As discussed in our October 2022 Client Alert, the Third Court of Appeals held in its October 2021 opinion that Citgo’s securities do not fall within the scope of Tex. Tax Code § 171.106(f). The court of appeals rejected Citgo’s argument that the securities were treated as inventory for federal income tax purposes because a dealer’s inventory securities are also subject to mark-to-market accounting under Internal Revenue Code § 475, holding that the company’s position would erase the distinction between inventory and non-inventory securities. The Texas Supreme Court initially denied Citgo’s December 2021 petition for review in September 2022. However, as discussed in our April 2023 Client Alert, the Texas Supreme Court granted Citgo’s motion for rehearing, withdrew its denial, reinstated Citgo’s petition, and requested full briefing on the merits.

In its briefing, Citgo argued that the statutory language is clear and unambiguous, and that its securities were treated as inventory for federal income tax purposes. The company contended that the appellate court’s decision ignored the plain language in its interpretation of the phrase “treated as.” In response, the Comptroller argued that the securities were merely insurance, hedging against price fluctuations of oil and other products and therefore, are treated as non-inventory securities under the Internal Revenue Code. In an unsurprising move, the Comptroller amended Comptroller Rule 3.591(b)(5), which defines inventory for apportionment purposes, in the midst of this litigation to adopt his litigation position that inventory is limited to “property held primarily for sale to customers in the ordinary course of a trade or business” and that “securities and loans held for investment, hedging, or risk management purposes are not inventory.”

Similarly, the Third Court of Appeals held in its August 2022 opinion that Conagra could not use gross proceeds from the sales of commodity futures contracts and options on commodity futures contracts when calculating the apportionment factor denominator. In its briefing before the Texas Supreme Court, Conagra argued that the Third Court of Appeals erred in concluding that only securities sold to customers in the ordinary course of the seller’s business are treated as inventory for federal income tax purposes. Conagra argued that its hedges can be treated as inventory under the statute even though they are not actually inventory, relying principally on Internal Revenue Code § 1221 and a series of federal cases. As in the Citgo case, the Comptroller argued the phrase “treated as inventory” means “is inventory.”

The Texas Supreme Court’s denial of review in both cases comes as a surprise to many who believed the taxpayers’ and amici parties’ strong statutory construction arguments, anchored in the Court’s preferred plain language analysis, weighed in favor of review. Now, unfortunately, taxpayers are left with uncertainty as to what the phrase “treated as” means for Texas tax purposes, because the phrase is used many other places in the Texas Tax Code.

Texas Franchise Tax: Guidance on Benefits Allowed for the Compensation Subtraction

In October 2023, the Comptroller’s Tax Policy Division issued a memo to the Audit Division concerning benefits includible in the Texas franchise tax compensation subtraction.³ This memo superseded prior guidance on the topic issued in 2013.⁴ Per the Comptroller’s statement on the superseded memo, the 2013 memo incorrectly interpreted the decision in Winstead v. Combs by concluding that “all expenses classified by the IRS as ‘working condition fringe benefits’ are deductible as a benefit under Texas Tax Code Section 171.1013(b)(2).”⁵ The agency now maintains, “[t]he proper standard, based on Winstead v. Combs, is that any item included in benefits for the purposes of the franchise tax compensation deduction must be similar to the items listed in Texas Tax Code Section 171.1013(b)(2) (workers’ compensation benefits, health care, employer contributions made to employees’ health savings accounts, and retirement), in addition to being deductible for federal income tax purposes.”⁶

The Comptroller’s revised policy states that, for the cost of an item to be included in benefits for the compensation subtraction, an item must:

1. Be similar to the items listed in Tex. Tax Code § 171.1013(b)(2) in that the item provides value to the employee in his or her personal capacity;
2. Be deductible for federal income tax purposes;
3. Not already included in wages and cash compensation; and
4. Meet all the other requirements of Rule 3.589(e)

The new memo focuses on the first requirement, providing examples of common expense categories that may or may not be included in the compensation subtraction. Eligible expenses provide value to the employee in his or her personal capacity and, under certain circumstances, may include:

1. Immigration expenses;
2. Meals while traveling, but not client meals;
3. Relocation travel expenses;
4. Company-provided vehicles for personal use, but not business use;
5. Health check-ups;
6. Sports club memberships;
7. Personal use of a cell phone;
8. Entertainment expenses for personal enjoyment, but not client entertainment or internal celebrations; and
9. Certain book and journal subscriptions, dues, and studies/tuition reimbursement.

