Band-Aids on a Critical Patient: Changes to the Texas Franchise Tax in 2013

Last week, the House passed HB 500, a major revision to the Texas franchise tax. This is the first indication of what changes may be in store for the Texas franchise tax, or margin tax, in 2013.  Below is a fairly complete list of all of the changes that HB 500 includes. Of course, the bill still must make its way through both the Senate and Governor Perry before it becomes law. Even if this bill becomes law, it may not be the only revision to the Texas franchise tax–Governor Perry has already threatened to call a special session because he believes HB 500 (and the other franchise tax revision bills) don’t provide  enough tax relief to Texas businesses.

As any reader of this blog knows, the major problem with the Texas franchise tax is that it treats various taxpayers differently depending on their industry. This means the entire tax is at risk of violating Texas’s constitutional requirement that a tax must be equal and uniform among taxpayers. Over the last two years, members of the Legislature have repeatedly admitted in hearings that the tax is both not equal and uniform and grossly unfair.

In my opinion, the proper fix is to remove the various industry specific rules and lower  the tax rate for everyone. However, the House feels differently. Through HB 500, the House strives to make the tax “fairer” by adding industry-specific rules. However, in reality, the bill seems to provide relief only to the industries that complained the loudest (often by filing lawsuits) while leaving other industries out in the cold.

Moreover, these changes make the tax even more complicated. We’re not yet to the level of complexity of the federal income tax, but we’re heading that direction.

Additionally, it’s not clear when these changes would be effective if they became law. One section of the bill states that the changes don’t come into effect until 2015. But another section states that “except as otherwise provided by this Act,” the bill is effective in 2014. The bill that left committee was to be effective in 2014. Further, some of the changes included in HB 500 are also making their way individually through the system as separate bills, all effective in 2014.

Without further ado, here are the changes to the Texas franchise tax code currently included in HB 500, organized by industry:

Changes Affecting all Taxpayers

– HB 500 would set the small business exemption permanently at $1 million in revenue (adjusted for inflation). Under current law, it drops to $600,000 in 2014. This change will almost undoubtedly make it through.

– The bill would give all entities (including combined groups) a minimum deduction of $1 million.

– Entities electing to deduct compensation would pay the tax at a .95% tax rate instead of a 1% tax rate.

– Entities could include wages and cash compensation paid to foreign employees, even though these employees are not issued a W-2.

– Entities with less than $5 million in revenue could use the amount reportable as cost of sales on the federal tax return as a COGS deduction. There are a lot of questions in my mind about how this section can, and should, be implemented. For instance, if the entity capitalizes its inventory costs, what happens to beginning inventory when it crosses the $5 million threshold? Any entity that qualifies for this special provision would also qualify for the EZ method. So an entity would have to determine whether its tax savings from the lower EZ rate would exceed any tax savings from using federal COGS.

– All entities could include in the cost of goods sold deduction 20% of costs attributable to accepting credit and debit cards. Current law expressly excludes these costs.

– The bill would increase the amount of “indirect costs” includible in the cost of goods sold deduction from 4% of total indirect costs to 5.5% of indirect costs.

– Under the bill, no-nexus members of combined groups would no longer have to report their receipts to the Texas Comptroller, even though combined groups have always been able to  exclude no-nexus members’ Texas receipts from the apportionment factor.

– The bill would create new credits for job creation and capital investment.

– Entities with existing unused credits under the old earned surplus / taxable capital franchise tax could now sell or assign the credits to others.

– Franchise tax refund claims filed after 2015 would qualify for an interest rate equal to the rate the Comptroller charges on delinquent taxes. Currently, successful refund claims earn a significantly lower interest rate.

– Sales tax permit holders would be required to include on all receipts “an additional notation showing the amount of taxes the customer is paying for the purpose of reimbursement” of the franchise tax. The provision would allow the retailer to estimate this amount. There doesn’t appear to be a penalty for a retailer that chooses not to follow this provision. This provision is interesting. It’s directly contrary to a provision that the Legislature almost passed several years ago that prevented taxpayers from doing exactly this. It’s also unclear whether a taxpayer would be required to remit the disclosed amount to the state as a “money represented to be a tax” under Texas Tax Code § 111.016 

Construction

– The bill changes the pass-through revenue exclusion for construction subcontractors to allow the exclusion if either the customer contract or the “subcontract” mandates the flow-through. . Under current law, the Comptroller takes the position that  an entity may only exclude revenue passed on to subcontractors when the entity’s contract with its customer mandates the flow-through.

– The bill would create a new credit for the rehabilitation of certified historic structures.

