State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP Texas Appellate Court Addresses Potential Application of COGS Deduction to Service Providers and Sellers of Intangible Property The Texas Court of Appeals for the Third Appellate District recently reversed a trial court and held that a rent-to-own business whose majority of revenues comes from rentalpurchase agreements was entitled to the preferential 0.5 percent Revised Texas Franchise Tax (RTFT) rate for the 2008 report year. 1 The Court of Appeals ruled that the taxpayer was entitled to the 0.5 percent tax rate applicable to certain retailers and wholesalers because the revenues constituted sales. Also, the Court of Appeals remanded the case to the district court to determine whether the taxpayer was entitled to claim the cost of goods sold (COGS) deduction and, if so, in what amount. While the precedential effect of the ruling may be somewhat limited in direct application, the decision provides important guidance in determining if a taxpayer is eligible for the 0.5 percent tax rate. Procedural History and Background For the 2008 report year at issue, the RTFT rates were set at 1.0 percent for businesses other than retailers and wholesalers and 0.5 percent for most retailers and wholesalers (and 0.575 percent for taxpayers with total revenue of not more than $10 million). 2 The 0.5 percent tax rate is not allowed to most taxpayers that realize the majority of revenue from the sale of products self-produced or produced by an entity that is part of an affiliated group to which the taxable entity also belongs. Likewise, taxpayers that provide retail or wholesale utilities, including telecommunications services, electricity, or gas are not eligible for the preferential tax rate. 3 The taxpayer, Rent-A-Center, Inc., operates a rent-to-own business in which the majority of revenue is generated from making merchandise available to customers via rental-purchase agreements. Rent-A-Center offers customers merchandise in four basic product categories: furniture and accessories, major consumer electronics, appliances and computers. The merchandise may be purchased immediately or, in the vast majority of cases, paid for on a rent-to-own basis pursuant to rental-purchase agreements. Release date July 29, 2015 States Texas Issue/Topic Franchise Tax Contact details John LaBorde T 832.476.3605 E john.laborde@us.gt.com Pat McCown Dallas T 214.561.2350 E pat.mccown@us.gt.com Terry Gaul T 832.476.5088 E terry.gaul@us.gt.com Adam Hines T 832.476.3665 E adam.hines@us.gt.com David Somerville T 832.476.3601 E david.somerville@us.gt.com Jamie C. Yesnowitz Washington, DC T 202.521.1504 E jamie.yesnowitz@us.gt.com Chuck Jones Chicago T 312.602.8517 E chuck.jones@us.gt.com Lori Stolly Cincinnati T 513.345.4540 E lori.stolly@us.gt.com www.grantthornton.com/salt 1 Rent-A-Center, Inc. v. Hegar, Texas Court of Appeals, Third District, Austin, No. 03-13-00101-CV, June 11, 2015. 2 TEX. TAX CODE ANN. 171.002(a), (b); 171.1016(a), (b). As discussed below, the tax rates were reduced for the 2014 report years and thereafter. 3 TEX. TAX CODE ANN. 171.002(c), (c-1)..
Grant Thornton LLP - 2 A customer acquires ownership of the merchandise after making all agreed-upon payments. Rent-A-Center may not terminate the rental-purchase agreements if the customer fulfills the terms of the agreements. During the 2007 accounting period (2008 RTFT report year), over 90 percent of Rent-A-Center s revenues were from payments made pursuant to rental-purchase agreements. Rent-A-Center claimed the 0.5 percent tax rate on its 2008 RTFT report on the basis that it was primarily engaged in the retail trade as described in Standard Industrial Classification (SIC) Manual Division G (Retail Trade). 4 Rent-A-Center also claimed a COGS deduction of approximately $1.2 billion dollars on its 2008 RTFT report. Upon audit, the Comptroller disallowed the 0.5 percent tax rate on the grounds that Rent-A-Center was a service business classified as Division I (Services) of the SIC Manual and posited that, as a service provider, Rent-A-Center was not entitled to the COGS deduction. 5 After the trial court held that Rent-A-Center was not entitled to use the 0.5 percent tax rate, Rent-A- Center timely filed an appeal with the Court of Appeals. Third Appellate Court s Decision and Reasoning After noting that this case presented an issue of first impression, the Court of Appeals defined the central issue as whether a rent-to-own business whose majority of revenues comes from making merchandise available to customers via rental-purchase agreements is primarily engaged in retail trade for Texas franchise-tax purposes under the RTFT in effect in 2008. With respect to the tax rate issue, the Court of Appeals noted that the facts were not in dispute and its review was based upon the proper application of the tax statutes and whether the taxpayer was primarily engaged in retail trade. The Court determined that Rent-A-Center s rent-to-own activities were more in the nature of selling (0.5 percent tax rate) than of renting or leasing (1.0 percent tax rate) and the taxpayer was primarily engaged in the retail trade. The Court focused on the unambiguous wording of the Tax Code and the referenced activities described in Division G of the 1987 SIC Manual. 6 According to the Court, the activities were those of establishments engaged in selling merchandise. The Court was unpersuaded by the Comptroller s reference to the taxpayer s underlying use of SIC Code 7359, Equipment Rental and Leasing, Not Elsewhere Classified, defined as establishments primarily engaged in renting or leasing (except finance leasing) equipment, not elsewhere classified of Division I (Services). Taxpayers whose primary activities are described in Division I (Services) are subject to the 1.0 percent tax rate. The Court was not persuaded by the language used in Rent-A-Center s Securities and Exchange Commission (SEC) Form 10-K filings to describe the rental-purchase agreements (e.g., use of terms rental, lease, lessor and lessee ) or the fact that title to the merchandise remains with Rent-A-Center at all times until the full purchase price has been paid. After acknowledging that undoubtedly the rental-purchase transactions are hybrids of rentals and sales, the Court determined that the rental-purchase transactions 4 TEX. TAX CODE ANN. 171.0001(12); 171.002(b). 5 TEX. TAX CODE ANN. 171.1012(a)(3)(B)(ii). 6 TEX. TAX CODE ANN. 171.0001(12)(A).
