The Comptroller of Public Accounts proposes amendments to §3.591, concerning margin: apportionment. The amendments implement House Bill 500, 83rd Legislature, 2013, effective January 1, 2014 and House Bill 2896, 84th Legislature, 2015, effective January 1, 2018. The amendments also update the section to reflect current guidance and improve readability.

Throughout the section, where applicable, the comptroller adds titles to statutory citations; replaces the term intangibles with intangible assets; replaces the term receipts with gross receipts; replaces the term gross receipts everywhere with gross receipts from an entity's entire business; references other relevant sections; replaces the term apportioned with sourced; replaces the term legal domicile of payor with location of payor; replaces the term revenue with gross receipts; and makes minor revisions to improve readability.

The comptroller amends subsection (b)(1) to remove circular language.

The comptroller removes subsection (b)(2), the definition of commercial domicile, and renumbers the subsequent paragraphs as necessary. The definition of commercial domicile is no longer necessary as the term is no longer used in this section.

The comptroller amends renumbered subsection (b)(3) to revise the definition of gross receipts to reflect that certain non-receipt items excluded when calculating total revenue are not used in calculating gross receipts. Any item of revenue excluded from total revenue is not included in computing gross receipts under Tax Code, §171.1055(a). For most entities, gross receipts will equal the amount reported in total revenue unless the taxable entity has excluded non-receipt items from total revenue that must be added back when computing gross receipts, including: $500 per pro bono services case; the actual cost of uncompensated care; the direct cost of providing waterway transportation; the direct cost of providing agricultural aircraft services and the cost of a vaccine. For example, under Tax Code, §171.1011(g-3) (Determination of Total Revenue from Entire Business), an attorney may exclude $500 from total revenue for handling a pro bono case. Since the $500 is not a receipt, there is no exclusion for pro bono work when calculating gross receipts.

The comptroller adds new language to renumbered subsection (b)(4) specifying that the federal tax year beginning on January 1, 2007, is the operative federal tax year for references to the Internal Revenue Code (IRC). The new language replaces the reference to Tax Code, §171.0001 (General Definitions).

The comptroller adds new subsection (b)(5) to define inventory. This definition is based on the discussion of inventory from IRC §1221(a)(1) and incorporates the guidance provided by STAR Accession No. 201311792L (November 21, 2013).

The comptroller amends subsection (b)(6) concerning investments to make clear that inventory is not included in investments. The definition incorporates the guidance provided by STAR Accession No. 201311792L.

The comptroller amends subsection (b)(7) concerning the definition of legal domicile to remove the definition of principal place of business and define the term separately in subsection (b)(9).

The comptroller adds new subsection (b)(9) to define principal place of business for all taxable entities. The comptroller removes the principal place of business definition from the definition of legal domicile in subsection (b)(7) and replaces the current definition with a definition based on the United States Supreme Court decision, Hertz Corp. v. Friend, Case No. 08-1107, slip op. at 1 (2010) where the court concluded that "...'principal place of business' is best read as referring to the place where a corporation's officers direct, control, and coordinate the corporation's activities."

The comptroller adds new subsection (b)(10) to define regulated investment company. The definition is consistent with the language in Tax Code, §171.106(b) (Apportionment of Margin to this State). Subsequent paragraphs are renumbered accordingly.

The comptroller adds new subsection (b)(14) to define Texas gross receipts pursuant to Tax Code, §171.103 (Determination of Gross Receipts from Business Done in this State for Margin).

The comptroller amends subsection (c)(1) to provide guidance from Tax Code, §171.106(b) relating to the sourcing of receipts from services provided to a regulated investment company. New subparagraphs (A) and (B) provide guidance on how to determine Texas gross receipts and gross receipts from an entity's entire business, respectively, for a regulated investment company.

The comptroller amends subsection (c)(2) to track the statutory language in Tax Code, §171.106(c) relating to the sourcing of receipts from services provided to an employee retirement plan. New subparagraphs (A) and (B) provide guidance on how to determine Texas gross receipts and gross receipts from an entity's entire business, respectively, for an employee retirement plan.

The comptroller amends subsection (d)(1) to delete the reference to §3.595 (relating to Margin: Transition) as the transition period is no longer within the statute of limitations and §3.595 has been repealed.

The comptroller amends subsection (d)(2) to add language to limit the filing of an initial report to taxable entities with a beginning date prior to October 4, 2009, pursuant to §3.584(c)(1) (relating to Margin: Reports and Payments). The comptroller also adds reporting requirements for taxable entities with a beginning date on or after October 4, 2009, consistent with §3.584(c)(2).

The comptroller amends subsection (d)(5) to explain that exclusions under §3.587 of this title (relating to Margin: Total Revenue) that are non-receipt items are not deducted from receipts.

The comptroller amends the title to subsection (e) to more accurately reflect the contents of the subsection.

The comptroller deletes the original language in subsection (e)(1) concerning bad debt recoveries. The comptroller determines the guidance unnecessary and intends no change in policy by this deletion.

