Texas Franchise Tax Update

Transcription

1 Texas Franchise Tax Update 2017 This 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 (2017). All rights reserved.

2 Instructor Jimmy Martens, trial and appellate attorney, is the founding partner of Martens, Todd, Leonard & Ahlrich, a boutique tax litigation law firm located in downtown Austin, Texas. Mr. Martens has handled the trial of 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 Amusement & Vending, L.P., 422 S.W.3d 632 (Tex. 2013); In Re: AllCat Claim Service, L.P., 356 S.W.3d 455 (Tex. 2011); and Titan Transportation, L.P. v. Combs, 433 S.W.3d 625 (Tex. App. Austin, 2014, pet. denied). His recent appellate cases include: Combs v. Newpark Resources, Inc., 422 S.W.3d 46 (Tex. App. Austin 2013, no pet.); Hegar v. CGG Veritas Services (U.S.), Inc., 2016 Tex. App. LEXIS 2439 (Tex. App. Austin Mar. 9, 2016, no pet.); Graphic Packaging Corp. v. Hegar, 471 S.W.3d 138 (Tex. App. Austin 2015, pet. filed); and Gulf Copper & Mfg. Corp. v. Hegar, No. D-1-GN (53rd Dist. Ct., Travis County, Tex. Feb. 22, 2016), pet. filed, No CV. He limits his law practice to Texas tax and multi-state tax controversies and litigation. He is board certified by the Texas Board of Legal Specialization in Tax Law. Mr. Martens is a former council member of the Tax Section for the State Bar of Texas and the former chair of the CLE Committee. He is also a CPA and teaches for the Texas Society of CPA s statewide courses on Texas franchise and sales tax. Mr. Martens received his B.B.A. and J.D. from The University of Texas at Austin, both with honors. Mr. Martens may be reached by at jmartens@textaxlaw.com or by telephone at (512) Visit for blog post updates regarding trending issues in Texas tax law.

3 TABLE OF CONTENTS I. INTRODUCTION... 1 II. REPORTS... 1 EXTENSION PAYMENTS FOR COMBINED GROUPS... 1 III. RATE... 1 PREPAID CALLING CARDS... 1 IV. EXEMPT ENTITIES... 2 FARMERS COOP SOCIETIES... 2 V. REVENUE EXCLUSION... 2 NEW COMPTROLLER POLICY LIMITS EXCLUSIONS... 2 VI. COGS... 4 QUALIFICATION... 4 ACCOUNTING METHODS... 5 CALCULATION... 5 VII. APPORTIONMENT... 7 SINGLE V. THREE FACTOR... 7 SERVICES... 9 TANGIBLE PERSONAL PROPERTY TRANSPORTATION INVESTMENTS & CAPITAL ASSETS VIII. OTHER IMPORTANT CHANGES SOUTHWEST ROYALTIES TEXAS AMENDS FILING DEADLINES CPA FIRMS... 13

4 Texas Franchise Tax Update Page 1 I. Introduction This paper discusses Texas tax developments during , including key legislative amendments, judicial opinions, policy changes, and trending issues. II. Reports Extension Payments for Combined Groups For reports originally due on or after January 1, 2017, a combined group may use the 100% option regardless of any changes in combined group members. 1 This rule change is beneficial for taxpayers because it allows a combined group to file an extension request using the 100% option even if the combined group has added members since the previous year. In prior years, combined groups could only use the 100% tax due extension option if the combined group lost a member, or if the members of the combined group remained the same as they were on the last day of the period in which the report was due. 2 III. Rate Prepaid Calling Cards Prior to January 1, 2018, retailers or wholesalers engaged in the sale of prepaid phone calling cards were often disqualified for the lower 0.5% franchise tax rate for retailers or wholesalers because providing prepaid phone calling cards was considered a telecommunications service. An entity who provides retail or wholesale utilities, including telecommunications services, electricity, or gas cannot qualify for the 0.5% rate. 3 Effective January 1, 2018, a legislative change in Texas Tax Code clarifies that the provision of telecommunications services does not include selling telephone prepaid calling cards. 4 This taxpayer-friendly change in the statute will allow a variety of taxpayers to now qualify for the reduced franchise tax rate See 34 Tex. Admin. Code 3.585(a)(i) (policy applicable to reports originally due on or after January 1, 2017). See 34 Tex. Admin. Code 3.585(a)(i) (policy applicable to reports originally due prior to January 1, 2017). Tex. Tax Code (c)(3). H.B. 2126, Act of May 29, 2017, 85th Leg., R.S. (to be codified at Tex. Tax Code (c-2) (eff. Jan. 1, 2018)).

