For Texas jewelry wholesalers, jewelry boxes and related materials may be subject to use tax

At this time of year, it’s tough to miss the seemingly endless number of television commercials involving gifts of jewelry. In those commercials, the gift is typically presented in a small box, often bearing a retailer’s name or logo, which the recipient eagerly opens. It’s hard to imagine from the loving looks that follow how Texas use tax could possibly intrude on that happy scene. But it does, according to the state’s Third Court of Appeals’ recent opinion in Combs v. Chapal Zenray, Inc., 03-1 0-00646-CV (Tex. App. – Austin 2011), previously discussed in a post on this site captioned “Texas use tax may not apply to some wrapping and packaging materials purchased out-of-state.” That earlier post described how a state district court had decided that Texas use tax doesn’t apply to wrapping and packaging materials purchased out-of-state and used by a Texas seller in shipping jewelry to out-of-state customers. Now, the state’s Third Court of Appeals has weighed in on the subject, reversing the district court and rendering judgment in favor of the Texas Comptroller of Public Accounts.

As the Court of Appeals described the case, Chapal, a jewelry wholesaler, had purchased the jewelry boxes and related materials in question outside of Texas, affixed those items to jewelry while the materials were in this state, and then shipped them along with the jewelry to out-of-state retailers who displayed the combined products in their stores in order to sell the jewelry to the ultimate consumers. In its opinion, the Court rejected Chapal’s contention and held that the exclusion from the definition of a taxable “use” in Subsection (f)(2) of Texas Tax Code Ann. §151.011 ("Use and Storage") for property “attached” to other property to be transported outside the state for use solely outside the state did not apply to the jewelry boxes and other materials because they were not “attached” to the jewelry items under a proper interpretation of that Tax Code provision.

The Court of Appeals framed the issue as follows:

The central issue in this case is whether Chapal’s actions in affixing the materials to the jewelry before transporting the items outside the state was the type of nontaxable use contemplated by section 151.011(f)(2), a question that turns on the proper construction of the term “attaching” as used in that provision.

Observing that the terms “attach” and “attaching” are not defined by the Tax Code or the Comptroller’s rules, the Court engaged in a detailed analysis of two subsidiary issues: first, how permanent the “attachment” had to be for property to be excluded from taxation; and, second, whether the necessary degree of attachment had to be considered from the point of view of the direct purchaser (e.g., the retailers that bought and displayed the combined products for sale in their stores) or the ultimate consumers for whom the jewelry boxes and related materials had little, if any, usefulness when they no longer contained or were otherwise no longer affixed to the jewelry.

On the first issue, the Court concluded that it was at least “…not unreasonable to believe the legislature intended to exclude from taxation only property that, after being attached to other property, serves as a component of a finished product—an integration of components that provides a sustained functionality, aesthetic appeal, or usefulness that is greater than that which the components possess individually.” As to the second issue, after concluding that the Tax Code provision was ambiguous, the Court felt it was obligated to follow the Comptroller’s interpretation (which did not contradict the plain language of the code provision) that the attachment of the materials must result in a finished product that has functionality, aesthetic appeal, or usefulness to the ultimate consumer throughout the product’s useful life. In short, the Court of Appeals concluded that Chapal’s use of the materials did not qualify for the exclusion from the statutory definition of “use” contained in Tax Code §151.011(f)(2), meaning that the state was entitled to judgment as a matter of law.

The Court’s reasoning in Chapal Zenray doesn’t seem restricted to the jewelry industry but instead could apply to any Texas wholesaler operating in a similar manner. For that reason, all Texas wholesalers, and their tax advisers, should carefully review the opinion and its impact on their businesses, especially the Court’s hints about other issues that hadn’t been raised at the district court. Also, the case should be monitored for further developments, since Chapal will most likely seek a rehearing of the Third Court’s November 18th opinion.  

The Texas Supreme Court Has Upheld the Revised Franchise Tax

Yesterday, November 28th, the Texas Supreme Court upheld the revised franchise tax, the so-called "Margin Tax," against a constitutional challenge claiming that the tax was imposed on the net income of individuals. Here is a link to the Court's majority decision in In Re Allcat Claims Service, L.P. and John Weakly. Two Justices joined in this concurring and dissenting opinion.

There's another, and different, constitutional challenge against the tax pending at the Court, In Re Nestle USA, Inc., Switchplace, LLC, and NSBMA, LP. Here's a link to the Plaintiff's Brief on the Merits in that case that was filed last week.

