Texas Refund Opportunity: Comptroller Announces Franchise Tax Policy Changes

As a result of two franchise tax decisions, the Comptroller announced two policy changes regarding the revenue exclusion for certain flow-through funds and eligibility for claiming the cost of goods sold deduction.

By Jess Johannesen, SALT manager

On June 30, 2016, the Texas Tax Policy Division issued a letter ruling which, effective immediately, revises two franchise tax policies following two prior court case decisions. [1] Based on the courts’ language and analysis, Texas has revised its policies for the franchise tax with regard to (1) an exclusion from total revenue of certain flow-through funds that are mandated by contract to be distributed to other entities and (2) qualifying activities for the cost of goods sold (COGS) deduction.

The first policy change stems from a case in the Court of Appeals of Texas which determined that the taxpayer was entitled to exclude from total revenue certain payments that the taxpayer made to its subcontractors who provided the taxpayer’s services for its customers. [2] In this case, the taxpayer was in the business of hauling, delivering and depositing “aggregate” at real property construction sites, where it was used as an ingredient in concrete or as a foundation for the construction of roads, buildings and parking lots. The taxpayer provides this service primarily through the use of subcontractors, and the taxpayer is contractually obligated to share a portion of its gross receipts from the project with the subcontractors. The state’s statute provides an exclusion of certain flow-through funds that are mandated by contract or subcontract to be distributed to other entities. [3]

The Court of Appeals rejected the state’s argument that there must be a contract between the contractor and its customer that requires the contractor to use a subcontractor to complete a specific task, which the contractor in this case did not have. Therefore, under the revised policy, payments are treated as a flow-through funds if: (1) the taxable entity has a contract with its customer providing that a subcontractor may be used and requiring payment to the subcontractor or (2) there is a written contract between the taxable entity and the subcontractor where payment is based on the funds paid to the taxable entity by the taxable entity’s customers. Timing of the payments is not material. However, for such payments to qualify for the exclusion, the flow-through funds must have a reasonable nexus to the actual or proposed design, construction, remodeling or repair of improvements on real property. [4]

The second policy change results from another case in the Court of Appeals of Texas which found that the taxpayer (the reporting entity for a combined group) was entitled to claim a COGS deduction for its subsidiary’s activities, including the removal and disposal of waste materials from oil and gas well drilling sites. [5] The taxpayer was an integrated oilfield services company that provided services necessary for the drilling of oil and gas wells by its customers, exploration and production companies. Under the franchise tax, a taxable entity “furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance or real property” is considered the owner of the labor and materials and may use the COGS deduction. [6]

Texas initially denied the COGS deduction, asserting that the taxpayer’s removal and disposal of waste materials was a service, and therefore, the taxpayer did not qualify to use the COGS deduction. The court held that the taxpayer furnished labor to a project for the construction or improvement of real property and was entitled to claim the COGS deduction under Texas law. [7] Under the revised policy, Texas is expanding the interpretation of what is considered to be furnishing labor or materials to a project for the construction, improvement, remodeling, repair or industrial maintenance of real property. Specifically, it will no longer be required that an entity actually physically touch the real property or make a change to the real property to qualify for the COGS deduction. However, a reasonable nexus must still exist between the taxpayer’s customer and the real property project.

These two policy changes are similar, but there is one slight difference in that the flow-through revenue exclusion uses the term “proposed,” which is absent from the COGS deduction. For example, costs for activities performed by architects or engineers could qualify for the flow-through exclusion from revenue without regard to whether construction actually occurs. Additionally, it is still possible that costs may be considered too far removed from the construction, improvement, remodeling, repair or industrial maintenance of real property. In such cases, the costs would not qualify for either the revenue exclusion or a COGS deduction. For example, legal services or accounting services are too far removed and would not qualify for either the flow-through revenue exclusion or COGS deduction.

Aprio has experience consulting with clients regarding Texas franchise tax issues and can assist you with any refund claims to ensure that you are claiming all exclusions and deductions to which you are entitled.

Contact Jess Johannesen, SALT manager, at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the August 2016 SALT Newsletter. To view the newsletter, click here.

[1] Texas Policy Letter Ruling No. 201606856L, 06/30/2016. This ruling supersedes Texas Policy Letter Ruling No. 201406920L (June 10, 2014), which contained Texas’ prior policy stance on these issues.

[2] Titan Transportation, LP v. Susan Combs, Comptroller of Public Accounts of the State of Texas, 433 SW3d 625, 03/14/2014.

[3] Tex. Tax Code Ann. §171.1011(g).

[4] Tex. Tax Code Ann. §171.1011(g)(3).

[5] Susan Combs, Comptroller of Public Accounts of the State of Texas v. Newpark Resources, Inc., 422 SW3d 46, 12/31/2013.

[6] Tex. Tax Code Ann. §171.1012(i).

[7] Tex. Tax Code Ann. §171.1012(i).

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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