Texas Legislature Passes New Business Tax
by Steve Moore, Partner, Tax Section, Jackson Walker L.L.P.
The Texas Legislature passed House Bill 3 on May 2, 2006 in the Special Session which began on April 17, 2006. HB3 is the first major business tax legislation adopted in Texas since 1991. The new tax is called a "margin" tax, and it replaces the current franchise tax.
Jackson Walker's Tax Section is providing this brief summary of the new business tax so that you can begin to evaluate the impact the tax will have on your organization. As you will see, the margin tax is a novel tax, and you will undoubtedly have questions on how the tax will be applied and enforced.
Basic Calculation
In a nutshell, the calculation of the new margin tax is based on a taxable entity's (or unitary group's) gross receipts after deductions for either (x) compensation or (y) cost of goods sold. An affiliated group must choose one type of deduction to apply to the entire group. The "tax base" is apportioned to Texas using a single-factor gross receipts apportionment formula with no throwback rule - Texas gross receipts divided by aggregate gross receipts. The tax rate applied to the Texas portion of the tax base is 1% for all taxpayers except a narrowly defined group of retail and wholesale businesses who pay a 0.5% rate. There is a safety net so that the margin tax base may not exceed 70 percent of a business's total revenues.
Gross Revenue Less (x) Compensation or (y) Cost of Goods Sold
For purposes of the margin tax, a taxable entity's total revenue is generally total income as reported on IRS Form 1120 (for corporate entities) or IRS Form 1065 (for partnerships and other pass-through entities) plus dividends, interest, gross rents and royalties, and net capital gain income, minus bad debts, certain foreign items, and income from related entities to the extent already included in the margin tax base.
HB3 includes a very short and specific list of items which are excluded from gross receipts, namely funds received in trust, such as sales taxes, as well as real estate sales commissions paid to non-employees. In addition, general contractors may exclude flow-through payments to subcontractors. Lending institutions may exclude loan proceeds.
Health care providers may generally exclude payments received under the Medicaid, Medicare, Children's Health Insurance Program (CHIP), workers' compensation, the TRICARE military health system, the Indigent Health Care and Treatment Act, as well as the actual costs of "uncompensated care."
The Compensation Deduction
For purposes of the margin tax, "compensation" includes wages and net distributive income from partnerships, limited liability companies, and S Corporations to natural persons, plus stock awards and stock options as well as workers compensation benefits, health care, and retirement to the extent deductible for federal income tax purposes. The deduction for compensation may not exceed $300,000 for any single person. Compensation does not include social security or Medicare contributions.
The Cost of "Goods" Sold Deduction
Under the new margin tax, a "good" is limited to real or tangible personal property sold in the ordinary course of business, but the term does not include provision of services. The term "cost of goods sold" is defined in HB3 to include the direct costs of acquiring or producing goods. Such direct costs include production labor, processing, assembling, packaging, and inbound transportation, utilities, storage, control storage licensing and franchising costs, and production taxes. Certain indirect costs for production facilities, land and equipment, such as depreciation, depletion, amortization, renting, leasing, repair, maintenance, research, and design are also included. The "cost of goods sold" definition does not include selling costs, advertising, distribution and outbound transportation costs, interest or financing costs, income taxes or franchise taxes. Up to four percent of administrative and overhead expenses may be included in "cost of goods sold" to the extent they are allocable to the costs of acquiring or producing goods. The "cost of goods sold" must be capitalized to the extent required by Section 263A of the Internal Revenue Code.
Who is Subject to Tax
Corporations, limited partnerships, certain general partnerships, limited liability companies, business trusts, professional associations, and other legal entities that enjoy any element of state law liability protection are subject to the new margin tax. The only exemptions are for sole proprietorships, general partnerships that are owned 100% by natural persons, narrowly defined passive income entities (including certain Real Estate Investment Trusts and certain family limited partnerships), entities that already have a specific exemption under the current Texas franchise tax, grantor trusts, estates of a natural person, an escrow, or a real estate mortgage investment conduit. Otherwise taxable entities that have $300,000 or less in gross receipts in a year are also exempt for that year.
Transition and Filing
Regular annual margin tax returns will be due on May 15 of each year, and they will be based on financial data from the previous calendar year. The first margin tax returns will be due on May 15, 2008, and they will be based on financial data beginning January 1, 2007. Businesses that currently pay the Texas franchise tax will file an information return with their next franchise tax filing that must indicate what the taxpayer's "margin tax" liability would have been. These numbers are going to be used for revenue estimating purposes.
Unitary Combined Reporting
The margin tax will require Texas businesses to file on a unitary and combined basis for the first time. An affiliated group of entities in a unitary business will file a consolidated return including all taxable entities within the group. The unitary group includes all affiliates with a common owner (i.e., 80% owned), and the group includes entities with no nexus in Texas. The group does not include entities with 80 percent or more of their property and payroll outside the United States. Exempt entities are not part of the group.
The affiliated group is a single taxable entity for purposes of filing the margin tax return, and the combined return is designed to be the sum of the returns of the separate affiliates.
Apportionment
The new margin tax is apportioned using a single-factor gross receipt formula (Texas gross receipts divided by aggregate gross receipts). Receipts that are excluded from the tax base must also be excluded from gross receipts for apportionment purposes.
Texas gross receipts includes receipts from the sale of tangible personal property delivered or shipped to a buyer in this state, services performed in this state, the use of a patent, copyright, trademark, franchise, or license in this state, sale of real property in this state (including royalties from minerals) and other business done in this state. Only gross receipts from those entities within the group which have nexus in Texas are included in the calculation of Texas receipts. Sales to states in which the seller is not subject to an income tax are not deemed to be a Texas receipt (i.e., no throwback rule).
Aggregate gross receipts shall include the gross receipts (as described above) of each taxable entity in the combined group without regard to whether an individual entity has nexus with Texas.
Credits / NOL's
Taxable entities which have credits under the previous Texas franchise tax law may generally claim those credits against the margin tax, but generally, no new credits may be accumulated against the margin tax and all existing credit provisions are repealed. Net operating losses as they were valued on a taxpayer's books and records and apportioned to Texas in 2007 (based on 2006 business activity) under the old franchise tax may be taken in ten percent installments until they are exhausted or until 2026.
Administration and Enforcement
The Office of the Comptroller of Public Accounts of Texas will have rulemaking authority with respect to the new margin tax. The current Comptroller, Carole Keeton Strayhorn has already requested an Attorney General's Opinion on whether the new margin tax safely avoids classification as an income tax that could be in violation of the Bullock amendment in the Texas Constitution.
Resources and Contact
The text of HB3 can be viewed in its entirety by clicking here.
Jackson Walker's Tax Section can be contacted by clicking here.
The primary state and local tax contact at the firm is Steve Moore in Jackson Walker's Austin office. Mr. Moore can be reached at smoore@jw.com or 512-236-2074.
We look forward to helping you decipher and deal with the new tax.
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