5 Texas Franchise Tax Update Page 2 IV. Exempt Entities Farmers Coop Societies A cooperative that is either a farmers cooperative society that has at least 500 farmer-fruit grower members who is incorporated under either: (1) Chapter 51 of the Texas Agriculture Code, or (2) is a cooperative whose single member is a farmers cooperative described in Section 521(b)(1) of the Internal Revenue Code is exempted from the franchise tax. Tex. Tax Code (eff. 2017). V. Revenue Exclusion New Comptroller Policy Limits Exclusions In 2016, the Comptroller s Tax Policy Division authored a memorandum announcing a policy interpretation change based upon the decision in Titan Transportation, L.P. v. Combs. 5 The memorandum was issued on the heels of the Texas Supreme Court s denial of the Comptroller s Petition for Review. 6 Titan Transportation hauled and deposited aggregate (a construction material made of rock, gravel, dirt, sand, or fines) at construction sites using independent haulers. 7 Titan did not have written contracts with its customers, but Titan did have written contracts with the independent haulers. These contracts split the revenue earned from customer jobs between Titan and the subcontractor. 8 Titan sought to exclude its payments to the independent haulers from its Texas franchise revenue based on the following provision: (g) 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. 9 The Comptroller originally denied Titan s claim because (1) Titan was not a construction company, (2) Titan did not have customer contracts that referenced its written agreements with the Comptroller Letter No L (June 2016); Titan Transportation, L.P. v. Combs, 433 S.W.3d 625 (Tex. App. Austin 2014, pet. denied). After full briefing on the merits, the Texas Supreme Court denied the Comptroller s Petition for Review on May 1, See Titan Transportation 433 S.W.3d at 629. See generally id. at Tex. Tax Code (g)(3) (subsequently amended in 2013 to expressly address contracts and subcontracts).

6 Texas Franchise Tax Update Page 3 independent haulers, and (3) Titan did not pay its independent haulers with the same dollars that Titan received from its customers. 10 The Third Court of Appeals rejected each of these arguments. 11 First, the court explained that the real property revenue exclusion under Texas Tax Code (g)(3) is not limited to construction companies. 12 A taxpayer must simply show some reasonable connection between the real property services delineated in the statute and the service, labor, or materials for which the subcontractors receive payment. 13 Titan had the required connection because its services were logically and reasonably connected with the construction of real property improvements. 14 Second, the court held that Titan s independent hauler agreements satisfied the statute s mandated by contract language. 15 In doing so, the court rejected the Comptroller s argument that Titan needed contracts with its customers referring the work done by the independent haulers. Third, the court rejected the Comptroller s segregate, wait, and trace payment requirement as overly-formalistic and inconsistent with the statute s plain text. 16 The statute s flow-through language did not require Titan to pay its independent haulers with the same dollars that Titan received from its customers. 17 Having failed to convince the Texas Supreme Court to overturn Titan Transportation, the Comptroller now appears fixed on limiting the case s application to its specific facts. In his recent memorandum, the Comptroller states that the contractual mandate requirement in Texas Tax Code (g) will be satisfied: [I]f 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. For example, the contract between the taxable entity and the subcontractor require payment based on a percentage of the funds the taxable entity receives from its customer See Titan Transportation 433 S.W.3d at 630. Id. at 627. See id. at Id. Id. Id. at 641. Id. at Id. Comptroller Letter No L (June 2016).

