The Combs v. Chevron opinion is out, and it's big news for the Texas state tax world

Today’s sales tax opinion from the Texas Third Court of Appeals in Austin, Combs v. Chevron USA, Inc., No. 03-07-00127-CV, is big news for its treatment of both substantive tax law and tax procedure. The substantive issue was whether temporary scaffolding supplied by a third party to a refinery undergoing maintenance was a nontaxable service or the taxable rental of tangible personal property. The procedural question was whether a court can consider a refund issue that was presented to the Texas Comptroller of Public Accounts for the first time in a motion for rehearing after an administrative refund hearing that addressed other, unrelated issues.

The Court of Appeals decided that the scaffolding was a taxable rental under the circumstances, and that a court can’t consider a new refund issue raised for the first time in a rehearing motion. Because these are both important developments in Texas tax law, they’ll be discussed in more detail in a future post (or posts). In the meantime, businesses in similar situations – and their tax advisors – should carefully review the Court’s opinion (which can be found by following the link above). 

Too much product modification could cost a seller its favorable tax rate

As mentioned in a previous post captioned “Amended Comptroller rules solve the rental income flow-through problem and make other changes,” the Texas Comptroller of Public Accounts recently amended several administrative rules applicable to the revised franchise tax, or “Margin Tax.” One of the amended regulations, Rule 3.584 (“Margin: Reports and Payments”), includes a change that would double the tax rate – from 0.5% to 1% – for any wholesaler or retailer that earns more than half of its revenue from selling products that it or an affiliate modifies, provided that the modifications increase the sales prices of the products by more than 10%. The amendment applies to franchise tax reports due on and after January 1st of this year. 

The language implementing this change is contained in Subsection (d)(3)(B) dealing with entities engaged in the wholesale or retail trade. Those entities are normally eligible for the 0.5% tax rate rather than the general 1% rate. However, except for certain eating and drinking establishments, those entities can lose their eligibility for the lower tax rate if 50% (or more) of their total revenue from wholesale or retail activities comes from the sale of products they produce or that are produced by other entities in the same affiliated group. According to the new sentence added to the amended rule, “A product is not considered to be produced if modifications made to the acquired product do not increase its sales price by more than 10%.”

The January 2010 issue of the Comptroller’s Tax Policy News electronic policy newsletter, just posted on the agency’s web site, the Window on State Government, contains two examples of how the amended rule works. The sellers in both examples are apparel retailers that sell the same product in both modified and unmodified versions. However, the change in the rule’s language could apply to any businesses selling modified products, not just clothing stores. 

The good news here is that the amended rule provides a bright line test for determining when an item is or isn’t “produced” by a wholesaler or retailer for purposes of determining the applicable tax rate. On the other hand, setting that bright line as anything above a 10% sales price increase imposes a very low threshold for potentially disqualifying otherwise eligible sellers from the beneficial tax rate. It will be interesting to see how the Comptroller’s staff applies this new standard in future audits and whether any wholesalers, retailers or their trade associations attempt to challenge it in the meantime.

Predicting some Texas tax developments in 2010

Now that the New Year has begun, it’s time to look into our crystal ball and make some predictions about Texas tax developments during 2010. A few developments expected from the Comptroller of Public Accounts, the state Courts and the Legislature are summarized below. Future posts will cover them in more detail when – and if – they actually occur.

• The Comptroller. During 2009, the agency circulated many draft administrative rules for comment by practitioners and other interested parties. A few of the drafts later moved to the formal rulemaking proposal stage, such as one proposing to amend Rule 3.333 regarding the application of sales and use taxes to security services to update the rule to reflect legislation enacted as far back as 1999. (The proposed amendments to Rule 3.333 begin at 34 TexReg 9099.) Because most of the drafts were still under consideration at year-end, readers should expect several proposals for new or amended Comptroller rules to appear in 2010 issues of the Texas Register. Based on the drafts in circulation, the proposals will cover, at a minimum, sales and use taxes, the revised franchise tax (or “Margin Tax”), and more specialized subjects like motor vehicle sales and use taxes.

