United States: Texas Margin Tax Rate Debate—Controversies Ensue

Under current Texas law, companies generally pay a franchise tax, known as the "Texas margin tax," at the default rate of 1 percent of their taxable margin. Companies engaged primarily in retail or wholesale trade are taxed at a ½ percent rate. Qualification for the reduced rate has generated debate between taxpayers and the Texas Comptroller, who is taking a fairly aggressive stance on this issue. Taxpayers in Texas should carefully review the areas of controversy.

Fundamentals of Qualification for the Lower Tax Rate

Enacted in recognition of the low profit margins basic to retail and wholesale industries,¹ Section 171.002(b) of the Texas Tax Code gives qualified taxpayers a significant benefit in the form of the reduced margin tax rate of ½ percent. Generally, entities can qualify for the reduced rate only if: (1) the total revenue from their activities in retail or wholesale trade is greater than the total revenue from their activities in trades other than the retail and wholesale trades; (2) less than 50 percent of total revenue from activities in retail or wholesale trade comes from the sale of products produced by the entities or by any member of their affiliated group; and (3) the entities do not provide retail or wholesale utilities.²

The first major requirement for the reduced tax rate is that revenues from retail-trade or wholesale-trade activities must be greater than revenue earned from other activities. The statute does not specifically require the total retail or wholesale revenue of a business to exceed 50 percent in order to qualify. This poses interesting questions for a company with three or more major sources of revenue, like a software company that sells software, provides installation and implementation services, and also offers IT support to the general public. If 40 percent of the company's revenue comes from retail sales, 30 percent comes from implementation services, and 30 percent from the IT support, will it qualify for the reduced rate under the statute? Likely yes, as the language of the code indicates that such a company should be eligible for the retailer rate.

The second major requirement for the reduced rate is that less than 50 percent of the taxpayer's retail or wholesale revenue may come from the sale of products produced by the taxpayer or a member of its affiliated group. For purposes of the margin tax, "affiliated group" is defined as a group of entities in which a controlling interest is held by a common owner or by one or more of the member entities.³ This requirement is aimed at preventing manufacturers from utilizing the lower tax rate, but it also presents potential tax-planning opportunities. For example, a company that sells goods it manufactures and goods from other sources could subcontract out its manufacturing operations to an unrelated party. The company would no longer sell goods produced by the entity or a member of its affiliated group. Thus, the company would be able to qualify for the reduced rate.

Defining "Retail Trades" and "Wholesale Trades"

The major dilemma for the taxpayer in attempting to decide its appropriate tax rate is determining whether it meets the definition of "retailer" or "wholesaler." For purposes of the margin tax, "retail trades" and "wholesale trades" are defined as the activities described in Divisions G and F (respectively) of the 1987 Standard Industrial Classification (SIC) Manual published by the Federal Office of Management and Budget.⁴ The taxpayer needs to be familiar with the basics of the SIC manual and the activities described in the relevant divisions in order to determine which rate is appropriate for its business.

Division G of the 1987 SIC defines "retailers" as:

establishments engaged in selling merchandise for personal or household consumption and rendering services incidental to the sale of the goods. In general, retail establishments are classified by kind of business according to the principal lines of commodities sold (groceries, hardware, etc.), or the usual trade designation (drug store, cigar store, etc.). Some of the important characteristics of retail trade establishments are: the establishment is usually a place of business and is engaged in activities to attract the general public to buy; the establishment buys or receives merchandise as well as sells; the establishment may process its products, but such processing is incidental or subordinate to selling; the establishment is considered as retail in the trade; and the establishment sells to customers for personal or household use. Not all of these characteristics need be present and some are modified by trade practice.

Division F of the 1987 SIC defines "wholesalers" as:

The SIC system was developed in the 1930s by the federal government to classify industries by a four-digit code.⁵ In 1997, the SIC manual was replaced by the six-digit North American Industry Classification System, though certain government departments and agencies continue to use the SIC codes.⁶ The purpose of the manual, according to its introduction, is to classify "the entire field of economic activities." The SIC manual breaks down this field of economic activities into 11 "divisions" of activities, each of which is further broken down into "major groups" classified by two-digit codes, which in turn are divided into three-digit "industry groups" and then into four-digit "industries." Many of these "industries" are described very specifically.

