Texas Governor Rick Perry recently signed HB 500, which enacts several amendments to the franchise tax (“Margin Tax”) that are beneficial to Texas taxpayers and HB 800, which allows a taxpayer to take a credit for qualified research and development expenses. The statute changes go into effect on January 1, 2014. The changes with the broadest implications are: (i) a temporary 2.5% rate reduction for all taxpayers in 2014; and (ii) making permanent the $1 million exemption for small businesses. HB 500 also effects several changes that will have various (slight to substantial) impacts on certain types of businesses. In addition, the Comptroller recently revised Rule 3.588 to incorporate many favorable provisions to the calculation of cost of goods sold.
HB 500 Amendments Applicable to All Taxpayers
Reports Due In 2014
HB 500 reduces the tax rates for all taxpayers by 2.5 percent for reports due in 2014. Retailers and wholesalers will benefit by a rate reduction from 0.5 percent to 0.4875 percent, and all other taxpayers will benefit by a rate reduction from 1.0 percent to 0.975 percent.
Reports Due In 2015
The franchise tax rates will either revert back to the original rates (0.5 percent and 1.0 percent) or be reduced by an additional 2.5 percent of the original rate (0.475 percent and 0.95 percent). The franchise tax rates will be reduced for reports due in 2015 if the Comptroller certifies that the revenue estimate for the 2015 fiscal biennium exceeds the original estimate for the same period by an amount sufficient to offset the expected revenue loss caused by the rate reduction.
Reports Due In 2016 and After
The franchise tax rates are set to revert back to the original rates (0.5 percent and 1.0 percent) for all reports due on or after January 1, 2016.
$1 Million Revenue Exclusion
Taxpayers may deduct $1 million in revenue from their computation of taxable margin. This $1 million exclusion/deduction has existed since the franchise tax was overhauled in 2007, but it was previously set to be reduced to $600,000 for reports due on or after January 1, 2014. HB 500 made the $1 million exclusion permanent. The $1 million exclusion/deduction means that small businesses with less than $1 million in revenue are not subject to the franchise tax. For reports due on or after January 1, 2014, taxable margin will continue to be computed based on the lesser of:
- 70 percent of total revenue; or
total revenue less the greater of:
- $1 million; or
- cost of goods sold or compensation, as applicable to the taxpayer.
Although this exclusion effectively exempts taxpayers with less than $1 million in annual revenue from the franchise tax, it would also benefit taxpayers with less than $3.33 million in annual revenue and less than $1 million in cost of goods sold or compensation because such taxpayers would elect to reduce their revenue by $1 million instead of computing taxable margin by multiplying revenue by 70 percent.
HB 500 Amendments Applicable to Specific Taxpayers/Industries
Exclusions from Total Revenue
HB 500 included several changes to better account for the economic realities of certain businesses. For reports due on or after January 1, 2014, total revenue will now be calculated as follows:
- Aggregate and/or barite transportation companies—Payments to independent contractors for the performance of delivery services will be excluded from total revenue.
- Landman services—Payments to independent contractors for the performance of landman services will be excluded from total revenue.
- Motor carriers—Revenues derived from taxes and fees will be excluded from total revenue.
- Waterway transportation companies—Direct costs associated with transporting goods will be excluded from total revenue in the same manner as those costs would be deducted from total revenue under a cost of goods sold deduction.
- Pharmacies—Reimbursements paid to pharmacies in a pharmacy network will be excluded from total revenue.
- Vaccines—Actual costs paid for vaccines will be excluded from total revenue.
Internet Hosting—Revenue Sourcing
HB 500 added subsection (g) to Tex. Tax Code § 171.106, which provides that customer receipts from Internet hosting services will be considered Texas receipts for only the customers located in Texas.
Texas Combined Group—Retail or Wholesale Electric Utility Providers Excluded
Retail or wholesale electric utilities are now unable to be included as a member of a combined group that includes an entity that does not provide retail or wholesale electric utilities if that combined group would not:
- qualify as a retailer or wholesaler without the inclusion of the retail or wholesale electric utility provider(s); and
- have more than five percent of the combined group’s total revenue derived from retail or wholesale electric utility operations.
Deduction for Relocation Costs
HB 500 provides further incentive for businesses seeking to relocate to Texas. A taxpayer that relocates its main office or other principal place of business to Texas on or after September 1, 2013 (not January 1, 2014), may deduct those relocation costs from its apportioned margin, but only if the taxpayer did not do business in Texas and is not a member of an affiliated group that includes a member that is doing business in Texas on the date of the relocation. Eligible relocation costs are those allowable as deductions for federal income tax purposes.
