More Complexity with the Texas Franchise Tax: Does a rent-to-own store qualify for the half-percent rate?

Over the next couple of weeks, I plan on writing about several Texas tax cases currently pending before the Texas appellate courts. Several cases involve the Texas franchise tax. Many more involve the Texas sales tax.

Today we’ll discuss a Texas franchise tax case recently argued in Travis County District Court: Rent-a-Center, Inc. v. Combs, Docket No. D-1-GN-11-001059. This case involved the qualifications for the margin tax half-percent rate.

Generally, wholesalers and retailers must pay only .5% of “taxable margin” in Texas. All other entities must pay 1% of taxable margin (unless the taxpayer qualifies for and elects the .575% “EZ Method” Rate). The statute instructs taxpayers to refer the 1987 Standard Industrial Classification Manual to determine whether they qualify as wholesalers or retailers. If over half of a taxpayer’s revenue is described by an activity listed in Division F (“Wholesale Trade”)  or Division G (“Retail Trade”) of the Manual, the taxpayer may qualify for the half-percent rate. (The taxpayer must also not manufacture the goods that it sells, or retail utilities.)

The problem is, the 1987 SIC Manual does not adequately classify every business. Some businesses fall through the cracks; they may fall under more than one category. Other times a business may not fall under any category at all. This is often because the world has drastically changed since 1987. It’s also because the SIC Manual was simply not meant for the task that the Texas Legislature has assigned to it.

The rent-to-own industry is one industry that has fallen through the SIC Manual’s cracks. In many ways, rent-to-own stores are similar to any other furniture or electronic retailer. They have a large inventory, showrooms, many salespeople, and eventually sell virtually every item in their inventory. However, in some ways they are different. While rent-t0-own stores occasionally sell items straight from the showroom floor, their customers usually purchase via rent-to-own agreements. Under these agreements, the customer elects to pay a rental fee in exchange for temporary possession and use of an item. If the customer eventually pays enough in rental fees, title of the rented item passes to the customer. The customer also often has the option to execute a purchase option in the middle of the lease term. This option allows the customer to immediately obtain title to an item after paying a certain percentage of the remaining payments in a lump sum.

Several codes under Division G describe the merchandise that Rent-to-Own stores sell. For example, code 5722 describes “establishments primarily engaged in the retail sale of . . . household appliances,” including televisions. But neither this code nor any other code in the 5000s addresses whether a business that sells its products under rent-to-own agreements should be included. SIC Code  7359 (which would not qualify a taxpayer for the half-percent rate) describes “Equipment Rental and Leasing.” It describes “establishments primarily engaged in renting or leasing (except finance leasing) equipment.” Although this section clearly describes a business that owns a fleet of rental assets that it leases until the end of the assets’ useful lives, it’s not clear whether this category is broad enough to include rent-to-own stores. Rent-to-own stores are different because they virtually always transfer title to a rental customer before the end of the useful life of the inventory.

One rent-to-own business, Rent-a-Center, Inc., determined that it was best described by codes in the 5700s, and paid its Texas franchise tax using the half-percent rate. The Comptroller disagreed and sent the company a tax bill for over $1 million. Rent-a-Center paid the tax in protest and sued the Comptroller for a refund. The case went before a jury in December 2012, but after the jury heard a full day of testimony, the judge dismissed the panel after determining that there were no issues of fact for the jury to decide. On January 18, 2013, the judge  issued an order resolving the remaining legal questions. The order was entirely in the Comptroller’s favor; Rent-A-Center took nothing.  While the taxpayer has not yet appealed this order, it’s likely that it will.

If the appellate court does hear this case, it will certainly provide useful guidance to rent-to-own stores. If the Third Court of Appeals determines that the trial court wrongly decided the case, the Texas franchise tax bills of rent-to-own stores could potentially drop by more than half. (Not only may the industry qualify for the half-percent rate, but it may also qualify for a larger cost of goods sold deduction if the courts determine that the businesses are engaged in the business of selling–not renting–goods.) The case may also be relevant to taxpayers outside of the rent-to-own industry if it explains how to address businesses that have fallen into the empty spaces between the industry descriptions included in the SIC Manual. I don’t represent Rent-A-Center, but I will post an update here if and when the taxpayer files its appeal.