More to come in future posts.

The Texas State & Local Tax Law Blog has been nominated as a candidate for the LexisNexis Top 20 Tax Law Blogs of 2011

UPDATE: Thanks to everyone who supported this blog and helped it to reach the rank of the LexisNexis Top 20 Tax Law Blogs of 2011, as indicated by the new badge on the right.

As you can see from the badge on the right, the Texas State & Local Tax Law Blog has been nominated as a candidate for the LexisNexis Top 20 Tax Law Blogs of 2011. There are many excellent tax law blogs on the web, and it was really an honor just to be nominated in this very competitive field. Still, it would be an even bigger honor to make this year’s Top 20 Tax Law Blogs. So, if you’d like to support this blog, LexisNexis has invited tax practitioners to comment on the announcement post on their Tax law Community site. You’ll have to register if you’re not already a Tax Law Community member, but it’s easy and quick to do so.

The comment period ends tomorrow, November 18th, so please put in a good word for the blog between now and then.

Out-of-state purchases of veterinarian-prescribed drugs and medicines are exempt from Texas sales and use tax

Here’s a development that will save Texas animal owners some sales and use tax. This past July 15th, a representative of the Texas Comptroller of Public Accounts’ Tax Policy Division issued a letter ruling, indexed as STAR Accession No. 201107164L, declaring that an item qualifying as a “drug” or “medicine” purchased by a Texas customer over the telephone from an Arizona pharmacy is exempt from Texas sales and use tax when prescribed by a veterinarian for the customer’s animals, such as cats, dogs and horses. According to the letter ruling, an item eligible for the exemption as a veterinarian-prescribed “drug” or “medicine” under Texas Tax Code §151.313 (“Health Care Supplies”) and the Comptroller’s Rule 3.284 (“Drugs, Medicines, Medical Equipment, and Devices”) is a product that is

• applied to the body;
• ingested or inhaled; or
• intended or marketed for the diagnosis, cure, mitigation, treatment or prevention of disease, illness, injury or pain.

The Tax Policy representative then provided a non-exclusive list of drugs and medicines that are exempt when prescribed (or dispensed) for animals by a veterinarian:

·       Drugs that are labeled for use only by or on the order of a licensed veterinarian;

·       Flea & Tick prevention which are applied to the pet (sprays, dips, shampoos, powders, liquids);

·       Food designed for animals (including vet-prescribed food sold over-the-counter);

·       Dietary supplements & vitamins;

·       Toothpaste & dental rinses (does not include toothbrushes or dental tools);

·       Ear cleansers/drops/rinses;

·       Eye drops; and

·       Skin medications.

It’s worth noting that this ruling is good news not only for Texas pet owners, but also for farmers and ranchers. That’s because the inquiry that resulted in the ruling specifically mentioned horses, and it’s hard to imagine the Comptroller’s office not also applying the ruling’s principles to vet-prescribed drugs and medicines for all kinds of farm and ranch animals. 

Some interesting Texas tax issues in recently-filed state court lawsuits

Last Friday, the May 2011 Comptroller of Public Accounts Case List and Summary of Issues (updated through June 14, 2011) appeared on the Texas Attorney General’s web site. This latest Comptroller Case List provides an update of many state tax cases now pending in court and also describes some newly-filed state tax lawsuits. What follows are some observations about a few of the latter that appear particularly interesting.

Here are three new Texas tax lawsuits that businesses and their state tax advisers should watch:

1.        Keystone RV Company Inc. v. Combs, et al., Travis County District Court Cause Number D-1-GN-11-001284. According to the Comptroller Case List, the principal issue in this franchise tax protest and refund suit filed last April 29th is “Whether warranty services provided under contract by a third-party are sufficient to establish nexus.” In Texas, unlike in some other states, the courts have held that “physical presence” is required to support nexus for franchise tax purposes as well as for sales and use tax purposes. Accordingly, it looks like the broader issue in this case is whether a contractual relationship alone can create physical presence here for an out-of-state seller.

