Texas Rules that Net Proceeds from Inventory Hedging Transactions are Included in Apportionment
September 28, 2022
By: Aspen Fairchild, SALT Senior Associate
At a glance
- The main takeaway: In Texas, taxpayers are required to include the net proceeds from their inventory hedging transactions in the denominator of their gross receipts factor, since inventory hedging is not treated the same as physical inventory.
- Assess the impact: It’s important to apply the appropriate rules to your business transactions to minimize taxability and reduce the risk of incurring unexpected tax liabilities and penalties.
- Take the next step: Aprio’s State and Local Tax (SALT) team has extensive experience with the Texas Franchise Tax and can help your business determine the appropriate rules for your transactions.
Schedule a free consultation today to learn more!
The full story:
On August 24, 2022, the Texas Court of Appeals issued an opinion in which it addressed whether the net proceeds or gross proceeds from a taxpayer’s inventory hedging transactions should be included in the receipts factor for apportionment purposes.
Background of the case
The taxpayer is a packaged food company with operations in Texas. To produce the food products that it sells to grocery stores, convenience stores and food service businesses, the taxpayer purchases the necessary components and raw materials from its suppliers. These components and materials are sent to manufacturing plants, which create the final products. To manage the risks associated with potential fluctuation in the price of the components and raw materials, the taxpayer bought and sold commodity futures contracts and options on commodity futures.
The Texas Franchise Tax is imposed on a taxpayer’s taxable margin, which is the apportioned amount of the taxpayer’s total margin. Total margin is equal to total revenue less one of four permissible adjustments:
- Costs of goods sold,
- One million dollars, or
- 30% of total revenue.
Apportionment is calculated based on a single gross receipts factor.
Of particular relevance in this case, are the rules relating to a “security,” which is defined by reference to Internal Revenue Code (IRC) section 475(c)(2) and includes instruments described in IRC sections 475(e)(2)(B)-(D). Specifically, total revenue excludes the tax basis (typically the cost) of securities.
This is significant because amounts excluded from the calculation of total revenue are typically also excluded from the calculation of gross receipts for purposes of computing the gross receipt factor. For example, if a security is purchased for $100 and is sold for $150, only $50 is included in total revenue and in the gross receipts factor (i.e., the basis amount is excluded, essentially resulting in the inclusion of net proceeds).
However, there is an exception to this rule where the security is “treated as inventory of the seller for federal income tax purposes.” In those cases, the gross proceeds are considered gross receipts for the apportionment factor (i.e., the gross receipts factor would include $150 instead of $50). When these amounts are included only in the denominator, as in this case, including the gross receipts (without basis exclusion) reduces the apportionment percentage, which results in a lower Texas Franchise Tax liability.
The ruling explained
In this case, the taxpayer’s commodity futures contracts and options on commodity futures were considered securities. The taxpayer’s position was that these securities should be treated in the same way as inventory so the gross proceeds could be included in the denominator of the gross receipts factor without having to exclude basis.
In arguing for the change, the taxpayer stated that its securities were “in substance, inventory because it used the commodity hedges to manage the cost of the raw materials it used to manufacture the products [it] ultimately sold” and were “a substitute for the raw materials.” However, the Court stated that the securities were not merchandise, stock in trade, raw materials, works in process, finished products, or supplies physically part of the food products sold to customers, and were not “in substance” or a “substitute” for its raw materials inventory.
In addition, although the taxpayer’s federal tax treatment for its hedging transactions is similar to the treatment provided for inventory, the securities were not “treated as inventory of the seller” for federal tax purposes. The taxpayer did not:
- Purchase from or sell to customers the securities in the ordinary course of business,
- Report the sales of securities as sales of inventory on its federal income tax return and
- Hold the securities as inventory for federal income tax purposes.
For these reasons, the Court denied the taxpayer’s use of gross proceeds for purposes of computing its Texas Franchise Tax apportionment factor.
The bottom line
Aprio’s SALT team has experience with the Texas Franchise Tax and can assist your business to make sure that it is applying the appropriate rules for your transactions to minimize your taxability as much as possible. In addition, our assistance will reduce the risk that your business will incur unexpected tax liabilities and penalties.
We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the September 2022 SALT newsletter.
Conagra Brands, Inc. v. Glenn Hegar, Comptroller of Public Account of The State of Texas. Texas Court of Appeals, Third District, No. 03-21-00111-CV. August 24, 2022.
 Tex. Tax Code § 171.0001(13-a).
 Tex. Tax Code § 171.1011(g-2).
 Tex. Tax Code § 171.1055(a).
 Tex. Tax Code § 171.106(f).
 Inventory of a taxpayer is excluded from the definition of a “capital asset” under IRC § 1221(a)(1). Similarly, hedging transactions are also excluded under IRC § 1221(a)(7).
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.
About the Author
Jeff Glickman is the partner-in-charge of Aprio, LLP’s State and Local Tax (SALT) practice. He has over 18 years of SALT consulting experience, advising domestic and international companies in all industries on minimizing their multistate liabilities and risks. He puts cash back into his clients’ businesses by identifying their eligibility for and assisting them in claiming various tax credits, including jobs/investment, retraining, and film/entertainment tax credits. Jeff also maintains a multistate administrative tax dispute and negotiations practice, including obtaining private letter rulings, preparing and negotiating voluntary disclosure agreements, pursuing refund claims, and assisting clients during audits.