7 Texas Franchise Tax Update Page 4 The Comptroller s new policy interpretation appears to defy the Titan Transportation decision s rationale, which is to exclude from taxation gross receipts that do not constitute actual gain or income to the taxpayer and to prevent double-taxing the same income. 19 VI. COGS Qualification Movie Theatres. In AMC Theatres, the Court held that a movie theater could include costs for space to exhibit films in its cost of goods sold deduction. 20 AMC, a movie theater, qualified for the COGS deduction because it owns and sells tangible personal property defined under Texas Tax Code (a)(3)(A)(ii) (the media provisions). This case is not yet final, as the Comptroller still has the opportunity to file a Petition for Review with the Texas Supreme Court. * Note: Several recent Comptroller hearings emphasize the heavy burden of proof and documentation requirements that the Comptroller imposes on taxpayers in order to prove their entitlement to the COGS deduction at an administrative hearing. Marine Transport Services. In Comptroller Hearing No. 107,707, the taxpayer was an operator of rowboats and deck barges engaged in the transportation of sand and gravel. 21 The auditor disallowed the COGS deduction because she determined that the taxpayer was a marine transportation company who provided services and was not eligible to claim the COGS deduction. The taxpayer has the burden of showing audit error by a preponderance of evidence. 22 But, the Courts treat a franchise tax deduction as tantamount to an exemption and construe the provisions strictly against the taxpayer. The Comptroller imposes the clear and convincing evidence burden of proof on the taxpayer to prove its entitlement to the COGS deduction. 23 In this case, the nature of the taxpayer s business should have qualified for the COGS deduction. However, the Comptroller held that the taxpayer failed to meet its burden of proof to show that it sold goods during the audit period. The Comptroller affirmed the audit assessment. Software Development. The Comptroller held in Hearing No. 111,107, that an IT consulting company did not qualify for the COGS deduction because it did not own the software that it wrote for its customers. The Comptroller treated the taxpayer as providing a service and therefore was not entitled to deduct costs related to developing the software programs Titan Transportation, 433 S.W.3d at 628, Am. Multi-Cinema v. Hegar, No CV, 2017 Tex. App. LEXIS 85 (Tex. App. Austin Jan. 6, 2017, no pet. h.) Comptroller Hearing No. 107,707 (STAR No H) (October 2016). See 34 Tex. Admin. Code 1.40(2)(B). Comptroller Hearing No. 107,707 (STAR No H) (March 2017). Comptroller Hearing No. 107,107 (STAR No H) (June 2016).

8 Texas Franchise Tax Update Page 5 Landscaping Services. In Comptroller Hearing No. 111,562, the taxpayer operated a landscaping business that engaged in landscape construction and landscape maintenance. 25 Under the Tax Code, a taxable entity that furnishes labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property is considered the owner of the labor or materials, and may include allowable costs in its COGS deduction. 26 The Comptroller held that the taxpayer s evidence was insufficient to qualify for the COGS deduction. Accounting Methods Election Switching. A taxpayer cannot change their election of the COGS accounting methodology on which a report is date after the later of (1) the due date of the report, or (2) the date the report is filed. 27 In Comptroller Hearing No. 110, 749, the taxpayer was a wholesaler of scanning and barcode products. During the audit period, the taxpayer attempted to switch from using the expense method of reporting to the capitalization method. The Comptroller held that the taxpayer can only change its accounting method up to the due date of the report (or filing date of the report if later). The taxpayer was not allowed to amend its franchise tax reports to change the election of its COGS methodology. Calculation Auto Repair Shops. In Autohaus, 28 the court held that an auto repair shop could not include mechanics labor in its COGS deduction. Autohaus is an automotive dealership who included labor costs incurred as part of repair work to install automotive parts on customer-owned vehicles in its COGS deduction. Autohaus contended that repair labor costs were properly included in its COGS deduction as installation costs under Texas Tax Code Autohaus argued that Comptroller Rule 3.588(b)(7) was invalid as it applied to the statutory term production because it imposed additional restrictions not present in the statute. The court held that Autohaus was not entitled to include its repair labor costs as costs of goods sold, because the repair labor costs were not the costs of acquiring goods (automotive parts). Autohaus has filed a petition for review with the Texas Supreme Court. This case is currently pending review. The Court s decision in Autohaus effectively erased the term installation from the definition of production in Texas Tax Code (a)(2). 29 Shortly after the Autohaus decision was issued, the legislature changed the COGS statute to expressly erase the term installation Comptroller Hearing No. 111,562 (STAR No H) (June 2016). See Tex. Tax Code (i). 34 Tex. Admin. Code 3.588(c)(2); Comptroller Hearing No. 110,749 (STAR No H) (July 2016). 28 Hegar v. Autohaus LP, CV, 2017 Tex. App. LEXIS 1575 (Tex. App. Austin Feb. 24, 2017, pet. filed) (currently pending at the Texas Supreme Court, No ). 29 Hegar v. Autohaus LP, CV, 2017 Tex. App. LEXIS 1575 (Tex. App. Austin Feb. 24, 2017, pet. filed) (currently pending at the Texas Supreme Court, No ).

