Texas Franchise Tax "Technical Corrections" Bill Approved by the Texas House of Representatives

The Texas Franchise Tax (a.k.a. Margin Tax) “Technical Corrections” bill was passed by the Texas House of Representatives (the "House") on May 2, 2007 and is now on its way to the Senate. The new Margin Tax, which is effective for tax returns filed in 2008, is based on deducting the taxpayer’s choice of either cost of goods sold (COGS) or compensation from total revenue. The bill (House Bill 3928), filed by Representative Jim Keffer, Chairman of the Ways and Means Committee, was modified in committee and amended during the House debate to approve the bill.

The fiscal analysis of the bill, as passed by the House, is expected to be revenue neutral. However, it should be noted that several of the provisions that were included in the bill will generate additional revenue. Specifically, the line references for determining total revenue for partnerships were changed to incorporate gross rental income rather than net rental income. Additionally, the bill would now establish controlling interest at more than 50 percent of ownership rather than the 80 percent threshold that was established in the tax when passed by the Legislature last year. The controlling interest threshold is important to the determination of whether a company is included in a unitary combined group.

There are three specific provisions that were included in the bill as it passed the House that would reduce the revenue generated by the Margin Tax. Two of the three provisions are considered technical in nature by the House: a clarification in the apportionment treatment of the sales of securities and loans, and a clarification that the 4.5 percent earned surplus tax rate would apply in the calculation of the business loss carryforward tax credit. The third provision provided for an increase in the small business exemption from $300,000 to $600,000.

There were several amendments that were filed that were either withdrawn or defeated that would have been detrimental to businesses. Certain amendments would have changed the current apportionment method of “Joyce” for unitary combined group to the more far reaching Finnegan method. Additionally, there were several amendments that would have increased the tax rates on certain classes of taxpayers. These changes were proposed to cover the cost of an even larger small business exemption and other changes to the tax.

The following is a summary of the more relevant clarifications:

