As Texas Franchise Tax Challenged, Comptroller Revises Policies

As the Texas Supreme Court considers whether the Texas franchise tax violates the Texas Constitution’s prohibition on taxing the income of individuals in Allcat Claims Service, L.P. v Combs, the Comptroller published revisions of its policy on franchise tax reporting methods.

Challenge to Texas’ Franchise Tax

Allcat Claims Service, L.P. filed a petition with the Texas Supreme Court (“Court”) challenging the constitutionality of the Texas franchise tax or the “Margins Tax.” The petition claims that the Margins Tax, in effect since 2006, constitutes a tax on a natural person’s partnership income. The Texas Constitution provides that the state may not impose a net income tax on natural persons without the approval of a majority of registered voters.

Although the Court has been asked to decide whether the Margins Tax is a tax on the income of a natural person, corporations and limited liability companies may be able to amend their Texas franchise tax returns to obtain tax refunds if the Court finds that the Margins Tax is an income tax. Under Texas law, the Court must rule on the constitutionality of the tax within 120 days of the petition.

Lending Institutions

The Comptroller recently posted a corrected letter ruling (STARS No. 201101133L) on its online research system. The letter discusses the Comptroller’s interpretation of Tax Code §171.1012(k). This section allows a regulated lending institution that offers loans to the public to take interest expense as cost of goods sold (COGS) when computing Texas franchise tax.

The taxpayer in the letter ruling was regulated by the Texas Office of Consumer Credit and made loans to third parties who wanted to purchase heavy equipment manufactured by one of the taxpayer’s affiliates. The Comptroller, however, denied the interest expense because the Comptroller “does not believe” that the taxpayer makes loans to the public.

Many “lending institutions,” including credit unions, private-label credit card companies, and car-finance companies, loan money to “members” or individuals wishing to purchase goods sold or manufactured by related or affiliated companies. Based on this observation, we believe that the Comptroller’s definition of “public” is too narrow and does not properly implement §171.1012(k).

Software Company Audits

In a memo to the agency’s Audit Division (STARS No. 201108166L), the Comptroller instructs auditors to allow software companies to compute Texas franchise tax using the COGS method and to include expenses related to software licenses in COGS. Please note that this is a revised policy, and software companies that were audited prior to the August 2011 memo should request that the audit be amended if the auditor denied the use of COGS. Also of interest, but not included in the memo, receipts from the sale or license of a software program are considered receipts from the sale of intangibles and are apportioned based on the legal domicile of the payor.

Reporting Methods for Auditor-Combined Groups

In a corrected memo (STARS No. 201108165L), the Comptroller provides advice for auditors who determine that taxpayers must report Texas franchise tax as a combined group. Auditors are instructed to use a computation (i.e., COGS, compensation, or 70% of total revenue) method that was used (or elected) by any reporting member or member group. Further, the method for computing margin is not restricted to the method used by the entity chosen as the reporting entity for the combined group.

However, the newly combined group may not use a reporting method unless at least one member of the group or member group elected to use the method on its Texas franchise tax report. And a combined group may not use a reporting method that would have been used by a member that failed to file a Texas franchise tax report.

Temporary Help Service

In a recent issue of its monthly newsletter, the Comptroller reported a district court decision, Taylor & Hill, Inc. v. Combs, et al., Cause No. D-1-GN-10-004429. Taylor & Hill, Inc. (“T&H”), a registered professional engineering firm, used COGS to report its Texas franchise tax. The Comptroller determined that T&H was not eligible to use COGS and computed the company’s tax based on 70% of total revenue. T&H filed suit to recover the additional tax.

One of T&H’s arguments was that because it temporarily assigned its employees to clients, it was a temporary help service. Tax Code §171.1011(k) allows a temporary help service to exclude from its revenue amounts billed and paid for certain expenses paid to assigned employees, including wages, payroll taxes, employee benefits, and workers’ compensation benefits.

The judge agreed that T&H provided a temporary employment service and was required to use the compensation method to compute its margin and to exclude reimbursements for wages and benefits paid to assigned employees.