Generally, broader SIC categories control over subcategories.⁷ Therefore, if a company is not described by the divisional group, it should not be classified in any of the subcategories of the division. For example, a company falling under Division I of the manual that leases and sells furniture to private individuals might consider reporting under the SIC code for "Equipment Rental and Leasing." However, this code falls under Major Group 73, "Business Services," which includes establishments engaged primarily in rendering services to businesses. Because the broader major group code is inappropriate, the more narrow category should not apply.

The Tax Code references activities described in Division G or F, not subcategories under those divisions. Thus, any exclusionary language in the subcategories under Division G or F (or any inclusive language in a subcategory under any other division) should not control over the language in Division G or F as a whole. For example, a retailer that could arguably fit into a subcategory under another division should nonetheless be classified in Division G as a retailer.

When a company is determining its SIC code, it should first determine the most appropriate division before looking to the more specific industry descriptions. Following this hierarchy will help taxpayers eliminate error. Where possible, each company should report a specific industry code rather than a catchall code used for unclassifiable miscellaneous activities. Again, locating the specific code most applicable is made easier by first determining the appropriate division of the business. More than a theoretical exercise, classifications under the SIC manual have real-world implications. A company that properly reports its SIC code can save considerably more time and money than a company that fails to do so.

We have assisted a large taxpayer that obtains substantial tax savings by carefully analyzing and correcting a mistakenly reported SIC code. Careful analysis may show that the taxpayer qualifies for the lower rate or that it should take steps to mitigate an underreporting error.

Examples of Classification Complexity

Consider the example of a wholesaler that develops and sells software to retailers. The company seems to qualify under the general definition of Division F, which includes establishments engaged in the sale of merchandise to retailers. In fact, Division F includes an industry code for "Computers and Computer Peripheral Equipment and Software," which classifies companies engaged in wholesale distribution of software. However, Division I of the manual, which classifies services, also includes a seemingly applicable industry code for "Prepackaged Software." This SIC code is used by establishments engaged primarily in the design, development, and production of prepackaged computer software. In this type of situation, determining the appropriate code requires a consideration of the manual's hierarchy. First, the company must look to the division descriptions. The company sells merchandise; it does not provide a service. Therefore, it should use a code in Division F and report the "Computers and Computer Peripheral Equipment and Software" code.

To reiterate some key points, to qualify for the ½ percent rate, a plurality of the company's total revenue must come from the activities described in Divisions G and F of the SIC manual. The SIC that was reported to the Comptroller is not controlling. For example, a given business may have reported a SIC outside Division G or F but may nevertheless qualify for the ½ percent rate depending on its activities.

Problems in determining the proper code may arise where both the language in the Tax Code and the structure of the SIC manual are applied to complex specific activities. For example, there is no guidance in the SIC manual regarding the definition of "selling" in the context of a retail transaction. Nor is it clear where the line is drawn for the Division G subcategory "Rendering Services Incidental to the Sale of the Goods."

Again, taking up the example of a software company, consider a situation in which a business sells software to consumers and also offers implementation services. Assume that the implementation services account for a majority of its revenue. It would seem as though this company must use the 1 percent rate because the company earns more revenue through services than through the sale of software. However, the implementation activities undertaken are incidental to the sale of the software and are arguably activities described in Division G of the SIC manual. Would such a company qualify for the lower rate? There is not yet a clear answer in the margin tax context.

Many Taxpayers Are Being Challenged

The Comptroller's Office is taking a tough stance on the ½ percent rate issue. In the 2011 fiscal year, Texas budgetary shortfalls are estimated to be anywhere between $15 billion and $18 billion.⁸ Contributing in part to this shortfall is the margin tax: when passed in 2006, the tax was expected to generate $6 billion in revenue each year.⁹ This year, the tax was expected to generate only $4.3 billion, and actual returns may be lower.¹⁰ One reason for the shortfall relates to the higher-than-expected number of entities claiming the ½ percent rate. It is not surprising, then, that auditors are taking a careful look at those businesses using the reduced rate.

Who Is Most at Risk?

Based on discussions with Comptroller officials, there are reportedly 1,319 active margin tax field audits and 569 active margin tax desk audits involving the tax rate and other issues.¹¹ Additionally, approximately 1,000 taxpayers have received notices from the Comptroller that they are improperly claiming the ½ percent tax rate.¹² This issue is on the Comptroller's radar. Rate-reporting errors could be costly to taxpayers.