2.        Rent-A-Center, Inc. v. Combs, et al.,Travis County District Court Cause Number D-1-GN-11-001059. The main issue in this protest suit filed last April 11th is whether, under the revised franchise tax or “margin tax” applicable to the 2008 report year, the “...Plaintiff’s rent-to-own business qualifies for the 0.5% rate under [Tex. Tax Code ann.] §171.002(b)....” There have been many administrative disputes over whether a particular seller is a wholesaler or retailer entitled to use the 0.5% tax rate instead of the generally-applicable 1% rate. So, depending on the narrowness of Rent-A-Center’s facts, the outcome of this litigation may provide firmer guidance for resolving other taxpayers’ tax rate issues in 2008 and in future years.

3.        Dow Jones & Company, Inc. v. Combs, et al., Travis County District Court Cause Number D-1-GN-11-001506. This protest suit raises some very important issues regarding the Comptroller’s administration of Texas sales and use taxes, as suggested by its description in the Comptroller Case List:

Plaintiff alleges that [Tex. Tax Code ann.] §151.319, which provides an exemption for newspapers having a sales price of less than $1.50, violates the Equal Protection Clause and the First Amendment of the U.S. Constitution. Plaintiff alleges that Comptroller’s application of §151.319 violates the rule promulgation requirements of the APA.

This suit arose from the Comptroller’s decision in 2010 that the Wall Street Journal (and possibly the New York Times as well) did not meet the definition of a tax exempt “newspaper” in Tax Code §151.319 because its newsstand price exceeded $1.50. One especially interesting aspect of the case is that the policy decision was not announced in a formal administrative rule but rather in an article in the February 2010 issue of the Tax Policy News, the monthly electronic tax policy newsletter published on the Comptroller’s web site, the Window on State Government.

While the Tax Policy News is closely followed and widely respected by Texas tax practitioners, and has been mentioned often here on the Texas State and Local Tax Law Blog, its pronouncements technically aren’t “rules” promulgated in the manner required by state law. Instead, the “APA” referred to in the case description, being the Texas Administrative Procedure Act, spells out the formal method of proposing and adopting rules such as those interpreting the state’s Tax Code. So, besides addressing constitutional principles, the Dow Jones case should also result in a better understanding of the extent that the state courts will allow the Comptroller to interpret the Tax Code outside of the strict rule making procedures of the APA.

The Texas Legislature has re-defined "physical presence" for use tax purposes

An earlier post on this site captioned "There's a new bill in the Texas Legislature for taxing out-of-state sellers like Amazon.com" discussed the introduced version of Texas House Bill 2403, officially captioned on the Texas Legislature's web site as a bill “Relating to retailers engaged in business in this state for purposes of sales and use taxes.” As it happens, last Friday (Friday the 13th for those with a superstitious bent), H.B. 2403 in a slightly modified form passed the Texas Senate and is now an enrolled bill. That means that it just needs the Governor’s signature to become law effective next January 1st (and there have been press reports that Governor Perry hasn’t yet decided if he’ll approve it).

If the final bill does become law, it still shouldn’t affect the ongoing tax dispute between the Texas Comptroller of Public Accounts and Amazon.com because Section 3 of the enrolled bill provides that

The change in law made by this Act does not affect tax liability accruing before the effective date of this Act. That liability continues in effect as if this Act had not been enacted, and the former law is continued in effect for the collection of taxes due and for civil and criminal enforcement of the liability for those taxes.

Still, the new law is likely to have a significant impact after its effective date. For instance, consider the following portion of the “Author’s / Sponsor’s Statement of Intent” in the Texas Senate’s Bill Analysis of what became the final version of H.B. 2403:

Many businesses are using business models that allow them to exploit a physical presence loophole in the law and consequently to avoid state sales tax responsibilities, despite creating and maintaining markets across state lines through remote sales while having a physical presence in Texas.  With the advent of the Internet and the emergence of e-commerce, the number of sellers maintaining a physical presence while making remote sales to customers has exploded, creating a significant and growing loss of sales tax revenue to the states.  This loss of revenue is compounded by the fact that traditional retailers with a storefront presence who must collect state and local sales and use taxes are placed at a competitive disadvantage. 

That statement of legislative intent suggests that at least the Texas Senate thinks that many “loophole exploiting” sellers are currently operating in Texas. If so, it’s likely that the Comptroller will start seeking out those sellers for assessments once the Tax Code changes become effective. For that reason, businesses inside and outside of Texas that believe that they might fit within the Senate’s description of “loophole exploiters” should confer with their state tax advisers as soon as possible to see what options are available before the changes made by H.B. 2403 go into effect at the first of the year.