• The Courts. A number of state tax issues that were moving through the Texas courts in 2009 could be decided this year. For instance, according to the Texas Attorney General’s November 2009 Comptroller of Public Accounts Case List and Summary of Issues (updated through December 21st), several pending state court cases involve the “credit interest” issue challenging the way the Comptroller calculates interest for an audit period when there are both overpaid and underpaid taxes within the period. That issue is discussed in detail in the Comptroller’s Decisions in Hearing No. 48,091 (2009) and Hearing No. 49,371 (2009), administrative proceedings that probably became the Lubrizol and Lyondell Chemical court cases described on p. 81 of the Attorney General’s November case list. Although settlement negotiations are in progress in both of those cases, according to the case list, other pending cases involving the same issue appear to be on track for decision by the courts.     

• The Legislature. Barring a special session, the Texas Legislature won’t meet in 2010. That doesn’t mean that state and local taxes have fallen off the legislative radar screen. In fact, this past November the Speaker of the House, Joe Straus, gave the House Ways and Means Committee a homework assignment in the form of an “interim charge” to review seven specific state and local tax issues. The broadest parts of the assignment were to “Monitor the revised franchise tax and identify changes to simplify the tax and improve compliance and fairness…” and to “Examine the state’s major tax exemptions to determine how the current costs and benefits compare with the original legislative objectives. Make recommendations for adjustments as needed.” (See p. 33 of the 81st Legislature’s Interim Committee Charges for the full list of the Ways and Means Committee’s assignment.) If history is a guide, the result of the committee’s efforts will be considered in the next regular legislative session beginning in January of 2011.  

Photo credit: ©iStockphoto.com/Amanda Rohde

Amended Comptroller rules solve the rental income flow-through problem and make other changes

The Texas Comptroller of Public Accounts has adopted, effective December 31, 2009, amended versions of eight administrative rules affecting the revised franchise tax or “Margin Tax.” As explained below, the big news is how the Comptroller decided to amend (or not amend) Rule 3.582 (“Margin: Passive Entities”), codified at 34 Texas Administrative Code (“TAC”) §3.582.

As explained in a previous post on this site captioned “Rental income flowing through a partnership can be “passive” for 2008 and 2009,” the Comptroller had originally planned to amend Rule 3.582 to formally incorporate a particular interpretation of the law that had been the agency’s policy from 2008, the first year of the revised franchise tax. That interpretation was that rental income that flowed from a partnership to a partner as part of distributive income did not lose its character as “rent” and therefore did not qualify as passive income in the hands of the recipient partner. Following negative comments from several sources, including the Texas Bar Tax Section’s State Tax Committee, the Comptroller’s office announced in January of 2009 that the agency would not amend the rule and would not apply the policy interpretation to either 2008 or 2009 tax reports. However, absent a legislative change to Section 171.0003 of the Texas Tax Code (“Definition of Passive Entity”), the Comptroller’s office stated its intent to adopt the policy by a rule amendment to be effective in 2010.

Well, the 2009 legislative session came and went without any modification of Section 171.0003, so the Comptroller again proposed to amend to Rule 3.582. As proposed, the rule would have altered the qualifications to be considered a passive entity – starting in 2010 – by adding language to Subsections (c)(2)(B) and (d)(1) of the rule to exclude rental income from the “passive” category when received as a distributive share of partnership income. That, in turn, would have made it harder (and in some cases impossible) for the recipient partner’s passive income to reach the required “90% of federal gross income” level to qualify the partner as a passive entity that’s not subject to the revised franchise tax. The adopted version of the rule eliminates the additional language and leaves things for 2010 as the Comptroller had declared them to be for 2008 and 2009 (and as some businesses and their tax advisors had thought they had always been).