9 Texas Franchise Tax Update Page 6 Effective on September 1, 2017, production means construction, manufacture, development, mining, extraction, improvement, creation, raising, or growth. 30 Heavy Construction Equipment Rental. In Hegar v. Sunstate Equipment 31 the court held that Sunstate could deduct only the costs of acquiring or producing the heavy equipment as allowed under Texas Tax Code (k-1). The court held that Sunstate could not include delivery and pick-up fees. This case is not yet final, as Sunstate still has the opportunity to file a Petition for Review with the Texas Supreme Court. Asbestos Settlement Payments. In Owens Corning, 32 the Court held that payments for product liability damages related to an asbestos settlement did not qualify for the COGS deduction as costs of quality control under Tex. Tax Code (d)(9). Unlike the three examples of costs of quality control provided in the franchise tax statute, the payment that Owens Corning made to the asbestos trust fund were not money spent to improve the quality of the asbestos-containing products or goods themselves. Grocery Stores. In a hearing decision issued in May , the Comptroller allowed addition COGS for labor costs incurred by a grocery store in its deli and pharmacy departments. In doing so, the Comptroller analyzed detailed evidence presented by the taxpayer regarding 23 job classifications held by thousands of employees, and allocated percentages to each class based upon taxpayer testimony, national surveys, a labor study, and job descriptions. After an exhaustive review of the evidence, the Comptroller increased the allocation percentages for labor from 20-25% for the various departments to 70-84% over the amounts allowed in the audit. This hearing serves as a good example of the overwhelmingly detailed evidence that a taxpayer is often required to present at an administrative hearing in order to meet its burden of proof. Ready-Mix Concrete. In US Concrete v. Hegar, 34 a trial court held that costs attributable to the production of concrete could be included in a US Concrete s COGS calculation, but disallowed costs attributable to the transportation of the concrete. US Concrete engaged in the manufacture and delivery of ready-mixed concrete in an unhardened state. US Concrete sought deductions for costs related to concrete trucks, truck operators, and dispatch costs associated with manufacturing concrete. 30 Act of June 1, 2017, H.B. 4002, 85th Leg., R.S. (to be codified at Tex. Tax Code (eff. September 1, 2017). 31 Hegar v. Sunstate Equipment Co., LLC, CV, 2017 Tex. App. LEXIS 481 (Tex. App. Austin Jan. 20, 2017, no pet. h.). 32 Corning v. Hegar, CV, 2017 Tex. App. LEXIS 2922 (Tex. App. San Antonio, Apr. 5, 2017, pet. filed No ) 33 Comptroller Hearing No. 112,139 (STAR H)(May 2017). 34 US Concrete, Inc. v. Hegar, Cause No. D-1-GN , 53 rd Judicial District, Travis County, Tex. Feb. 2, 2017) (pending on appeal at Cause No CV).

10 Texas Franchise Tax Update Page 7 The trial court held that some of US Concrete s truck costs and labor costs for drivers were transportation costs specifically excluded from the cost of goods sold deduction. The court further held that US Concrete could include truck depreciation, repairs, and fuel costs and driver labor costs properly allocable to the production of ready-mixed concrete in its COGS deduction. 35 This case is pending on appeal at the Third Court. Broadcasting Stations. In Comptroller Hearing No. 111,560, the Comptroller held that a Spanish language television and broadcasting company costs related to transmitters, antennas, and towers were distribution costs, and were not eligible for the COGS deduction. 36 VII. Apportionment Single v. Three Factor Background. Texas is a signatory state to the Multi-State Compact. Texas enacted the Multi-State Compact as Texas Tax Code section In doing so, Texas bound itself to implementing and enforcing its provisions. Under the Compact, all member states, including Texas, are obligated to enact legislation adopting and allowing the use of the three-factor apportionment as an option for taxpayers to use in apportioning income. Texas did so under Tax Code section , article IV(9), which sets forth the three-factor apportionment formula: 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. Under Texas Tax Code section , article III(1), taxpayers have the option to use either the three-factor formula ( Compact Formula ), or any alternative state apportionment formula ( State Formula ): Any taxpayer subject to an income tax whose income is subject to apportionment and allocation for tax purposes pursuant to the laws of a party State... may elect to apportion and allocate his income in the manner provided by the laws of such States... without reference to this Compact, or may elect to apportion and allocate in accordance with Article IV See Tex. Tax Code (c); 34 Tex. Admin. Code 3.588(d)(1). Comptroller Hearing No. 111,560 (September 2016). See Tex. Tax Code Ann , art. III, 1. Income is subject to allocation under U.S. Supreme Court precedent when an out-of-state business derives the income from an unrelated business activity that constitutes a discrete business enterprise. See Allied-Signal, Inc., As Successor-In-Interest to Bendix Corp. v. Director, Division of Taxation, 504 U.S. 768 (1992).