Taxpayers at risk of audit and tax controversy should start mitigating their damages by taking steps to correct the problems going forward and addressing past errors. The following are examples of companies that may be at risk for controversy:

• Companies that inadvertently report nonqualifying SICs through clerical error but use the ½ percent rate.
• Companies claiming the ½ percent rate whose reported SICs are not within Division G or F (e.g., pure service companies).
• Companies involved in industries where there are gray areas. For example, companies that are primarily engaged in leasing transactions are arguably entitled to the ½ percent rate because of the ambiguity in the definition of "selling" in the SIC manual.¹³

Who May Qualify for the Reduced Rate but Is Overpaying?

Given the complicated definitional issues, some companies eligible for the reduced rate may be unaware that they qualify for, and are therefore missing out on, significant tax savings. The following are examples of companies at risk for missing out on refund opportunities:

• Companies whose activities fall within the broad language in Division G or F but are specifically described in subcategories under nonqualifying SICs (like leasing to consumers).
• Companies that report SICs outside Division G or F for nonmargin tax purposes but obtain the majority of their income from retail or wholesale trade.
• Companies engaged in business activities not contemplated by the SIC manual, which has not been updated since 1987. For example, a retailer whose sales are made via the internet does not fit neatly into any major group listed under Division G and may consider itself ineligible for the reduced rate.
• Companies whose activities are described by Division G or F but which incorrectly navigate the SIC manual structure and self-report SIC codes that are less appropriate to their business.
• Companies that applied a "greater than 50 percent" test to determine their qualifications for the reduced rate instead of examining the majority of revenue from multiple activities.

What's the Rush?

As noted above, auditors are reviewing margin tax returns and are familiar with the questions surrounding the ½ percent rate. So far, many questions remain unanswered. As pressure builds to narrow the gap between the estimated revenue of the margin tax and the actual revenue, there may be increased pressure to release guidance unfavorable to taxpayer positions. Additionally, as these issues are contested, the chances of unfavorable revenue rulings and private letter rulings increase. The creation of adverse rules or the publication of unfavorable rulings may make it more difficult for taxpayers to receive the benefits of the lower tax rate. Accordingly, it is important that taxpayers address rate issues sooner rather than later, to ensure themselves the best chance of favorable resolution.

Taxpayers should take action now to: correct mistakenly reported SIC codes, evaluate currently reported SIC codes for appropriateness, consider the applicability of the lower rate to taxpayers not reporting SIC codes in Division G or F who otherwise qualify, and reconsider qualification in light of the plurality-of-revenue test present in the Tax Code.

As discussed above, in our experience, taxpayers caught in the rate debate fall into one of two categories: (1) taxpayers that claimed the ½ percent tax rate and are now facing a dispute with the Comptroller; and (2) taxpayers that used the 1 percent rate when arguably under the statute they qualify for the ½ percent rate. The implications can be huge. We have helped companies save millions by correcting the problems promptly. Our success is based, in part, upon having decades of experience successfully resolving issues with the Texas Comptroller. We have built and are able to draw upon solid relationships with key officials at both the Comptroller's Office and the Office of the Attorney General to efficiently resolve these and other issues related to the Texas margin tax. We would be happy to discuss these issues with any affected taxpayer.

Footnotes

1 Texas Tax Reform Commission, Section by Section Analysis, Tax Reform Version 79S30236, Section 2.01.

2 Tex. Tax Code § 171.002(c).

3 Tex. Tax Code § 171.0001(1).

4 Tex. Tax Code § 171.0001(12) & (18).

5 The History of NAICS, North American Industry Classification System Association, 2009, available at www.naics.com/info.htm (all web sites herein last visited March 3, 2011).

6 Id.

7 The Texas Tax Code incorporates the activities described in Divisions F and G, not the activities described in the subcategories. Tex. Tax Code § 171.0001(12) & (18).

8 Ben Philpott, TX Budget Committee Chair Predicts $18 Bil Hole, THE TEXAS TRIBUNE, available at http://www.texastribune.org/texas-taxes/2011-budget-shortfall/tx-budget-committee-chair-predicts-18-bil-hole/ (May 11, 2010).

9 Robert T. Garrett, Combs aide: Franchise tax take off half a bil, THE DALLAS MORNING NEWS, Trailblazers Blog, available at trailblazersblog.dallasnews.com/archives/2010/08/combs-aide-franchise-tax-take.html (August 23, 2010).

10 Id.

11 Mike Reissig, Assoc. Deputy Comptroller, Franchise Tax Analysis and Audit Update, Presentation to the House Ways & Means Committee (August 17, 2010).

12 Id.

13 See TLH Enterprises, Inc. v. Combs, et al., No. D-1-GN-10-002768, Texas Comptroller of Public Accounts.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.