The comptroller adds language to subsection (e)(1) to consolidate the sourcing rules for receipts from advertising, which are currently addressed in subsection (e)(20) for newspapers or magazines, (e)(22) for radio/television, and (e)(26) for advertising services in other media. The proposed new language in subsection (e)(1) will provide a uniform sourcing rule across all media and will be consistent with the amendments to the general rule for sourcing receipts from services in subsection (e)(26), which states that a service is performed at the location of the receipt-producing, end-product act.

The comptroller restructures subsection (e)(2) concerning capital assets and investments into two new subparagraphs. The comptroller proposes to revise its treatment of the sale of investments and capital assets. Consistent with the Texas Supreme Court decision in Hallmark Marketing Co. v. Hegar, 488 S.W.3d 795 (Tex. 2016), net losses are no longer included in gross receipts. In addition, for reports originally due on or after January 1, 2021, net gains and losses will be determined on a sale-by-sale basis.

Under the current rule, gains and losses during an accounting period are offset to determine a "net" amount. The comptroller adopted this rule to comply with the holding in Calvert v. Electro-Science Investors, Inc., 509 S.W.2d 700 (Tex. Civ. App. - Austin 1974, no writ). See Tex. Comp. of Pub. Accts., Rule 026.02.12.013(2)(k) (1975) (STAR Accession No. 7601R1000B02). In its Electro-Science opinion, the Court of Appeals held that the plain meaning of "net gain" in the apportionment statute required that "gains and losses be offset against one another in order that a net figure be obtained."

However, more recently, in Hallmark Marketing Co. v. Combs, No. 13-14-00093-CV (Tex. App. - Corpus Christi-Edinburg 2014) (mem. op.), rev'd on other grounds, 488 S.W.3d 795 (2016), the Court of Appeals found that the statute was ambiguous:

"The ambiguity arises because it is unclear, by examining only the plain language of the statute, what the term "net gain" means. On the one hand, "net gain" may refer to the particular gain or loss that results from each individual sale when proceeds are offset by costs. ... On the other hand, 'net gain' may instead refer to the taxpayer's cumulative gain or loss on its various investment and capital asset sales made throughout the year."

The Texas Supreme Court reversed the Court of Appeals' Hallmark decision on other grounds, holding that "we do not need to relitigate the question in order to determine Hallmark did not have a net gain under any calculation." 488 S.W.3d at 799.

In the process of revising its rule to comply with the Supreme Court's determination that net losses may not be included in gross receipts, the comptroller has also evaluated its rule regarding the calculation of net gains and losses. The comptroller has concluded that the only reasonable interpretation is that net gains and losses should be determined separately for each sale of a capital asset or investment.

The objective of the apportionment statute is to apportion an entity's total revenues based on the entity's business activity in Texas relative to the entity's entire business activity. The apportionment statute uses an entity's gross receipts as a proxy for business activity. Given this objective, it makes no sense to negate gains from one transaction with losses from another, resulting in one business activity essentially negating another.

Suppose a real estate investment company sold two Texas investment properties, with the loss on one sale equaling the gain on the other. If the loss offsets the gain for apportionment purposes, the company will have no Texas receipts and a zero Texas apportionment factor even though it had substantial business activity in the State. The comptroller has concluded that the Legislature could not have intended that absurd result. Rather, the only reasonable interpretation of legislative intent is the opposite -- the Legislature provided that only the net gain from a sale would be included in the calculation to prevent losses from being used to offset gains.

Accordingly, new subparagraph (A), which includes the statutory language from Tax Code, §171.105(b), also includes several clauses. New clause (i) provides the comptroller's revised interpretation; an entity's net gain or net loss is determined separately for each sale of a capital asset or investment. New clause (ii) provides the comptroller's previous interpretation of the provision and limits its applicability to reports originally due prior to January 1, 2021. New clause (iii) provides an example of the comptroller's revised interpretation and clause (iv) provides an example of the comptroller's previous interpretation.

New subparagraph (B) contains language from the original subsection (e)(2) on the sourcing of gains from the sale of intangible assets. The comptroller adds information on the sourcing of gains from the sale of capital assets and investments that are real property or tangible personal property.

In subsection (e)(3), the comptroller replaces the sourcing rules for receipts from the sale of computer software services and programs with the sourcing rules for receipts from the sale of computer hardware and digital property and adds new subparagraphs (A) through (J). The title is changed accordingly.

In new subparagraph (A), the comptroller treats the sale of software installed on computer hardware as part of the sale of the computer hardware.

In new subparagraph (B), the comptroller treats the lease of software installed on computer hardware as part of the leasing of the computer hardware.

In new subparagraph (C), the comptroller treats the sale of digital property on fixed physical media (such as compact discs) as the sale of tangible personal property. This treatment is consistent with the treatment of other intellectual property that is sold in non-digital fixed physical media (such as books).

In new subparagraph (D), the comptroller treats the lease of digital property on fixed physical media (such as compact discs) as the lease of tangible personal property.

In new subparagraph (E), the comptroller treats the sale of digital property transferred by means other than fixed physical media as the sale of intangible property, which is sourced to the location of the payor. This treatment is consistent with the former paragraph (e)(3) regarding computer software.