• Amends the definition of “client company” to include a business that contracts with a temporary employment service as well as a staff leasing firm.
• Amends the definition of “controlling interest” to change the threshold from 80 percent or more to more than 50 percent. Controlling interest for a
  • corporation is either more than 50 percent owned directly or indirectly, of the total combined voting power of all classes of stock of the corporation, or more than 50 percent owned directly or indirectly, of the beneficial ownership interest in the voting stock of the corporation;
  • partnership, association, trust, or other entity other than a limited liability company (LLC) is more than 50 percent, owned directly or indirectly, of the capital, profits, or beneficial interest in the partnership, association, trust, or other entity;
  • LLC is either more than 50 percent of
    • the total membership interest of the LLC, owned directly or indirectly; or
    • the beneficial ownership interest in the membership interest of the LLC, owned directly or indirectly.
• Amends the definition of the Internal Revenue Code to mean the Internal Revenue Code of 1986 that was in effect for the federal tax year beginning on January 1, 2007, not including any changes made in federal law after that date.
• Amends the definition of “lending institution” to mean an entity that makes loans and is either
  • regulated by the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Office of Thrift Supervision, the Texas Department of Banking, the Office of Consumer Credit Commissioner, the Credit Union Department, or any other comparable regulatory body;
  • licensed by, registered with, or otherwise regulated by the Department of Savings and Mortgage Lending;
  • a broker or dealer as defined by the Securities Exchange Act; or
  • an entity that provides financing to unrelated parties solely for agricultural production.
  (Note: The amended definition of lending institutions that appeared in the filed version of the bill that would have limited the definition to only depository institutions or affiliates of a depository institution was removed.)
• Adds a definition of “natural person” to mean a human being or the estate of a human being.
• Amends the definition of “staff leasing service company” to mean a business entity that offers staff leasing services or temporary employment services. The addition of temporary employment services to the definition of staff leasing service company will allow the client company of a temporary employment service provider to deduct certain payments to the provider as compensation.
• Amends the definition of a “taxable entity” to specifically include limited liability partnerships (LLPs) and clarify that the exclusion for a general partnership owned by natural persons does not apply to LLPs.
• Deletes the references to a family limited partnership (FLP), passive investment partnership (PIP), and trust as entities that are not included as a taxable entity. If an FLP, PIP, or trust qualifies as a passive entity, the entities would be excluded from being a taxable entity.
• Amends the definition of a “taxable entity” to exclude a nonprofit self-insurance trust created under Chapter 2212, Insurance Code, a trust qualified under Section 401(a), Internal Revenue Code; or a trust or other entity that is exempt under Section 501(c)(9), Internal Revenue Code.
• Clarifies that an entity is not subject to the Margin Tax or the Additional Tax (a.k.a. Exit Tax) if, during the period on which the report is based, the entity qualifies as a passive entity.
• Clarifies that the applicable Margin Tax rate is applied to taxable margin, rather than per year of privilege period. Additionally, a retail electric provider that does not provide and is not affiliated with an entity that provides transmission and distribution utility service is considered to be primarily engaged in retail or wholesale trade and as such qualifies for the half percent tax rate.
• Adds a new section that provides that once school maintenance and operations property tax rates (M&O tax rate) reach $.50/$100 of valuation any excess Margin Tax revenue would be equally split to further reduce the M&O tax rate, reduce the Margin Tax rates, and increase the level of equalization of a school districts enrichment tax effort.
• Repeals the ability of a taxable entity to change its election of COGS or compensation on an amended return, and requires that a taxable entity “notify the comptroller of its election not later than the due date of the annual report.”
• Clarifies that the determination of total revenue is the sum of the “amount reportable as income” on the line references to the Internal Revenue Service (IRS) federal income tax returns, and defines that the “amount reportable as income” means the amount entered on the line to the extent the amount entered complies with federal income tax law.
• Amends the line references for the determination of total revenue for a partnership to be the “amount reportable as income” on lines 1c, 4, 6, and 7 on IRS Form 1065; lines 3a and 5 through 11 on IRS Form 1065, Schedule K; line 17 on IRS Form 8825; and line 11, plus line 2 or 45 on IRS Form 1040, Schedule F. These changes in line references ensure that guaranteed payments are not double counted in the determination of total revenue and that “gross rental income” rather than “net rental income” is captured for partnerships in the determination of total revenue.
• Amends the definition of “tangible personal property” to include “live and prerecorded television and radio programs.”
• Amends COGS to
  • limit depreciation, depletion, and amortization to the amounts “reported on the federal income tax return on which the franchise tax report is based”;
  • provide that a taxpayer can choose to either expense or capitalize costs;
  • prohibit used merchandise sellers, such as pawn shops, that make loans to the public from choosing interest as COGS; and
  • clarify that an entity engaged in lending to unrelated parties for agricultural production qualifies to take interest expense as COGS. (Note: The original version of the bill deleted the reference to the inclusion of all research and experimental expenditures described by Section 174, Internal Revenue Code as an eligible COGS expense. That reference was replaced in the committee substitute and was included in the bill passed by the House.)
