On April 15, 2016, the Texas Supreme Court ruled that the Texas Comptroller cannot offset net losses from sales of capital assets and investments against other gross receipts in determining the Revised Texas Franchise Tax (RTFT) sales factor denominator.1 In reversing lower court rulings that had endorsed the Comptroller's regulatory interpretation of a statute, the Supreme Court ruled that the Comptroller's regulation conflicted with the plain meaning of the statute.
Background
The taxpayer, Hallmark Marketing, LLC, filed its 2008 RTFT return with a gross receipts apportionment factor denominator that excluded an overall net loss sustained by the taxpayer on the sale of capital assets and investments. This exclusion had the effect of reducing the taxpayer's Texas apportionment factor. Upon audit by the Comptroller, the taxpayer claimed that the net loss was not to be netted against other gross receipts pursuant to the plain language of the RTFT. The statute upon which the taxpayer relied stated the following: "[i]f a taxable entity sells an investment or capital asset, the taxable entity's gross receipts from its entire business for taxable margin includes only the net gain from the sale."2
The Comptroller disagreed with the taxpayer's position, pointing to a regulation interpreting the statutory language, providing that "if the combination of net gains and losses results in a net loss, the entity should net the loss against the other receipts, but not below zero."3 In line with the regulation, the Comptroller adjusted Hallmark's apportionment denominator by netting the loss against the other receipts. This adjustment decreased the denominator and increased the apportionment factor percentage, resulting in a larger RTFT liability.
District Court's Summary Judgment Ruling
Following the Comptroller's assessment, Hallmark paid the amount assessed by the Comptroller under protest and then filed suit against the Comptroller in Travis County District Court. In a motion for summary judgment, Hallmark alleged that the Comptroller's regulation violated the plain language of the statute by misinterpreting the statutory phrase "net gain from the sale" which resulted in the audit assessment.
The Comptroller also made a motion for summary judgment as a matter of law based on three substantive items of authority: (i) a statute defining the taxpayer's losses as "amounts of reportable income" deductible from everywhere receipts; (ii) regulatory authority which was a reasonable construction of the statute; and (iii) case law4 analyzing a predecessor statute requiring an offset between gains and losses to obtain a net amount. The Comptroller also procedurally argued that Hallmark could not produce evidence that it was entitled to a refund. On December 4, 2013, the District Court granted the Comptroller's motion for summary judgment as a matter of law and denied Hallmark's motion for summary judgment.5
Court of Appeals Raises Ambiguity of Statute
In affirming the District Court's ruling, the Court of Appeals focused on the Comptroller's rule, which required that with respect to the sales factor treatment of capital assets and investments, "[i]f the combination of net gains and losses results in a net loss, the taxable entity should net the loss against other receipts, but not below zero."6 The Court of Appeals was compelled to analyze the Comptroller's rule because it first determined that the underlying statute was ambiguous with respect to the phrase "net gain."7 Since the statute was ambiguous, the Comptroller was empowered with "broad discretion" to promulgate tax regulations as long as these rules did not conflict with state or federal law.8 Following an examination of the dictionary definition of "net gain," the Court of Appeals determined that the Comptroller's approach in its rule was a reasonable interpretation and was supported by case law precedent.9
Texas Supreme Court Decision Avoids Ambiguity Issues
In finding for the taxpayer, the Texas Supreme Court passed on the issue of statutory ambiguity raised by the Court of Appeals. In doing so, the Supreme Court noted that even if the statute were ambiguous, such ambiguity was irrelevant in this case because both parties agreed that the sale of the taxpayer's investments resulted in the calculation of a net loss, not a net gain.
Based on this stipulation, the Supreme Court found that the Comptroller's position requiring the inclusion of net losses in the taxpayer's calculation had the effect of impermissibly rewriting the statute. The Supreme Court began by noting that the Comptroller's reliance on the case law endorsed by the Court of Appeals was improper, given that the case clarified how to calculate Texas apportionment with a net gain, but not a net loss. Ultimately, the Supreme Court determined that the words "includes only the net gain" within the sales factor statute served to exclude consideration of net losses. Since the statute did not allow inclusion of net losses in the calculation, the Comptroller's regulation allowing for an offset of net gains with net losses exceeded the Comptroller's authority. The Supreme Court then rejected the Comptroller's argument that a net gain could actually mean a net loss if the amount of the taxpayer's losses exceeded its gains.
The Comptroller then asserted that the same methods used to account for the RTFT margin should also be used to calculate the franchise tax margin apportionment factor, so the losses had to be included in the apportionment factor since they were in the franchise tax base.10 The Supreme Court disagreed, noting that the RTFT statute requiring items excluded from total revenue to be excluded from the RTFT apportionment factor. The RTFT statute did not require inclusion of all items in total revenue to be included in the RTFT apportionment factor.11 Rather, Hallmark followed both RTFT statutes – inclusion of the net loss in total revenue, and exclusion of the net loss from the sales factor denominator. As additional support, the Supreme Court found that the general provisions contained in the franchise tax base statute was trumped by the more specific statute detailing the appropriate sales factor calculation. Accordingly, the Supreme Court came to the conclusion that the statute as written made sense, the taxpayer followed the statute, and the Comptroller adopted a rule that was not entitled to deference because it conflicted with the statute.