Grant Thornton LLP - 3 more closely resemble sales than leasing. As a result, the activities described in Division G of the SIC Manual controlled and the 0.5 percent tax rate applied. Regarding the COGS deduction, the Court noted that the trial court did not reach the issue. Accordingly, the Court of Appeals made no COGS determination and remanded the issue back to the district court for factual determination. Commentary The Court based its tax rate decision on the contention that the payments made to Rent- A-Center were deemed to be sales rather than rents or leases, and that the Comptroller s contention that the taxpayer was not engaged in the retail trade was strained. Therefore, a more thorough analysis of the nature of the payments, such as pre-ownership payments versus payments made at time of title transfer, was not required. It should be noted that the Court did not frame the lower 0.5 percent tax rate as either a tax imposition statute or as a tax exemption or deduction. If the Court did so, a heavy burden could have been placed upon the Comptroller or the taxpayer, respectively, and the analysis ultimately applied by the Court may not have been utilized. The decision does raise several interesting issues which deserve further discussion, including the use of the SIC Manual in determining the RTFT rate, the application of the COGS deduction, and the effect of legislation surrounding these issues that was enacted following the tax year in controversy in this decision. Use of Industry Codes to Determine Tax Rate To begin, the case focused on industry codes that are integrally important in determining the RTFT rate. The Texas legislature s reliance upon the 1987 SIC Manual to make these determinations for a tax that became effective beginning in 2008 is curious. The SIC system was replaced by the North American Industry Classification System (NAICS) system on January 1, 2003; a time lapse of some 16 years and an additional five years before the January 1, 2008 effective date of the RTFT. The NAICS system was updated in 2007 and 2012. 7 In any event, the choice of either the SIC Manual or the NAICS system would lead to some level of confusion and controversy given that the classifications are used to impose two different types of tax rates, one that is twice the amount of the other. A single line of business may be described in more than one Division or none at all. In addition, the Division description may belie the underlying codes (as in the case of Rent-A-Center). The Division descriptions and underlying codes are replete with cross-references inconclusive in nature or, at best, a form of rough justice. 7 The SIC Manual shows its age in a number of locations. For example, included in SIC Code 5999, Miscellaneous Retail Stores, Not Elsewhere Classified, are typewriter stores-retail. Included in SIC Code 7699, Repair Shops and Related Services, Not Elsewhere Classified, is [t]ypewriter repair, including electric. Comparatively, the NAICS adds not only cordless telephones but also cellular phones to its classifications, both of which are lacking in the 1987 SIC Manual.
