consol. Independent School Dist., 176 S.W. 3d (Tex. 2005), in which the Texas Supreme Court held that capping local school property taxes at $1.50 per $100 valuation amounts to a statewide property tax in violation of the Texas Constitution. The court gave lawmakers until June 1, 2006, to resolve the problem. The special session considered a comprehensive tax reform plan based upon the recommendations of the Texas Tax Reform Commission. The cornerstone of the reform plan is the elimination of the corporate franchise (income) tax at the end of 2006 and a substantial lowering of the property tax rate from $1.50 per $100 in value to $1.00 per $100. To replace lost revenue, Texas will impose a new Taxable Margin Tax ( TMT ) on most business operations, including many partnerships and LLCs. The legislative package also increases the state cigarette tax, currently at 41 cents per pack, to $1.41 per pack. The information below analyzes the new TMT, which was included in Texas House Bill 3 ( HB 3 ). Although the TMT does not become effective until periods beginning on or after January 1, 2007, these tax changes may trigger immediate financial statement considerations for some taxpayers. Due dates and reporting periods are discussed further below. Overview of the TMT - The TMT is unique in its structure, but has several characteristics similar to a gross receipts tax. The starting point for the TMT is a broad definition of total revenues computed on a consolidated basis. Taxpayers may reduce total revenues by essentially deducting either: (1) 30% of total revenues; (2) costs of goods sold; or (3) employee compensation. The resulting number is then apportioned to Texas using a modified version of Texas s current single sales factor apportionment formula to determine the taxable margin. Retailers and wholesalers will pay tax at a rate of 0.5% tax on their taxable margin, while the tax rate imposed on other taxpayers will be 1%. This article is for informational purposes and is not intended to constitute legal advice. 1

2 Sutherland Observation - Ohio took a different approach to determine taxable revenues when it enacted the Commercial Activity Tax ( CAT ) last year. Rather than the Texas approach of apportioning total revenues using a single sales factor (which is generally an income tax approach), the Ohio CAT computes taxable revenues by determining the situs of each individual business activity and the resulting revenues (which is generally a transactional tax approach). Taxable Entities - An important characteristic of the TMT is that it applies to almost all entities, even many pass-through entities and entities that are disregarded for federal income tax purposes. The TMT is imposed on any taxable entity, which is defined as any entity that is a corporation, partnership, limited liability company, business trust, professional association, or other legal entity. Sole proprietorships, general partnerships owned by natural persons, passive income entities, REITs, grantor trusts, estates of a natural person, escrows, and REMICs are excluded from the definition of a taxable entity. The definition of taxable entity also excludes insurance companies, certain cooperatives, nonprofits, and other entities that are currently exempt from taxation under the franchise tax. An entity that owes less than $1000 in tax, or that has $300,000 or less in total revenues, is not required to pay tax. Tex. Tax Code Combined Group - Taxable entities that are part of an affiliated group engaged in a unitary business are required to file a combined report. An affiliated group includes all entities of which a controlling interest (i.e., 80% or more) is owned by a common owner, including entities without nexus in Texas. A unitary business is defined as a single economic enterprise that is made up of separate parts of a single entity or a commonly controlled group of entities that are sufficiently interdependent, integrated and interrelated through their activities. The combined group is generally considered one taxable entity for purposes of computing the TMT. Tex. Tax Code & Total Revenue Computation - The first step in computing the TMT is to compute total revenue, which is calculated based upon the amount reported on particular lines of a federal return. The basic TMT computation imposed on corporations references specific IRS Form 1120 lines as follows: Plus Minus Minus Line 1 c: gross receipts less returns and allowances Lines 4-10: dividends, interest, gross rents and royalties, capital gain net income, net gain from form 4797 and other income, Bad debt Foreign royalties and foreign dividends. Additional deductions are allowed for partnership distributions and dividends that qualify for the federal dividend received deduction. Taxable entities are also allowed to exclude from This article is for informational purposes and is not intended to constitute legal advice. 2