11 Texas Franchise Tax Update Page 8 This provision protects taxpayer interests by allowing multistate corporations the ability to make a business decision to choose the apportionment formula that best reflects the locations at which they earned profits. 38 Texas Tax Code section (a) provides an alternative state formula. It states: Except as provided by this section, a taxable entity s margin is apportioned to this state to determine the amount of tax imposed under Section by multiplying the margin by a fraction, the numerator of which is the taxable entity s gross receipts from business done in this state, as determined under Section , and the denominator of which is the taxable entity s gross receipts from its entire business, as determined under Section This provision states the alternative state formula, which for Texas is the single-factor apportionment formula: Texas Receipts/Total Receipts. Litigation and Comptroller Position. The Comptroller has consistently rejected taxpayers requests to use the three-factor formula. The Comptroller maintains that Texas Tax Code section does not apply to the franchise tax, alleging that the calculations of margin under franchise tax do not fall within the scope of section Further, the Comptroller alleges that section was repealed by implication and that section is merely advisory and not actual law that the Comptroller must follow. The lead case is Graphic Packaging Corp. v. Combs. The case is set to be argued before the Texas Supreme Court on September 13, The former chief justice of the Texas Supreme Court will present argument on Graphic Packaging s behalf. If Graphic Packaging prevails, the case will have implications well beyond the three-factor issue. If the Texas Supreme Court holds that the Texas franchise tax is a net income tax, then P.L will be implicated. Implicating P.L will widen the class of no nexus combined group members to include out-of-state businesses whose only physical presence in Texas is the solicitation of orders for the sale of tangible personal property. 38 See Multistate Tax Commission Third Annual Report and 46 State Tax News 346. Multistate Tax Comm n 3rd Ann. Rep. (1970) at 3; see also 46 State Tax News 346, 347 (1968) (citing 1967 speech by the first Commission Chairman explaining that the Compact gives a taxpayer the option to achieve uniformity if he so desires, by utilizing [three-factor apportionment] or using other allocation or apportionment rules which might be in effect in a state. The taxpayer has the choice of a business decision. ).

12 Texas Franchise Tax Update Page 9 Services Online Shipping Brokers. Receipts derived from an online service that matches shipping customers and transportation carriers are apportioned to the locations where the online matching occurs. 39 In a Comptroller ruling addressing this issue the Comptroller noted that receipts from a service are apportioned to the location where the service is performed. 40 The location where services are performed is based on the location where specific, end-product acts for which the customer contracts takes place, not at the location where non-receipt producing, albeit essential, support activities are performed. Here, the revenue generating service performed by the company is the matching of shipping customers and transportation carriers which occurred outside of Texas where the servers are located upon which the online matching software resides. The company has sales representatives in Texas who provide some customer support services. The customer service activities are non-receipt producing. Because the company s employees located in Texas did not provide revenue-generating services, no portion of the revenues earned by the company should be apportioned to Texas. Payment Risk & Fraud Prevention Services. The Comptroller has ruled that the receipts from the sale of payment risk and fraud prevention services are apportioned to the location of the customer. 41 In this ruling, the Comptroller found that the end-product act for which a retailer, lender, or other business contracts is the company s response to a request for fraud prevention information. Customers pay to receive payment risk and fraud prevention information at their own locations, on their own computers, by accessing the company s website. So, the Comptroller held that the receipts should be sourced to the location of the customer. Prepaid Calling Cards. In Comptroller Hearing No. 111,864, the Comptroller addressed whether the purchase and resale of prepaid phone cards should be excluded from the taxpayer s total revenue. 42 The taxpayer entered into agreements with vendors that purchased access to various communications networks. The vendors could purchase access at reduced rates based on voluminous usage commitments, intending to resell access to customers who wanted to make international phone calls. The vendors created the plastic cards and marketing materials that were placed in retail stores. The vast majority of consumers who purchased the phone cards used the card to make an international phone call, rather than a call within the United States. The State argued that for franchise tax purposes, the sale of a prepaid phone card is the sale of an intangible, and revenue should be apportioned accordingly. If the prepaid phone cards were characterized as an intangible, then the receipts for those sales would be apportioned to Texas based on the location of the distributor or retailer that purchased the card from the taxpayer Comptroller Letter No L (April 2016). 34 Tex. Admin. Code 3.591(e)(26). Comptroller Letter No L (March 2017). Comptroller Hearing No. 111,864 (May 2016).