Another significant modification of the proposed rule was the elimination of language in Subsection (e) that would have limited the circumstances in which income that’s designated as passive by the Section 171.0003(a-1) of the Tax Code, such as interest, would have lost that characterization if earned as part of the taxpayer’s trade or business. The example in the proposed rule was a partnership that made loans as part of its active trade or business, in which case the interest earned on those loans would have been treated as non-passive. Based on comments from the Texas Bar Tax Section’s State Tax Committee and the Texas Society of CPAs, the Comptroller decided to eliminate that language.

Finally, for those readers keeping track, the other rules that were also amended effective December 31, 2009, are Rule 3.583 (“Margin: Exemptions”), 34 TAC §3.583; Rule 3.584 (“Margin: Reports and Payments”), 34 TAC §3.584; Rule 3.587 (“Margin: Total Revenue”), 34 TAC §3.587; Rule 3.589 (“Margin: Compensation”), 34 TAC §3.589; Rule 3.590 (“Margin: Combined Reporting”), 34 TAC §3.590; Rule 3.591 (“Margin: Apportionment”), 34 TAC §3.591; and Rule 3.593 (“Margin: Franchise Tax Credits”), 34 TAC §3.593. The Comptroller had proposed all of the rules for amendment in the October 30, 2009, issue of the Texas Register, beginning at 34 TexReg 7557, and formally adopted the amended rules in the December 25, 2009, issue of that publication, beginning at 34 TexReg 9464. Most of those rule amendments were relatively technical in nature and were adopted without any changes to the proposed versions.

(Note to practitioners: the above links to the Texas Register issues are correct as of the date of this post. However, because the Texas Secretary of State may change those links, in the future it may be necessary to search for these issues on the Secretary of State’s web site, starting with the site’s Texas Register page.)

Attention Texas appliance shoppers: a rebate could be coming your way

[UPDATE (December 29, 2009): The State has begun the process of selecting an administrator for the rebate program described in the post. On December 28th, the Comptroller’s office issued the agency’s Request for Proposals (RFP) “targeted toward businesses that can act as implementation contractors” for the Appliance Rebate Program. Businesses interested in becoming such a contractor should follow the link (current as of December 29, 2009) to the “Energy Efficiency Appliance Rebate Program for Stimulus Grant Program” page on the Comptroller’s web site, the Window on State Government.]  

Susan Combs, the Texas Comptroller of Public Accounts, recently announced that Texas will use approximately $23 million in federal stimulus funds for a mail-in rebate program for consumers who purchase certain energy-efficient household appliances during a 10-day period next April. Here’s the Comptroller’s press release announcing the program. The Comptroller also explained that offering the program in the spring, coinciding with Earth Day, will give retailers time to stock up on appliances, give the state time to select a vendor to administer the rebates, and allow ample time to inform consumers about details of the rebate program. The press release also includes a link to a more detailed explanation of the program from the agency’s State Energy Conservation Office.

Photo credit: ©iStockphoto.com/Sklemin Kirill

On the whole the rebates seem fairly generous, although some amounts will vary depending on the appliance type and energy efficiency of the model purchased, e.g., $255 - $640 for a water heater. Also, there are some restrictions. For instance, the rebates will apply only to purchases of certified “Energy Star” refrigerators, freezers, room air conditioners, central air conditioners, heat pumps, water heaters, clothes washers and dishwashers. What’s more, each of the new appliances has to replace the same type of old appliance that’s working.

To make the program even more attractive, a separate $75 recycling rebate will go to consumers who buy an eligible appliance and recycle their old one.

So, this use of federal stimulus funds is good news for Texas consumers who didn’t get shiny new household appliances over the holidays. They just have to keep their old energy hogs working for a few more months until they can be recycled and replaced with more energy-efficient and rebate-eligible models.

Finally, for consumers hoping to “double dip,” it doesn’t appear that the April rebate program will overlap with the Energy Star Sales Tax Holiday in May involving many of the same types of household appliances (the 2008 counterpart of the sales tax holiday was discussed in a previous post on this site captioned “Texas Sales & Use Tax: the Comptroller has provided more details about the new sales tax holiday on Memorial Day weekend for certain energy efficient products”).