3 taxable revenue any flow-through funds that are mandated by law or fiduciary duty to be distributed to other entities, such as transactional taxes. HB 3 provides a similar computation for partnerships based upon amounts reported on IRS Form 1065 and requires any other taxable entities to use a similar method to compute total revenue. For purposes of computing total revenue, members of taxable entities that filed as part of a federal consolidated group must compute total revenue on a pro forma basis that is, as if they had filed a separate federal return. However, intercompany transactions are excluded in calculating total revenues of the group. Tex. Tax Code Sutherland Observation - In addition to the broadly applicable rules for the computation of total revenue, HB3 contains a number of industry-specific rules. For example, revenues from certain oil and gas wells are excluded in the event oil prices drop below $40 per barrel and natural gas prices drop below $5. Revenues earned from the operation of a facility located on federally owned land are also excluded from total revenue. Deductions Against Taxable Margin - The next step in computing the TMT is to reduce total revenue by the greater of: (1) 30% of total revenue, or (2) total compensation or cost of goods sold (at the election of the taxpayer). 30% Total Revenue Deduction - HB 3 places a cap on taxable margin equal to 70% of the total revenues of a taxable entity. Tex. Tax Code Cash Compensation Deduction - Compensation includes wages, salaries, stock options, and other income paid to an entity s officers, directors, owners, partners, and employees. The deduction for compensation may not exceed $300,000 for any single person (regardless of whether the employee is located within or without Texas). Compensation also includes all noncash benefits paid to all officers, directors, partners, owners, and employees, including workers compensation benefits, health care, and retirement to the extent deductible for federal income tax purposes. Compensation also includes distributions from a partnership or LLC to a natural person. Tex. Tax Code & Cost of Goods Sold Deduction - Only those costs incurred to produce a good can be deducted. A good is defined to include real or tangible personal property and does not include service. Cost of goods sold includes all direct costs of acquiring or producing goods, including production costs for labor, materials, handling (such as processing, assembling, packaging, and inbound transportation), utilities, storage, control, licensing and franchising costs, and production This article is for informational purposes and is not intended to constitute legal advice. 3

4 taxes. Also includable are certain indirect costs for production-related facilities, land and equipment, such as depreciation, depletion, amortization, renting, leasing, and repair and maintenance, as well as costs attributable to research and design, geological and geophysical costs for locating minerals properties, and insurance. Excluded from cost of goods sold are costs for facilities, equipment, and land not used for the production of goods, selling costs, advertising, distribution and outbound transportation costs, interest or financing costs, and income and franchise taxes. Up to 4% of administrative and overhead expenses may be included, to the extent they are allocable to the costs of acquiring or producing the goods. Cost of goods sold shall be capitalized to the extent required by IRC 263A. Tex. Tax Code & Sutherland Observation The cost of goods sold deduction may be one of the most difficult and burdensome components of the TMT to administer. Although the deduction conforms to some extent to federal law, the deduction also contains Texas-specific components. Taxpayers must apply these differences to their combined operations, most of which may not be located in Texas. Apportionment - The resulting taxable base is apportioned to Texas using a modified version of Texas s single sales factor apportionment formula. Gross receipts includes receipts from the affiliated group s sale of tangible personal property, services, rentals, royalties, and other business. The computation of gross receipts for apportionment purposes differs from the computation of total revenue for purposes of computing the taxable margin. However, receipts that are excluded from the total revenue tax base must also be excluded for apportionment purposes. Texas gross receipts includes receipts from the sale of tangible personal property delivered or shipped to a buyer in Texas; services performed in Texas; the use of a patent, copyright, trademark, franchise, or license in Texas; the sale of real property in Texas; and other business transacted in Texas. Tex. Tax Code , & TMT Rate - The TMT rate is 1.0%, except for businesses predominately engaged in wholesale or retail business activity, which pay at a rate of 0.5%. The terms wholesale and retail are defined by reference to Divisions F and G of the 1987 Standard Industrial Classification Manual ( SIC ). A business is considered to be predominately engaged in wholesale or retail if more than half of its total revenue is derived from wholesale and retail sales of tangible personal property. If a taxable entity derives more than 50% of its revenue from retailing or wholesaling products that it or an affiliate produces, the taxable entity is not deemed to be predominately engaged in retail or wholesale. Food and drink providers are excluded from the 50% cap. HB 3 contains a provision that requires voter approval to raise the rate. Tex. Tax Code & This article is for informational purposes and is not intended to constitute legal advice. 4