Commentary
In this decision, the Texas Supreme Court prevented the Comptroller from offsetting gross receipts in the denominator other than those from the sale of investments and capital assets with net losses from the sale of investments and capital assets. The statutory phrase "only net gain" is not a proxy for profit or loss, but means only accumulated net gains in excess of accumulated net losses. Taxpayers with overall net losses from the sale of assets should look to amend or alter their filing positions to make sure that these losses are not netted against the other components of the RTFT sales factor denominator. The decision represents the continuation of a recent trend in which numerous regulations and positions promulgated by the Comptroller have been overturned.
While the decision may provide immediate potential benefit for certain taxpayers that have included net losses in the RTFT sales factor denominator, there are a number of additional issues which were not directly addressed by the Supreme Court that should be considered. To begin, the decision may not have any particular application to the construction of the Texas sales factor numerator, potentially resulting in a lack of complete consistency with respect to the numerator and denominator calculations. The statute controlling what is reported in the Texas numerator for purposes of the sales factor does not reference the term "net gains."12 Therefore, an appropriately situated taxpayer with Texas losses on the sale of investments may be able to currently deduct those net losses from the Texas numerator, yet not deduct them from the denominator. Taxpayers should not assume that what applies to the Texas apportionment denominator is automatically mirrored in the Texas apportionment numerator calculation.
Likewise, the decision does not address how differences between Texas and federal statutory definitions of certain terms, like "capital assets," may impact the net gain calculation for sales factor purposes.13 It is possible that based on definitional distinctions, depreciable machinery and equipment and land, as well as intangible assets used in a business may be considered a capital asset for RTFT purposes, but not for federal income tax purposes. It is important not to ignore these classification differences before netting and calculating the RTFT sales factor.
While the decision analyzed net losses on sales of investments, the Supreme Court did not weigh in on the issue of whether a taxpayer should be including net gains or gross proceeds from the sale of investments to calculate the RTFT apportionment denominator. There is ongoing uncertainty in Texas as to precisely when the gross proceeds from the sale of investments rather than the net gain can be used in the denominator. The general rule is if the investment sold was inventory in the hands of the taxpayer when sold, the gross proceeds can be utilized. The determination of whether the investment sold was inventory may be impacted by whether such investment is governed by the federal markto- market accounting election (IRC Sec. 475). Based on Comptroller guidance, taxpayers making this federal income tax election may be allowed to use the gross proceeds in the apportionment factor.14
Footnotes
1 Hallmark Marketing Co. v. Hegar, Texas Supreme Court, No. 14-075, April 15, 2016.
2 TEX. TAX CODE ANN. § 171.105(b).
3 34 TEX. ADMIN. CODE § 3.591(e)(2).
4 Calvert v. Electro-Science Investors, Inc., 509 S.W.2d 700, 702 (Tex. Civ. App. 1974).
5 Hallmark Marketing Co. v. Combs, Texas Court of Appeals, 13th Dist., Corpus Christi, Edinburg, No. 13-14-00093-CV, Nov. 13, 2014.
6 34 TEX. ADMIN. CODE § 3.591(e)(2)(E).
7 The Court of Appeals noted that the ambiguity in the statute existed because the term "net gain" either may indicate the specific gain or loss from each individual transaction for the sale of investments and capital assets, or refer to the annual accumulated gain or loss on the sale of investments and capital assets. The Comptroller's rule took the latter approach.
8 TEX. TAX CODE ANN. § 111.002(a).
9 Calvert, 509 S.W.2d at 702.
10 The Comptroller made this argument based on the converse of the fact pattern stated in TEX. TAX CODE ANN. § 171.1055(a): "In apportioning margin, receipts excluded from total revenue by a taxable entity under Section 171.1011 may not be included in either the receipts of the taxable entity from its business done in this state as determined under Section 171.103 or the receipts of the taxable entity from its entire business done as determined under Section 171.105."
11 This inclusion is a requirement of the Comptroller's rule, 34 TEX. ADMIN. CODE § 3.591(b)(4), but not of the law.
12 TEX. TAX CODE ANN. § 171.106.
13 For RTFT purposes, a capital asset is "[a]ny asset, other than an investment, that is held for use in the production of income and that is subject to depreciation, depletion, or amortization." 34 TEX. ADMIN. CODE § 3.591(b)(1). An "investment" is "[a]ny non-cash asset that is not a capital asset." 34 TEX. ADMIN. CODE § 3.591(b)(6). In contrast, the IRC definition of "capital asset" is all property, regardless of how long held, with the exception of inventory, depreciable assets, intangibles created by the taxpayer, accounts or notes receivable, government publications, commodities derivative financial instruments held by a dealer, hedging transactions, and supplies. See IRC §§ 1221; 1231. For federal income tax purposes, investment property is property that produces investment income. Examples include stocks, bonds, and Treasury bills and notes. Property used in a trade or business is not investment property.
14 See Letter Ruling No. 201311792L, Texas Comptroller of Public Accounts, Nov. 21, 2013; TEX. TAX CODE ANN. § 171.106(f-1).
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