Invalidates application of net gain sourcing regulation
On April 15, 2016, the Texas Supreme Court issued its decision in Hallmark Mktg. Co. LLC v. Hegar, holding that, for the purposes of determining the impact of apportionment factor representation of receipts from the sale of assets, a taxpayer could not be required to reduce its denominator by the amount of total net losses in excess of net gain.
In determining taxable margin for Texas franchise tax purposes, a business must multiply its total margin by an apportionment factor that consists of receipts from business conducted in Texas in the numerator and receipts from all business everywhere in the denominator (see, Texas Code (TC) Secs. 171.101 and 171.106). Pursuant to TC Sec. 171.105(b), “[i]f a taxable entity sells an investment or capital asset, the taxable entity’s gross receipts from its entire business for taxable margin purposes includes only the net gain from the sale.” The Texas Comptroller of Public Accounts has issued interpretative regulations regarding this provision, stating “[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” (see 34 Texas Administrative Code (TAC) Sec. 3.591(e)(2)).
In filing its franchise tax report for 2008, Hallmark took the position that the Comptroller’s administrative regulation was in conflict with TC Sec. 171.105(b), and that the application of TAC Sec. 3.591(e)(2) to require Hallmark to offset its other receipts with its total net losses in computing its Texas apportionment factor denominator was a regulatory overstep by the Comptroller. On audit, the Comptroller determined that, under TAC Sec. 3.591(e)(2), Hallmark was required to offset its other receipts with its total net losses in computing its Texas apportionment factor denominator, and assessed additional tax resulting from the increase of the ratio of Texas receipts to total receipts. Hallmark appealed, and lost at trial and before the Texas Third Court of Appeals on the grounds that TC Sec. 171.105(b) was ambiguous, and that, therefore, the application of TAC Sec. 3.591(e)(2) was valid. Hallmark appealed to the Texas Supreme Court, which reversed these prior decisions and held in Hallmark’s favor.
In reaching its decision, the Texas Supreme Court rejected the relevance of the statutory ambiguity on which the trial and appellate courts relied, and stated that the question of whether to net gains against losses was not at issue. Instead, the question for the court was whether overall net losses from the sale of assets should be used to offset other receipts, such as those from the sale of services or inventory. On this narrow matter, the court focused on the plain meaning of TC Sec. 171.105(b), which addresses solely the inclusion of the net gain, and does not in any way contemplate factor representation of overall net losses. Accordingly, to the extent that TAC Sec. 3.591(e)(2) required taxpayers to offset other receipts with overall net losses, the regulation exceeded the statutory authority.
As a result of this decision, taxpayers with overall net losses from the sale of assets should review the computation of their Texas apportionment factor to make sure that they do not offset other receipts with overall net losses in either the numerator or denominator going forward and for all open years. Where net losses have previously been represented in the numerator, or where numerator representation outweighs denominator representation, taxpayers should consider whether additional taxes may be due as a result of an increase in Texas-sourced margin. Where net losses have previously been represented in the denominator, or where denominator representation outweighs numerator representation, taxpayers should consider whether refunds may be due as a result of a decrease in Texas-sourced margin.
Further, from a broader perspective, this ruling represents another in a recent string of court decisions finding that regulations and other quasi-regulatory activities by state taxing authorities have overstepped the bounds of the statutory authority. Where a taxpayer has a material liability stemming from a filing position that is based solely on guidance by a state taxing authority, it could be beneficial to review the statutory structure to determine whether that guidance is properly supported.