Health Care Industry

– The bill allows “health care institutions,” such as hospital and similar entities, to exclude all Medicaid, Medicare, and certain other government payments from revenue.  Under existing law, these health care institutions may only exclude 50 percent of these payments, even though doctors and other “health care providers”may exclude all of them.

– The bill would allow all taxable entities to exclude cost of vaccines from revenue.

– The bill would allow pharmacy networks a revenue exclusion similar to the one that the law currently gives pharmacy cooperatives.

Agriculture & Timber

– The bill would allow crop-dusters to exclude from revenue virtually all of the direct costs of providing their service.

– The bill would allow entities engaged in the business of harvesting trees a cost of goods sold deduction for the costs of acquiring or producing timber, even if the entities never own the land, timber, or resulting wood.

Transportation

– The bill would allow motor carriers—entities registered under Chapter 643 of the Transportation Code—to exclude from revenue “flow-through revenue derived from taxes and fees.” It’s unclear precisely what revenue this provision excludes.

– The bill would allow aggregate transporters to exclude subcontracting payments from revenue.

– A different provision in the bill would provide a similar exclusion for barite transporters.

– Under current law, a waterway transportation company that does not own the goods it transports would not normally qualify for a cost of goods sold deduction. This provision would allow such an entity to exclude from revenue the direct costs of “inbound and outbound transportation services.” The revenue exclusion would equal the cost of goods sold the entity would deduct if it sold the goods it transports. The wording of this provision is interesting because the subsection for the COGS deduction expressly excludes outbound transportation costs from the deduction.

Rental Real Estate Owners

– The bill would allow commercial property landlords to exclude from revenue receipts for reimbursement of ad valorem taxes and “any tax or excise tax imposed on rents.” The provision expressly states that that reimbursements for interest and depreciation are not excluded from revenue by this provision.

– However, a separate provision in the bill would allow all landlords to deduct depreciation from revenue. But this provision would not be effective until 2016.

Oil & Gas

– The bill would allow entities providing landman services to exclude subcontracting payments paid to the landman performing the services.

– The bill would allow a pipeline entity that transports petroleum products it does not own to deduct COGS. The deduction would include the entity’s depreciation, operations, and maintenance costs.

Movie Theaters & Broadcasters

– The bill would clarify that movie theaters may include payments for the right to show a motion picture in cost of goods sold.

– The bill would change the apportionment rules for broadcasters. It would treat receipts from licensing television programs and film as Texas receipts only if the direct customer is legally domiciled in Texas. This rule would not apply to cable and satellite providers, though it would apply to cable television networks. This change would not be effective until 2015.

Internet Hosting Companies

The bill would change the apportionment rules for internet hosting companies to treat “receipts from internet hosting” as a Texas receipt only if the customer is in Texas. The Legislature apparently intends for this provision to apply to server farms and website hosting companies. The uncertainty around the existing sourcing rules kept these industries from moving to Texas.

Auto Repair

Automotive repair shops—entities classified under SIC Code 753—would now qualify as retailers eligible for the .5% rate. This would include body shops, paint shops, tire repair, brake shops, and others, but would not include inspection shops, towing services, window tinting, or oil-change shops.

Equipment Rental Companies

The bill attempts to qualify equipment rental and leasing companies—entities classified under SIC Code 735—for the .5% rate. However, the language of the bill the House passed doesn’t actually do this. Hopefully the Legislature will change this before the bill finally passes.

Rent-to-Own Stores

Rent-to-own stores—stores regulated by Chapter 92 of the Business & Commerce Code—would qualify for the .5% rate for retailers and wholesalers.

Utility Companies

This provision would automatically “kick out” a utility provider from a combined group to preserve the half-percent rate for the remainder of the group. Under current law, if a combined group contains a member engaged in retailing or wholesaling utilities, the entire group would not qualify for the .5% rate.

Insurance Companies

The bill would clarify that nonadmitted insurance organizations subject to a gross receipt tax in any state—not just Texas—are exempt from the Texas franchise tax.

Companies Relocating to Texas

Companies that previously had no Texas franchise tax responsibility that relocate their main office or principal place of business to Texas may deduct their relocation costs from apportioned margin. In other words, relocating companies would be allowed a deduction in addition to COGS and compensation.

My personal thoughts? Tax relief is welcome, but these changes make an already complicated tax even more complicated. The House Research Organization’s report on the version that left committee perhaps puts it best: “CSHB 500 would put a dozen [now over 30] bandages on a patient without addressing the underlying ailment.”

Stay tuned for further changes to these provisions. We still have a long way to go before any of these provisions are actually law.