Grant Thornton LLP - 4 Even so, given the difference between the preferential 0.5 percent tax rate for retailers and wholesalers, and the general 1.0 percent tax rate applicable to other industries, it is important for taxpayers in Texas to become familiar with the SIC Manual and the many intricacies and inconsistencies. For example, in the case of a rent-to-own business, Division I (Services) provides a specific SIC Code 7359, Equipment Rental and Leasing, Not Elsewhere Classified, which may lead one to conclude that such a taxpayer is subject to the 1.0 percent tax rate. However, the activities described in Division G (Retail Trade) include: [E]stablishments engaged in selling merchandise for personal or household consumption and rendering services incidental to the sale of the goods. In general, retail establishments are classified by kind of business according to the principal lines of commodities sold (groceries, hardware, etc.), or the usual trade designation (drug store, cigar store, etc.). Some of the important characteristics of retail trade establishments are: the establishment is usually a place of business and is engaged in activities to attract the general public to buy; the establishment buys or receives merchandise as well as sells; the establishment may process its products, but such processing is incidental or subordinate to selling; the establishment is considered as retail in the trade; and the establishment sells to customers for personal or household use. Not all of these characteristics need be present and some are modified by trade practice. For the most part, establishments engaged in retail trade sell merchandise to the general public for personal or household consumption. 8 Because the Texas statute refers to the activities described in Division G 9 (Retail Trade) of the SIC Manual and not to the underlying codes, the Court s decision supports the notion that it does not matter that the SIC code describing rental and leasing activities is included within Division I (Services), and that Division G does not include a code for rental or leasing activities. Instead, the Court determined that the 0.5 percent tax rate applied, striking a blow to the Comptroller s consistent reliance upon SIC codes that effectively denied the 0.5 percent tax rate to taxpayers like Rent-A-Center. Comptroller s Historic Policy on SIC and NAICS Codes The Comptroller addresses the use of SIC and NAICS codes in the Frequently Asked Questions (FAQ) section of his Web site 10 as well as the instructions to the RTFT 8 Standard Industry Classification Manual of 1987, Division G. This may be accessed at https://www.osha.gov/pls/imis/sic_manual.display?id=7&tab=division. 9 TEX. TAX CODE ANN. 171.0001(12)(A). 10 For a discussion on SIC code usage, see Franchise Tax Frequently Asked Questions, Reports and Payments, Rule 3.584, No. 7, Texas Comptroller of Public Accounts. This may be accessed at: http://comptroller.texas.gov/taxinfo/franchise. In this FAQ, the Comptroller states that the SIC code is used to verify that the appropriate RTFT rate was used. For a discussion on NAICS code usage, see Franchise Tax Frequently Asked Questions, Reports and Payments, Rule 3.584, No. 8, Texas Comptroller of Public Accounts. This may be accessed at: http://comptroller.texas.gov/taxinfo/franchise. In this FAQ, the Comptroller states that the NAICS data helps in estimating revenue, answering requests from the Texas legislature and the public about taxable sales by industry, and providing taxpayers specific information about changes in the tax law that might affect a particular industry.
Grant Thornton LLP - 5 Report. 11 While use of the NAICS is not relevant for the actual tax rate used by taxpayers, taxpayers are required to provide their NAICS codes on page 1 of the Texas Franchise Tax Report and the Affiliate Schedule. It would appear that at the very least, the FAQ addressing the use of SIC codes will need to be revised to take into account the Court s interpretation. Application of the COGS Deduction It should be noted that the law entitling a taxpayer to the COGS deduction is separate and distinct from the tax rate statutes discussed above. The COGS deduction is allowed to sellers of goods defined as real or tangible personal property sold in the ordinary course of business of a taxable entity 12 without reference to the SIC Manual. The Court s determination in this case may appear to support a conclusion that Rent-A-Center is entitled to the COGS deduction, but the COGS statute also specifically allows the COGS deduction to certain renters and lessors of only motor vehicles, heavy construction equipment and railcar rolling stock. 13 It will be interesting to see what the trial court determines on remand with respect to the potential viability of the COGS deduction claimed by Rent-A-Center. Consequent Legislation Legislation enacted in 2013 directly addresses the tax rate applicable to the activities performed by Rent-A-Center and similarly-situated taxpayers. For report years beginning in 2014 and thereafter, the definition of retail trade has been amended to include rental-purchase agreement activities regulated by Chapter 92 of the Business and Commerce Code. 14 Qualifying taxpayers may now achieve the lower tax rate applicable to certain retailers and wholesalers through an explicit statute, rather than via statutory interpretation. Further, Texas recently enacted legislation reducing RTFT rates by 25 percent. 15 As a result of the enactment of this law, beginning with 2016 reports (generally based upon business done during federal income tax periods ending in 2015), the tax rate will be reduced from 1.0 percent to 0.75 percent for businesses other than retailers and wholesalers. The tax rate for businesses primarily engaged in the retail or wholesale trades will be reduced from 0.5 percent to 0.375 percent. As such, the RTFT will retain the tax rate preference for retailers and wholesalers for the foreseeable future. The alternative E-Z tax rate of 0.575 percent for taxpayers with total revenue of not more than $10 million will be reduced to 0.331 percent for their 2016 RTFT reports. 16 Simultaneously, the maximum total revenue threshold to utilize the E-Z tax rate is being increased from $10 million to 11 Instructions, Texas Franchise Tax Report. 12 TEX. TAX CODE ANN. 171.1012(a)(1). 13 TEX. TAX CODE ANN. 171.1012(k-1). 14 TEX. TAX CODE ANN. 171.0001(12)(D), added by Ch. 1232 (H.B. 500), Sec. 1, Laws 2013, effective Jan. 1, 2014. 15 H.B. 32, Laws 2015, effective Jan. 1, 2016. For a detailed discussion of this legislation, see GT SALT Alert: Texas Governor Signs 25 Percent Franchise Tax Rate Cut Into Law. 16 TEX. TAX CODE ANN. 171.1016(b)(3).
Grant Thornton LLP - 6 $20 million. 17 The 0.75 percent and 0.375 percent tax rates and E-Z provisions remain in place unless and until modified by future legislation. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed. 17 TEX. TAX CODE ANN. 171.1016(a).