Under Texas Tax Code Section 171.002(c), an entity qualifies for a reduced tax rate if it is “primarily engaged in retail or wholesale trade” and the entity passes three qualifying tests. The first test is whether the total revenue from the entity’s activities in retail trade is greater than the total revenue from its activities in trades other than retail. The second test is whether less than 50% of the total revenue from activities in retail or wholesale trade comes from the sale of products an entity produces.1 The third test is that the entity does not provide retail or wholesale utilities, including telecommunications services, electricity, or gas.
The Comptroller’s Rule 3.584 was amended to establish that a taxable entity produces the product that it sells if it 1) asserts a software copyright with respect to the product or a component of the product; 2) asserts a patent right under U.S.C. Title 35 or the comparable law of any other foreign jurisdiction with respect to the product, a component of the product, or the packaging of the product; or 3) produces a component of the product, or acquires the product and makes a modification to the product unless the taxable entity can demonstrate that the component or modification does not increase the sales price of the product by more than 10%. If none of these provisions apply, the taxable entity does not produce a product it sells if an unrelated party manufactures the product and all components of the product to the taxable entity’s specifications.
The rule amendment adds to the definitions of “produce” and “product” and retains a de minimis safe harbor provision regarding when modifying a product an entity is not considered to “produce” the product. However, a burden is now imposed on the taxpayer to show that any product modification activities do not increase the sales price of the product by more than 10%. In addition, the Comptroller will now consider the assertion of a copyright or patent right with respect to the product or a component of the product to be a reasonable indicator that the taxable entity produces the product regardless of the impact on the sales price or what entity manufactures the product.
In many cases, the Comptroller’s interpretation will eliminate the tax benefit of having an unrelated party manufacture goods to the entity’s specifications. The justification provided for the change is that a “taxable entity should not be able to claim the cost-of-goods-sold deduction on goods that it ‘produces’ while simultaneously claiming it does not ‘produce’ the same goods for purposes of determining qualification for the reduced rate.” The “proposed amendment would benefit the public by updating the rule to more clearly state comptroller interpretation of statute and to reflect statutory changes…There would be no anticipated significant economic costs to the public.” Tax departments may beg to differ on this point. The changes are effective for reports originally due on or after the effective date of the amendment, which is September 4, 2019.
1Including products produced by an entity that is part of an affiliated group to which the taxable entity belongs.
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Eric L. Stein
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