The Comptroller of Public Accounts adopts amendments to §3.591, concerning margin: apportionment, with changes to the proposed text as published in the November 13, 2020, issue of the Texas Register (45 TexReg 8104). The rule will be republished.

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.

The comptroller received comments regarding the proposed amendments from Jo Ellen Stark of Union Pacific; Celeste Embrey of Texas Bankers Association; Kim Chamberlain of Securities Industry and Financial Market Association (SIFMA); Chris Rosas of Rackspace; Angela Miele of Motion Picture Association; Patrick Reynolds of Council on State Taxation (COST); Dale Craymer of Texas Taxpayers and Research Association (TTARA); Sandi Farquharson of Ryan; and Brandon Newton of Crowe LLP.

Throughout the section, 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 the definition of "capital asset" in subsection (b)(1) to remove language that makes it circular with the definition of "investment" in subsection (b)(6).

The comptroller removes former subsection (b)(2), the definition of "commercial domicile," and renumbers the subsequent paragraphs as necessary. The definition 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 the definition of "Internal Revenue Code" in renumbered subsection (b)(4) to specify 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).

Sandi Farquharson of Ryan requests that following language be deleted from the definition: "Securities and loans for investment, hedging, or risk management purposes are not inventory." However, the comptroller will retain the language because it is an accurate statement that will assist auditors and taxpayers in determining what is and is not inventory.

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

The comptroller amends the definition of "legal domicile" in subsection (b)(7) to remove the definition of "principal place of business" because the term will be separately defined in subsection (b)(9).

The comptroller adds new subsection (b)(9) to define "principal place of business" for all taxable entities. The definition is based on the United States Supreme Court decision, Hertz Corp. v. Friend, 559 U.S. 77, 92 (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.

Sandi Farquharson of Ryan comments that the parenthetical reference to IRC § 475(c)(2) in subsection (b)(11) should be "Security Defined" rather than "Mark to market accounting method for dealers in securities." The comptroller lists the title of the section rather than the title of the paragraph within the section. Therefore, the comptroller declines to make this change.

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 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.

Angela Miele of MPA requests that subsection (e)(1) be applied prospectively since it changes the sourcing of receipts for radio/television advertising transmitted from a location in Texas. The comptroller amends subsection (e)(1) to retain the option to source these receipts for prior periods based on the transmitter location, as provided in former subsection (e)(22).

The comptroller restructures subsection (e)(2) concerning capital assets and investments into new subparagraphs, and revises the treatment of the sale of investments and capital assets. To be 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 of the statute is that "net gain" refers to the net amount resulting from proceeds of an asset sale reduced by the adjusted basis in the asset. Because the statute only permits the inclusion of net gains, the net loss from the sale of one asset cannot be used to offset the net gain from another asset.

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 the "net gain," that is, a positive amount resulting from the proceeds from an asset sale less the asset's adjusted basis, is included in gross receipts, and the net gain should not be neutralized by net losses on other transactions.

Accordingly, new subparagraph (A) provides that only the "net gain" from the sale of an investment or capital asset should be included in gross receipts. New subparagraph (B) defines "net gain." New subparagraph (C) retains the legacy rule for legacy periods. New subparagraph (D) provides that sourcing as a Texas or non-Texas receipt is determined by the asset type. And new subparagraph (E) provides examples.

Celeste Embrey of TBA and Kim Chamberlain of SIFMA request that subsection (e)(2) still allow the netting of gains and losses. Both argue that computing the net gain or loss separately for each sale would cause undue burden and not allowing the netting of the losses could exclude a material segment of a taxpayer's business. The comptroller disagrees. The addition of only net gain involves fewer transactions than the addition of net gains and net losses, and it is the offsetting of gains with losses that could result in the exclusion of a material segment of a taxpayer's business.

Additionally, Sandi Farquharson of Ryan argues that the comptroller does not have the authority to limit the losses with respect to Texas receipts without a legislative change because Section 171.103 does not contain the same language as Section 171.105 with regards to including "only the net gain." The comptroller addressed this argument in STAR Accession 202001008L (January 22, 2020): "Although the 'net gain' language only appears in Section 171.105 for gross receipts everywhere, we will also apply the Hallmark decision to the calculation of Texas gross receipts. There must be symmetry between Texas gross receipts and gross receipts everywhere." Therefore, the comptroller declines to make this change.

Revised subsection (e)(3) 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 (I). The title is changed accordingly.

New subparagraph (A) treats the sale of software installed on computer hardware as part of the sale of the computer hardware.

New subparagraph (B) treats the lease of software installed on computer hardware as part of the leasing of the computer hardware.

New subparagraph (C) 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).

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

New subparagraph (E) 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.

New subparagraph (F) treats the receipts from the delivery of digital property as a service as receipts from providing services.

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

New subparagraph (H) treats the receipts from the use of digital property as receipts from the use of an intangible asset.

New subparagraph (I) provides two 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.

Brandon Newton of Crowe LLP requests a more robust definition of "digital property" and a clearer distinction between the sale of digital property and the delivery of digital property as a service. Subparagraph (C) of subsection (e)(3) identifies "digital property" as "computer programs and any content in digital format that is either protected by copyright law or no longer protected by copyright law solely due to the passage of time." Also, subparagraph (D) of subsection (e)(13) identifies factors that may be considered in distinguishing the purchase of access to computer services over the internet from the purchase or lease of digital property. The comptroller believes that these provisions, along with the examples in subparagraph (I) of subsection (e)(3), will be sufficient guides to auditors and taxpayers.

The comptroller moves former 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), which formerly concerned both dividends and 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.

Sandi Farquharson of Ryan comments that the subsection (e)(10) is unnecessary as it does not serve any different purpose from subsection (e)(17), concerning loans and securities treated as inventory of the seller. She also restates her comments to the definition of "inventory" in subsection (b)(5). For the reasons stated in the discussion of subsection (b)(5), the comptroller declines to make changes to subsection (e)(10). Subsection (e)(10) will alert auditors and taxpayers that these types of financial derivatives are not considered to be inventory for the purpose of subsection (e)(17).

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 more clearly explain the sourcing of 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.

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