A recent franchise tax refund case is good news for transportation companies

The Comptroller of Public Accounts recently granted a refund to a railroad under the former franchise tax, and that’s good news for all transportation companies under the revised version of the tax, the so-called “Margin Tax.” In the Comptroller’s Decision in Hearing No. 48,507 (2009), decided last June but only recently added to the Comptroller’s STAR research database as document no. 200906480H, a railroad that operated entirely within Texas claimed a franchise tax refund for 2003 and 2004. In those years, the railroad’s tax was measured by its taxable capital apportioned to this state based on its Texas gross receipts compared to its gross receipts everywhere. The railroad said it had overstated its Texas apportionment percentage, and thus overpaid its tax on its original reports, because it failed to exclude from its Texas gross receipts the payments it received for transporting freight cars within Texas as part of the freight cars’ interstate journey.

Image: Wikimedia Commons/Public Domain (Leaflet)

The railroad in question was performing transportation services entirely within Texas, and normally receipts from services performed in Texas are treated as Texas receipts. However, during the years in issue, Subsection (b)(45) of the Comptroller’s Rule 3.549 (“Taxable Capital: Apportionment”) expressly allowed a transportation company (a term that included a railroad) to count as Texas receipts just the receipts it derived from the transportation of goods or passengers in intrastate commerce (i.e., it could exclude receipts derived from transporting property or people in interstate commerce). For purposes of its refund claim, the railroad wanted to exclude from its Texas receipts the receipts from transporting the freight cars in Texas because that transportation was a segment of an interstate journey (for example, taking the cars from a point in Texas to an interchange point in this state where another railroad would move them out-of-state). The railroad contended that such a segment wasn’t “intrastate commerce” as specified in the rule. The Comptroller’s staff disagreed and argued that all of the railroad’s receipts were from intrastate commerce because all of the railroad’s tracks were located in Texas and the transportation occurred in this state.

The Administrative Law Judge (ALJ) from the State Office of Administrative Hearings (SOAH) analyzed how the term “intrastate commerce” had been historically understood and applied by the Comptroller for nearly three decades. In doing so, he pointed out that the rule provision of excluding receipts from the Texas segment of an interstate journey was more restrictive than required by current federal Commerce Clause interpretations. Nevertheless, the SOAH ALJ concluded that the Comptroller had to follow the agency’s own unambiguous rule because “…if an agency does not follow its own rules, its actions are considered arbitrary and capricious.”

Therefore, under the Comptroller’s own interpretations of the rule a transportation company’s receipts from “intrastate commerce” meant “…receipts for transporting goods from a Texas point of origin to a delivery point that is also in Texas, and … receipts for transporting goods in a segment of interstate commerce are not intrastate commerce, even when the transportation occurs in Texas.” Accordingly, the SOAH ALJ concluded that the railroad was entitled to its refund.

Hearing No. 48,507 is important not only because it isn’t limited to railroads hauling freight cars or to the 2003 and 2004 report years. The decision could apply to any type of transportation company that moves passengers or goods and to the pre-revised version of the franchise tax through the 2007 report year. What’s more, this decision could be significant even for reports filed in 2008 and later years under the revised franchise tax. That’s because Subsection (e)(32) of Rule 3.591 (“Margin: Apportionment”) applicable to the revised tax is phrased in substantially similar terms as the counterpart provision in Rule 3.549:

(32) Transportation companies. Transportation companies must report Texas receipts from transportation services in intrastate commerce by:

    (A) the inclusion of revenues that are derived from the transportation of goods or passengers in intrastate commerce within Texas; or

    (B) the multiplication of total transportation receipts by total mileage in the transportation of goods and passengers that move in intrastate commerce within Texas divided by total mileage everywhere.

So, railroads, other transportation companies and their tax advisors should carefully review Hearing No. 48,507 to determine if they might be entitled to refunds for open years through 2009 as well as to a more beneficial Texas apportionment percentage on their 2010 and later franchise tax reports.