Cost of Goods Sold Deduction
A pipeline operator that transports products belonging to another was previously unable to take a cost of goods sold deduction for pipeline-related expenses because it was viewed as a service provider. For reports due on or after January 1, 2014, a pipeline operator transporting crude oil, petroleum products, or natural gas belonging to another may calculate margin by deducting cost of goods sold, including depreciation, operations, and maintenance costs relating to the transportation services.
For reports due on or after September 1, 2013, a movie theater may calculate margin by deducting cost of goods sold, including costs relating to the acquisition, production, exhibition, or use of a film or motion picture.
Expansion of Retail or Wholesale Trade Definition
HB 500 expands the definition of “retail trade” to include the following activities/businesses:
- Automotive repair;
- Rental of tools, party and event supplies, and furniture; and
- Rental of heavy construction equipment.
Exemption for Non-admitted Insurance Company
For reports due on or after January 1, 2014, a nonadmitted insurance company is exempt from the franchise tax if it is subject to any tax imposed for the privilege of doing business in another state or a foreign jurisdiction.
Exemption for Political Subdivision
For reports due on or after January 1, 2014, a political subdivision corporation formed under Section 304.001, Local Government Code, is exempted from the franchise tax.
HB 800: Credit for Research and Development Expenses
HB 800 offers taxpayers with qualifying research and development expenses to claim either a sales and use tax exemption or franchise tax credit relating to those expenses.
Taxpayers engaged in qualified research, as defined in I.R.C. § 41, conducted in Texas may claim a franchise tax credit for the expenses associated with tangible personal property used in the qualified research.
Eligibility for R&D Credit
A taxpayer that has qualified research expenses is eligible to claim a corresponding franchise tax credit if it has not claimed a sales tax exemption under Tax Code § 151.3182 for the same period and is not a combined group with a member that has claimed a sales tax exemption under Tax Code § 151.3182 for the same period. A taxpayer will remain eligible to claim the franchise credit for subsequent periods, even if it has claimed a sales tax exemption in a period.
Amount of Credit
The amount of the franchise tax credit is dependent on the facts and circumstances surrounding the taxpayer’s qualified research activities.
Taxpayers not providing qualified research activities for an institution of higher education in report year:
Taxpayers with qualified research expenses in prior three years
- Credit = 5.0% X (Research Exp in Report Yr – Avg Research Exp in Prior 3 Yrs)
Taxpayer has no qualified research expenses in prior three years
- Credit = 2.5% X (Research Exp in Report Yr)
Taxpayers providing qualified research activities for an institution of higher education in report year:
Qualified Research Expenses in Prior Three Years
- Credit = 6.25% X (Research Exp in Report Yr – Avg Research Exp in Prior 3 Yrs)
No qualified Research Expenses in Prior Three Years
- Credit = 3.125% X (Research Exp in Report Yr)
The credit taken on a report may not exceed 50% of the taxpayer’s franchise tax liability for that year before any credit is taken.
If a taxpayer is not able to take a full credit on a report because of the limitation under Tex. Tax Code § 171.658, the taxpayer may carry forward the unused credit for up to 20 consecutive reports.
Section 7, HB 800, provides that the enacted statutes are effective January 1, 2014, and Section 6, HB 800, provides that the changes relating to the franchise tax apply to reports due on or after the effective date.
Effective June 5, 2013, the Comptroller amended Rule 3.588 Margin: Cost of Goods Sold to incorporate many interpretations that are beneficial to taxpayers. The amended Rule 3.588 adds the following favorable provisions to the cost of goods sold calculation:
Direct Costs—Rule 3.588(d) substantially modifies the definition of direct costs to include indirect labor costs:
(1) Labor costs. A taxable entity may include in its cost of goods sold calculation labor costs, other than service costs, that are properly allocable to the acquisition or production of goods and are of the type subject to capitalization or allocation under Treasury Regulation Sections 1.263A-1(e) or 1.460-5 as direct labor costs, indirect labor costs, employee benefit expenses, or pension and other related costs, without regard to whether the taxable entity is required to or actually capitalizes such costs for federal income tax purposes.
(A) For purposes of this section, labor costs include W-2 wages, IRS Form 1099 payments for labor, temporary labor expenses, payroll taxes, pension contributions, and employee benefits expenses, including, but not limited to, health insurance and per diem reimbursements for travel expenses, to the extent deductible for federal tax purposes.
(B) Labor costs under this paragraph shall not include any type of costs includable in subsection (f) or excluded in subsection (g) of this section. Costs for labor that do not meet the requirements set forth in this paragraph may still be subtracted as a cost of goods sold if the cost is allowed under another provision of this section. For example, service costs may be included in a taxable entity’s cost of goods sold calculation to the extent provided by subsection (f) of this section.