In new subparagraph (F), the comptroller treats the receipts from the delivery of digital property as a service as receipts from providing services.

In new subparagraph (G), the comptroller treats the receipts from the delivery of digital property as part of an internet hosting service as receipts from providing internet hosting services.

In new subparagraph (H), the comptroller treats the receipts from the use of digital property as receipts from the use of an intangible asset.

New subparagraphs (I) and (J) are examples of sourcing receipts from digital property. The examples illustrate that digital products lie at the intersection of multiple sourcing provisions, resulting in a complex roadmap for sourcing. Because the sourcing is dictated by statute, the complexity is unavoidable. However, many of the sourcing routes may lead to the same destination. For example, at least with regard to receipts received from individual consumers, the location where tangible personal property is delivered, the location where a service is performed, the location where the customer is located, and the location of the payor, may all be in the same state.

The comptroller moves subsection (e)(7) concerning the deemed sales of assets under IRC, §338 to new subsection (e)(22). The comptroller renumbers subsequent paragraphs accordingly.

The comptroller amends renumbered subsection (e)(7) concerning dividends and/ or interest to move the guidance related to interest to subsection (e)(12) and to retitle the paragraph accordingly. Subsection (e)(7) now contains guidance on dividends only.

The comptroller adds new subsection (e)(10) to provide guidance for sourcing receipts from the settlement of hedging contracts and other financial derivatives for risk management purposes. These types of investments are intangibles and the receipts are sourced to the location of the payor.

The comptroller adds new subsection (e)(12) to incorporate and reorganize the interest language moved from renumbered subsection (e)(7).

The comptroller amends renumbered subsection (e)(13) concerning Internet access fees to provide the comptroller's policy on sourcing receipts from internet hosting services to the location of the customer, pursuant to House Bill 500, 83rd Legislature, 2013, codified as Tax Code, §171.106(g), effective for reports originally due on or after January 1, 2014, and adds subparagraphs (A) through (E).

New subparagraph (A) defines "internet hosting service" using the language from Tax Code, §151.108(a), which Tax Code, §171.106(g) references.

New subparagraph (B) gives non-exhaustive examples of internet hosting services. These examples extend beyond what might be ordinarily considered as internet hosting services. However, the statutory definition extends beyond the ordinary meaning, as was noted by the analysis of the same definition that was proposed in House Bill 416 during the same legislative session. House Research Organization Analysis of House Bill 416, 83rd Legislature, 2013 ("A growing number of companies offering cloud computing services and products likely would fall under the definition of web hosting in the bill."). House Bill 500's specific exclusion of telecommunications service, which would not ordinarily be considered as an Internet hosting service, indicates that the Legislature was aware of the broad sweep of the definition. The specific meaning dictated by the legislation "elevate[s] the Legislature's substituted meaning even when it departs from the term's ordinary meaning." Entergy Gulf States, Inc. v. Summers, 282 S.W.3d 433, 442 (2009).

New subparagraph (C) gives non-exhaustive examples that are not internet hosting services.

New subparagraph (D) lists factors for distinguishing the purchase of access to computer services over the internet from the purchase or lease of digital property over the internet. The factors are taken from the Internal Revenue Service Notice of Proposed Rulemaking regarding "Classification of Cloud Transactions and Transactions Involving Digital Content," 84 Fed. Reg. 40317 (Aug. 14, 2019).

New subparagraph (E) provides guidance for determining the physical location of the customer. The statute refers to "the customer to whom the service is provided." The comptroller has concluded from these references that the "customer" means the purchaser, or the designee of the purchaser, that consumes the service. Thus, in a resale situation, the service provider should source the revenue to the customer's customer that actually receives the service.

The statute provides no further instruction for determining the location of the customer. New subparagraph (E) enables taxpayers to determine the most reasonable sourcing method based on the available information. The method will be subject to audit review for reasonableness under the circumstances.

The comptroller amends renumbered subsection (e)(14) addressing leases and subleases to standardize the language used throughout the section. The comptroller amends subparagraphs (C) - (E) to improve readability.

The comptroller amends renumbered subsection (e)(15) to improve readability.

The comptroller amends the title of renumbered subsection (e)(16) to include all loan servicing and adds two subparagraphs. New subparagraph (A) contains the original guidance for sourcing gross receipts from servicing loans secured by real property, pursuant to Tax Code, §171.103(a)(2). New subparagraph (B) provides guidance on sourcing gross receipts from servicing other loans that are not secured by real property.

The comptroller amends the title of renumbered subsection (e)(17) to reflect that the content applies only to loans and securities treated as inventory of the seller. The comptroller amends subparagraph (A) to state that loans and securities held by a taxable entity for investment or risk management purposes are not inventory. The comptroller adds references to information on sourcing receipts from the sale of loans and securities. The comptroller amends subparagraph (B) to reflect that the guidance applies to original reports due on or after January 1, 2008, pursuant to STAR Accession No. 201005671L (May 28, 2010).

The comptroller removes subsection (e)(20) concerning the sourcing of receipts from newspaper and magazine advertising from and incorporates the information into new subsection (e)(1) to consolidate sourcing rules for advertising.