5 Sutherland Observation - The alternative tax rates coupled with the cost of goods sold deduction are designed to mitigate a common problem with traditional gross receipts taxes, which often impose an inequitable tax burden on high-volume, low-margin retailers and wholesalers. Gross receipts taxes also pyramid because they lack resale exemption concepts. In addressing these issues, however, the TMT creates a very different tax environment for service providers than it does for sellers of tangible property. Compare a mall coffee shop with a carpet cleaning business. A mall coffee shop that sells $100 worth of mocha lattes is entitled to deduct cost of goods sold from revenue and to compute tax at the 0.5% rate. The carpet cleaner providing $100 worth of carpet cleaning services is not entitled to deduct costs of good sold, will most likely have fewer reductions to its total revenues, and will pay tax at a rate twice that of the coffee shop. Credits and Tax Attributes - Taxable entities which have accrued Texas credits for incentives under the former Texas franchise tax law may claim those credits against the TMT, under the terms and conditions provided for at the time they were accumulated; however, no new credits may be accumulated against the TMT (unless a written agreement exists effective before June 1, 2006 between the state and the taxpayer). In other words, all existing credit provisions are repealed. The Texas House amended HB 3 to allow taxpayers who expected to offset Texas business losses against future franchise tax payments to claim a credit against the TMT. The credit is computed by starting with the difference between the taxable entity s deductible temporary differences (including NOLs and net of any valuation allowance) and the taxpayer s taxable temporary differences as reported on the taxable entity s financial statements. The resulting amount is apportioned to Texas using the taxable entity s franchise tax apportionment rate and is multiplied by the 4.5% franchise tax rate. The resulting amount can be taken as a credit against the TMT at a rate of 10% of the credit per year. Tex. Tax Code ; HB 3, Enrolled Version 18. Due Dates - Regular annual returns are due May 15 for the current privilege period (calendar year), based on calculations on financial data from January 1 - December 31 of the previous calendar year. The first return is due May 15, 2008 on business done from January 1, 2007 to December 31, As with the current franchise tax, taxpayers do not make quarterly estimated payments. Tex. Tax Code & ; HB 3, Enrolled Version 22. Other Interesting Provisions - Please note these additional features of the margins tax: Partners may elect to include a partnership s taxable margin in their computation of their own TMT liability in lieu of the partnership reporting as a separate entity. Tex. Tax Code This article is for informational purposes and is not intended to constitute legal advice. 5

6 The Texas Supreme Court is given original jurisdiction over any constitutional challenges to the provision. The Court must issue a ruling on the constitutional challenge within 120 days after suit is filed. The Texas Attorney General ruled in an April 17, 2006 letter that the TMT is not an unconstitutional income tax. However, Texas Comptroller Carole Keeton Strayhorn (who is running for Texas Governor against Perry, the incumbent) delivered a letter to Governor Perry on May 1, 2006, arguing that the TMT is unconstitutional because it is imposed on partnerships. HB 3, Enrolled Version 24. HB 3 requires the Comptroller to gather data from Texas s taxpayers who are included in the top 1000 franchise taxpayers, employers, gross revenue generators, or property tax payers. The data will be analyzed to help determine the impact of the tax reform. HB 3, Enrolled Version 23. Next Legislative Action - HB 3 was one of five bills needed to enact all of the recommendations of the Texas Tax Reform Commission. HB 1 buys down property tax rates by 17 cents the first year with nearly $2.4 billion in surplus funding. HB 2 dedicates all tax revenues generated in House Bills 3, 4 and 5 to reduce property tax rates another 33 cents so that the new rate would be bought down to $1 per $100 valuation. HB 4 reforms the way the sales tax is assessed on used car sales. HB 5 levies an additional $1 per pack excise tax on cigarettes. House Bills 3 and 4 currently await the Governor s signature. House Bills 1 and 5 have passed the House, but are still pending in the Senate. The Senate and House are attempting to resolve differences between their respective versions of HB 2. Governor Perry is not expected to sign any legislation including HB 3 until he receives the entire package of all five bills. The special session adjourns on May 17, Additionally, because the Senate did not make any amendments to the House version of HB 3, the Senate has introduced its own amendments to HB 3 in a separate bill (SB 6). SB 6 is not expected to pass during the special session, and the Texas Legislature will wait to consider any technical corrections and substantive changes to the TMT when the regular session convenes in January This article is for informational purposes and is not intended to constitute legal advice. 6

7 For additional information on what this means for your business, or our state and local tax practice, please contact: Jeff Friedman Kendall Houghton Walter Hellerstein Eric Tresh Scott Wright Todd Lard Michele Borens Marc Simonetti Jessica Kerner Jolie Sims Charlie Kearns Maryann Luongo This article is for informational purposes and is not intended to constitute legal advice. 7