13 Texas Franchise Tax Update Page 10 The taxpayer argued that it was not selling an intangible. Rather, it was reselling a telecommunication service. Revenue from telephone calls are Texas receipts only if the calls both originate and terminate in Texas. Under this rule, a nominal amount of the company s revenue would be apportioned to Texas. The Comptroller held that the sale of a prepaid phone card is the sale or resale of a telecommunication service and revenue from the sale of such cards should be apportioned accordingly. Tangible Personal Property Time Charter Vessels. A Comptroller letter ruling addressed the sourcing of revenues from sales of liquefied natural gas (LNG) loaded onto time-chartered vessels in Texas ports. The purchasers of the LNG don t own the vessels, but charter them under time-charter agreements. A time-charter is generally defined as a charger for a specified period, rather than for a specific task or voyage. 43 Texas is a point of delivery state for franchise tax apportionment purposes. This means that receipts from the sale of tangible personal property are apportioned to Texas if the purchaser takes delivery of the property in this state- even if the property is then transported outside Texas. At issue in this ruling is whether the purchaser took delivery of the LNG at the point in time where the LNG was loaded onto time-chartered vessels in Texas ports. In ruling that the receipts were apportionable to Texas, the Comptroller distinguished time-charter arrangements from a typical common carrier arrangement. A time-charter is an arrangement of some permanency, because the customer is given full use of the vessel and the right to direct the vessel in all respects. The customer determines when and where the vessel should go, what cargo it should carry, what passengers will be transported, and other aspects of the voyage. The time-charter arrangement was more than just simple operational control of the vessel. Therefore, the Comptroller ruled that when LNG is loaded into a vessel in a Texas port, and the vessel is chartered by the LNG purchaser under a time-charter agreement with industry-standard terms, the LNG is delivered in Texas and the receipts should be apportioned to Texas for franchise tax purposes. Transportation Empty Miles. In September of 2016, the Comptroller s Tax Policy Division issued a memorandum addressing the treatment of empty miles e.g., unloaded miles traveled to pick up freight or to return home after delivery when calculating a transportation company s franchise tax apportionment factor. 44 The Comptroller s position is that a taxpayer may either include empty miles in both the numerator and the denominator of the apportionment factor, or exclude such miles from both. However, a taxpayer may not exclude empty miles when calculating the numerator (Texas receipts), but include empty miles in the denominator (receipts from everywhere) Id. Comptroller Letter No L (September 2016).