• Amends the definition of “compensation” to
  • include net distributive income from an LLC treated as a sole proprietorship but only if a natural person receives the distribution;
  • clarify that a taxable entity may include up to $300,000 per natural person owner in a partnership in the calculation of compensation;
  • clarify that benefits are included only to the extent deductible for federal income tax purposes; and
  • clarify that the $300,000 limitation on amounts paid to one employee applies to all amounts paid to the employee by all members of a combined group.
• Clarifies that the limitation that a taxable entity’s taxable margin cannot exceed 70 percent of total revenue applies to the taxable margin of a combined group.
• Clarifies that a member of a combined group may claim as COGS, qualifying costs, if the goods for which the costs are incurred are owned by another member of the combined group.
• Clarifies that each member of the combined group “shall be jointly and severally liable for the tax of the combined group.”
• Clarifies the language related to determining the taxable margin of a tiered partnership arrangement.
• Amends the language relating to the treatment of eliminated receipts between members of the combined unitary group for apportionment purposes. The bill clarifies that for apportionment purposes certain receipts ultimately derived from transactions between members of a combined group must be included in the numerator of the apportionment factor. Receipts that are “ultimately derived from the sale of tangible personal property between individual members of a combined group where one member party to the transaction does not have nexus in this state shall be included in the receipts of the taxable entity from its business done in this state . . . to the extent that the member of the combined group that does not have nexus in this state resells the tangible personal property without substantial modification to a purchaser in this state.” Further, “receipts ultimately derived from the sale” is defined to mean the amount paid by the third-party purchaser for the tangible personal property.
• Clarifies that an entity may, for apportionment purposes, consider the gross proceeds from the sale of loans or securities treated as inventory for federal income tax purposes as gross receipts.
• Amends the Temporary Credit provision for net operating losses to clarify
  • the credit applies to reports due after January 1, 2008;
  • the credit can be taken over twenty consecutive privilege periods;
  • the credit is the amount of “business loss carryforwards” calculated under Section 171.110(e) as that section applied to returns due before January 1, 2008 and the appropriate tax rate used to determine the credit is the 4.5 percent earned surplus rate;
  • the credit is equal to 2.25 percent of the amount determined under the previous provision for the first 10 consecutive reports and 7.75 percent of the amount for the 11th through the 20th consecutive reports; and
  • unused credits can be carried forward subject to the twenty-year limitation.
• Clarifies that an LLC must continue to file the public information report.
• Clarifies that the Comptroller may require an entity to file any necessary information to verify that the entity is not subject to the Margin Tax.
• Adds a new provision that clarifies that a client company can rely on information provided by a staff leasing services company when the information is provided on a form promulgated by the Comptroller or an invoice.
• Adds a new provision that requires the Comptroller to prepare a report for the Legislature that details at an industry level, if possible, certain information gathered from submitted tax returns.
• Clarifies that the Secretary of State may use the same procedures to reinstate a certificate or registration of a taxable entity after forfeiture by the Secretary of State as used to revive a corporation’s charter or certificate.
• Adds a new provision that requires entities to remit to the state any amounts collected as a result of a “fee, charge, reimbursement, or other item” included on a bill or invoice and represented as reimbursement of the Margin Tax. Additionally, the amount remitted is in addition to the Margin Tax liability owed by the entity.
• Adds a new subchapter to the tax that would establish a tax credit for certain art donations.
• Adds a new provision that establishes a “Small Business Tax Advisory Committee” that would be appointed by the Comptroller.
• Removes the requirement that certain entities file an information report on February 15, 2008.
• Clarifies the transition provisions to require the entities described below to pay an “additional tax” for the privilege of doing business in the state any time after June 30, 2007 and before January 1, 2008. The additional tax would be the appropriate Margin Tax rate applied to the entity’s taxable margin, which would be based on the period
  • beginning on the later of January 1, 2007 or the date the entity began doing business in the state; and
  • ending on the date the entity became no longer subject to the tax.
  This provision would apply to an entity that
  • is not doing business in the state on January 1, 2008;
  • would be subject to the new Margin Tax but was not subject to the old Franchise Tax; and
  • was doing business in the state after June 30, 2007 and before January 1, 2008.
  (Note: This provision has also been filed by Representative Keffer as stand-alone legislation [HB 1207].)
• Repeals the provision that allows for the inclusion of a passive entity in a combined group.

The Technical Corrections bill will now move to the Texas Senate and become the starting point for the Senate’s discussion on clarifications or changes to the Margin Tax. As the Senate begins its deliberations on the Technical Corrections bill, Ryan & Company will continue monitoring modifications to the bill on behalf of its clients who do business in Texas and would be affected by further changes.