The Comptroller has previously noted the relevance of the Winstead v. Combs decision for the cost of good sold subtraction, as well, due the ability to subtract certain labor costs, including employee benefit expenses.⁷ Following the Winstead ruling, the Comptroller amended the COGS rule to permit the subtraction of “employee benefits expenses, including, but not limited to, health insurance and per diem reimbursements for travel expenses, to the extent deductible for federal tax purposes.”⁸ However, the Comptroller’s new memo expressly excludes travel per diems from the definition of “benefits” for the compensation subtraction.⁹ It is not yet known whether the agency will try to bring its compensation and COGS “benefits” policies in line or leave the variance, such that different expenses are relevant for each subtraction.

Texas Franchise Tax: Legislative Changes to No Tax Due Reporting Effective for 2024

Senate Bill (“SB”) 3 made several changes to Texas’ No Tax Due Reporting scheme effective for reports originally due on or after January 1, 2024. First, SB 3 increased the no tax due revenue threshold from $1 million to $2.47 million and prohibits the Comptroller’s office from requiring taxable entities whose annualized total revenue is at or below the revenue threshold to file a No Tax Due Report. Second, SB 3 repealed the requirement that a new veteran-owned business file a No Tax Due Report during its initial 5-year exemption period. As a result, the Comptroller is discontinuing the No Tax Due Report for the 2024 report year and it will not be available for any new reporting periods. Third, SB 3 removed the right of certain entities to file a No Tax Due Report and now requires use of either the EZ or long franchise tax report form. Fourth, SB 3 did not remove the requirement that some No Tax Due taxpayers must still file either a Public Information Report (“PIR”) or Ownership Information Report (“OIR”).

For the 2023 report year and earlier, the five entity types that can file a No Tax Due Report are (1) taxable entities with annualized total revenue at or below the no tax due revenue threshold, (2) qualifying new veteran-owned businesses, (3) entities that qualify as passive entities, (4) qualifying real estate investment trusts (“REITs”), and (5) taxable entities with zero Texas gross receipts.

For the 2024 report year and beyond, these five entity types will file as follows:

1. Taxable entities with annualized total revenue at or below the no tax due revenue threshold do not owe any tax and are not required to file a franchise tax report. They are, however, still required to file a PIR or OIR.
2. New veteran-owned businesses are not required to file a franchise tax report for the initial five-year period that they qualify as a new veteran-owned business. For new veteran-owned businesses, no PIR or OIR is required during this initial five-year period.
3. Passive entities must file either the long form or the EZ Computation form. Both forms are being updated with a circle to darken in the taxpayer information section at the top of the form. Other than signing the report, passive entities need not provide information in any other section of the report and no PIR or OIR is required.
4. REITs also must file either a long form or EZ Computation form and darken the appropriate circle in the taxpayer information section at the top of the form. Other than signing the report, REITs need not provide information in any other section of the report. REITs must continue to file a PIR or OIR.
5. Taxable entities with annualized total revenue above the no tax due revenue threshold but zero Texas gross receipts must file either a long form or EZ Computation form and complete specific line items on the form to compute the entity’s total revenue and report zero on the Texas gross receipts line. Entities with zero Texas gross receipts must continue to file a PIR or OIR.

Texas Sales and Use Tax: Aggressive Taxation of Marketplace Sales

In recent years, the Texas Comptroller has begun taking the position, primarily during audits, that a single marketplace sale is actually comprised of two taxable transactions, the first being the marketplace provider’s sale of the taxable item to the consumer and the second being the marketplace provider’s sale of taxable data processing services to the marketplace seller. Said otherwise, the Comptroller treats the marketplace provider’s commission (typically a percentage of the marketplace sale) as the sale of taxable data processing services, separate and apart from the underlying sale of the taxable item (often a good) through the marketplace. So, the Comptroller seeks tax on the marketplace seller’s sale of taxable items through the marketplace and the marketplace provider’s commission earned for facilitating the sale.

The Comptroller’s policy results in great confusion and administrative burden for taxpayers, as most marketplace providers’ systems are not set up to recognize two transactions for each sale of an item through the marketplace and, once broken apart, the two “sales” are often taxed differently. For example, the sale of a good is taxed at 100% of the sales price, while the sale of taxable data processing services is taxed only at 80% of the sales price due to an automatic 20% exemption.