Labor costs now include indirect labor that can be directly attributed to production or resale activities. Supervisors and project managers are two examples of employees providing indirect labor that are now fully includable in cost of goods sold. The Comptroller previously allowed a full labor cost deduction (or inclusion in cost of goods sold) only for workers who physically touched the goods. The costs associated with other workers were previously deductible, but subject to the 4% cap on total indirect labor and administrative overhead.
This rule/policy change better harmonizes franchise tax with federal income tax respecting cost of goods sold. Moreover, Rule 3.588(d)(1)(A) was revised as the result of the decision in Winstead, PC v. Combs, et al., Cause Number: D-1-GN-12-000141, Travis County District Court. The court held in Winstead that employee-related expenses such as continuing education, travel and meal reimbursements, and company car expenses are includable in labor costs for purposes of the compensation deduction under Tex. Tax Code § 171.1013, to the extent deductible for federal tax purposes. The prior rule was invalid to the extent that such expenses were excluded from the deduction. Rule 3.588(d)(1)(A) now allows for the inclusion of certain labor-related expenses in the labor component of cost of goods sold. These changes further bridge the divide between the Texas franchise tax and the Internal Revenue Code.
Taxes—Cost of goods sold now expressly includes property taxes paid on buildings and equipment.
Indirect or Administrative Overhead Costs—A taxable entity may subtract as a cost of goods sold service costs, as defined in subsection (b)(9) of this section, that it can demonstrate are reasonably allocable to the acquisition or production of goods. The amount subtracted may not exceed 4.0% of total indirect and administrative overhead costs.
Service Costs—Indirect costs and administrative overhead costs that can be identified specifically with a service department or function, or that directly benefit or are incurred by reason of a service department or function. For purposes of this section, a service department includes personnel (including costs of recruiting, hiring, relocating, assigning, and maintaining personnel records or employees); accounting (including accounts payable, disbursements, and payroll functions); data processing; security; legal; general financial planning and management; and other similar departments or functions.
The gap between the Texas franchise tax and the Internal Revenue Code is still alive and well concerning the deductibility of service costs. Rule 3.588 maintains the Comptroller’s prior course that the inclusion of service costs in cost of goods sold is limited to 4% of the taxpayer’s total indirect and administrative overhead costs—regardless of the total amount that is included in that taxpayer’s cost of goods sold for federal tax purposes.
In addition, the Comptroller issued a memo on July 16, 2013 addressing the changes to Rule 3.588 that highlights a potentially problematic statement of policy regarding the 4% cap on service costs. The memo provides:
Indirect labor costs may also be service costs. Indirect labor costs that directly relate to production or acquisition and resale activities—and are NOT service costs—may be fully included in COGS under 3.588(d)(1)…In contrast, indirect labor costs that directly relate to production or acquisition and resale activities—and are service costs—may not be fully included in COGS under 3.588(d)(2) but are instead subject to the 4% cap under 3.588(f).
According to this statement of policy—and the language contained in the underlying rule—an indirect cost is fully deductible only to the extent that it does not fall under the definition of service costs. The problem is that the definition of service costs is so broad that it may always encompass activities that qualify as indirect labor.
Taxpayers’ Ability to Amend Franchise Tax Reports
An amended report may be filed within the time allowed by Tex. Tax Code § 111.107 to change the method of computing margin to the cost of goods sold deduction method or from the cost of goods sold deduction method to the compensation deduction method, 70% of total revenue, or, if otherwise qualified, the E-Z computation method. An election may also be changed as part of an audit.
Texas Franchise Tax Litigation Update
The following case issues are pending/active in Texas courts and administrative hearings:
- Whether a custom manufacturer may take the cost of goods sold deduction when some of the raw materials are provided by its customer. Tex. Tax Code § 171.1012 requires the taxpayer to own the “goods” sold in order to qualify for the COGS deduction, but what qualifies as “ownership” and what qualifies as “goods” (raw materials vs. the end product) are two of the primary questions to be decided. The case is currently in Administrative Hearings.
- Whether taxpayer may use three-factor apportionment pursuant to Texas Tax Code Chapter 141 (Multistate Compact) when Chapter 171 provides for single-factor apportionment. See Graphic Packaging Corp. v. Combs, Cause No. D-1-GN-12-003038, Travis County District Court.
- Whether certain expenses attributed to the generation and transmission of electricity are eligible for the COGS deduction. See Nextera Energy Power Marketing, LLC v. Combs, Cause No. D-1-GN-12-001372 Travis County District Court.
- Whether certain expenditures attributed to environmental disposal and reclamation services are eligible for the COGS deduction. See Newpark Resources, Inc. v. Combs (Texas Third Court of Appeals—Austin, 03-12-00515-CV), which is ready to be set for oral argument.