14 Texas Franchise Tax Update Page 11 The Comptroller intends to amend rule in accordance with this policy. Given the memorandum s apparent conflict with the text of the Comptroller s current apportionment rule and other guidance, litigation may be necessary to preserve refunds or other franchise tax savings opportunities for transportation companies. Investments & Capital Assets In Hallmark Marketing Co., LLC v. Hegar, the Texas Supreme Court held that a taxable entity should not include its net loss from the sale of investments in its franchise tax apportionment factor. 45 To apportion means to calculate the fraction of a taxpayer s business done in a state. The Texas franchise tax computes the apportionment ratio by dividing Texas gross receipts by gross receipts from everywhere. 46 Texas Tax Code (b) provides that [i]f a taxable entity sells an investment or capital asset, the taxable entity s gross receipts from its entire business for taxable margin includes only the net gain from the sale. Comptroller Rule 3.591(e)(2), interpreting this provision, states: If the combination of net gains and losses results in a net loss, the taxable entity should net the loss against other receipts, but not below zero. Hallmark argued that the language of the Comptroller s administrative rule conflicted with the language of the statute, because the plain text of the statute did not require Hallmark to include the net loss in its apportionment factor. The Texas Supreme Court held that the statute requires inclusion of only the net gain, and under no reading can net gain include a net loss. 47 As a result, Texas Tax Code (b) does not require taxpayers to include a net loss from the sale of investments and capital assets in its apportionment-factor denominator. 48 The court s holding creates an interesting issue for Texas taxpayers with respect to other components of the franchise tax that include terms like gains and net distributive income. For example, the term gains appears in the definition of passive entity and net distributive income is used to describe a component of the compensation deduction. 49 The Comptroller s administrative rules interpret these provisions to include losses. 50 Under Hallmark, a taxpayer could argue that the Comptroller s rule definitions of these terms are invalid Hallmark Marketing Co., LLC v. Hegar, No , 2016 Tex. LEXIS 314 (Tex. Apr. 15, 2016). Id. at *5. Id. at *4-5. Id. See Tex. Tax Code (a)(2)(c) and (a)(1) and (2). See 34 Tex. Admin. Code and

15 Texas Franchise Tax Update Page 12 VIII. Other Important Changes Southwest Royalties Southwest Royalties v. Hegar. 51 The Texas Supreme Court rejected the argument that down hole equipment qualified for the manufacturing exemption. Down hole equipment includes casing, tubing, stabilizers, anchors, packers, pumps, etc. The court held that downhole equipment was not directly used to process oil and gas because it did not separate the hydrocarbons into their component parts (oil, gas, and water). The court held that the evidence established that the changes to the hydrocarbons during their movement to the surface were directly caused by natural pressure and temperature changes. Note: The Southwest Royalties opinion does not entirely foreclose manufacturing exemption refunds for the oil and gas industry. A case-by-case analysis is necessary. Purchases of other types of equipment may satisfy either the court s definition of processing or other statutory language outlined in the manufacturing exemption. Texas Amends Filing Deadlines Deadline. Beginning September 1, 2017, a taxpayer s petition for redetermination of corporation income tax, personal income tax, sales and use tax, or other tax liability computed by the Texas Comptroller must be filed with the Comptroller within 60 days after the date the notice of determination is issued. Formerly, a petition for redetermination had to be filed within 30 days after the date on which the service of the notice of determination is completed. If a petition for redetermination is not timely filed, the determination is final on the expiration of the above period. Comptroller Decision on Petition for Redetermination An order or decision of the comptroller on a petition for redetermination becomes final at the time that a decision or order in a contested case is final under Chapter 2001, Government Code. Formerly, the Comptroller s order or decision became final 20 days after service on the petitioner of the notice of the order or decision. A taxpayer who is dissatisfied with the decision on a motion for redetermination is entitled to file a motion for rehearing in the time provided by Chapter 2001, Government Code, for filing a motion for rehearing in a contested case. Request for Hearing on Refund Claim A decision or order of the Comptroller following a refund hearing becomes final at the time a decision or order in a contested case is final under Chapter 2001, Government Code (formerly, 20 days after service on the claimant of the notice of the order or decision). A tax refund claimant who is dissatisfied with the decision on the claim is entitled to file a motion for rehearing in the time provided by Chapter 2001, Government Code, for filing a motion for rehearing in a contested case. S.B. 1095, Laws 2017, effective September 1, Southwest Royalties v. Hegar, No , 500 S.W.3d 400 (Tex. 2016).

16 Texas Franchise Tax Update Page 13 Formal Refund Claim Deadline. A person claiming a tax refund is entitled to a hearing on the claim if the person requests a hearing on or before the 60th day after the date the Comptroller issues a letter denying the claim for refund. CPA Firms Otherwise taxable insurance services are excluded from sales when they total less than 1% of the CPA firm s prior year s revenues. 52 Example: A CPA firm is paid $10,000 by an insurance company to determine the existence of fraud for purposes of loss coverage. The CPA firm generated revenues of $200,000 in the prior year. 1% of $2,000,000 is $20,000. Therefore, the CPA s fee of $10,000 is not subject to sales tax. 52 Tex. Tax Code (b) & (c) (eff. January 1, 2018).