Litigation involving this policy is likely for two primary reasons. First, there are meritorious arguments for challenging adverse audit assessments. Many marketplace providers disagree that their services are properly characterized as data processing. Moreover, even assuming that the characterization of a marketplace provider’s services as data processing is accurate, there are arguments that federal law (for example, the Internet Tax Freedom Act), and protections against duplicative taxation prevent the Comptroller from imposing tax on the commission in addition to the sale of the taxable item. Second, a legislative fix is unlikely given that that the 2023 Texas Legislature’s consideration of a bill seeking to expressly exclude marketplace provider services from the definition of data processing services saw limited action during the last session, presumably due to the negative fiscal note attached to the bill by the Comptroller’s office.¹⁰ The Comptroller estimated annual losses of between $20 million and $33 million over the next five years if the charges were treated as non-taxable.

Texas Sales and Use Tax: Local Tax Rule Amended Yet Again to Bolster Comptroller’s Litigating Position

For several years, the Comptroller and several Texas cities have been litigating how internet sales by in-state retailers to Texas residents (i.e., intrastate online sales) should be sourced for local sales and use tax purposes. Until 2020, these sales were generally sourced to the seller’s in-state place of business where the online purchase is “consummated” — that is, where the order is received or fulfilled by the seller. As a result, cities that host an online retailer’s order-processing facility or fulfillment center have traditionally received the local tax on 100 percent of the intrastate internet orders processed and fulfilled there. These cities then often rebate a large portion of the local sales tax revenue to the retailer through a revenue-sharing agreement that acts as an incentive for the retailer to establish its facility within the jurisdiction. The Comptroller argues that these revenue-sharing agreements are abusive and defy the intent of state law.

In 2020, to address these perceived abuses, the Comptroller adopted changes to the state’s local tax sourcing rule — Comptroller Rule 3.334 — including a change that would prevent online sales from being considered to be received at the seller’s place of business. In response, the cities of Round Rock, Coppell, DeSoto, Humble, Carrollton, and Farmers Branch — many of which host fulfillment centers for online retailers — filed suit in 2021 to overturn those changes in City of Round Rock v. Hegar, Travis County District Court Consolidated Case No. D-1-GN-21-003203. The cities raised procedural and substantive arguments, including that the Comptroller is creating a destination-sourcing local tax regime without legislative authorization.

In August 2022, the district court upheld the cities’ procedural complaints. In January 2023, the Comptroller readopted the rule to correct the procedural defects, but also included additional new language that online orders forwarded to a fulfillment center are not considered to be received at the fulfillment center. The Comptroller also included language that facilities like fulfillment centers are not places of business per the state’s sales tax law unless they meet certain criteria, like having sales personnel working at the facility and receiving orders from customers. The Comptroller’s amended sourcing rule effectively results in the local tax on many intrastate internet sales going to the location of the buyer. This version of the Comptroller’s amended sourcing rule is suspended pending the outcome of the litigation.

On October 27, 2023, the Comptroller proposed yet another change to the local tax rule: the addition of a single paragraph that borrows language from a portion of the Streamlined Sales and Use Tax Agreement (“SSUTA”). The proposed amendment asserts that an order is deemed to be received when all the information necessary to determine if it can be accepted is received by the seller, and that the location where an order is received by or on behalf of the seller is the first physical location of the seller that initially receives it, including an outlet, office, or “automated order receipt system.” The proposed amendment also asserts the location “from which a product is shipped shall not be used in determining the location where the order is received by the seller.” In comments published in the Texas Register with the proposed amendments, the Comptroller argued that “circumstances also require a clear articulation of the Comptroller’s interpretation of the term ‘received,’” and that “the proposed standard comports with the ordinary usage of the terms, as evidenced by the fact that the standard has been approved by twenty-four states” under the SSUTA. Noteworthy, Texas is not a participating member in the SSUTA.

This is another recent example in which the Comptroller has amended a rule that is the subject of litigation during the course of the litigation to mirror the agency’s litigating position. Despite the questionable timing, the Comptroller states that the principal reason for the 2023 proposed amendments is to make clear to taxpayers the Comptroller’s position regarding the disputed rule. Taxpayers and the Comptroller expect this issue to be fully litigated. City of Round Rock v. Hegar is currently set for trial on May 6, 2024.

1. 636 S.W.3d 281 (Tex. App.—Austin 2021, pet. denied).
2. No. 03-21-00111-CV (Tex. App.—Austin Aug. 24, 2022, pet. denied).
3. See STAR No. 202310005L (October 13, 2023).
4. See STAR No. 201305009L (May 14, 2013).
5. STAR No. 201305009L (May 14, 2013).
6. Id.
7. See STAR No. 201307727L (July 16, 2013) (not superseded).
8. 34 Tex. Admin. Code § 3.588(d)(1)(A).
9. See STAR No. 202310005L (October 13, 2023).
10. See HB 5070, 88th Legislative Regular Session.

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