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Texas Margin Tax on Business Entities. Texas Margin Tax - Agenda. Background Comparison to current law Detailed analysis Application and planning Financial reporting. Texas Margin Tax – Background.

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Texas Margin Tax on Business Entities


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    Presentation Transcript
    1. Texas Margin Taxon Business Entities

    2. Texas Margin Tax - Agenda • Background • Comparison to current law • Detailed analysis • Application and planning • Financial reporting

    3. Texas Margin Tax – Background • Texas Supreme Court holds that Texas system of funding schools violates Texas constitutional prohibition of a state-wide property tax, Neeley v. West Orange-Cove I.S.D. (Nov. 22, 2005) and established a June 1, 2006 deadline for a legislative fix. • Governor Perry appoints John Sharp to chair a Tax Reform Commission to recommend reform of the state’s business tax structure to close loopholes, broaden the base of businesses that pay the tax, and provide significant property tax relief. • HB 3 (margin tax) enacted in special session and signed by Governor Perry May 18, 2006. Part of a package of bills that included property tax relief.

    4. Texas Margin Tax – Background Old Law - Delaware Sub “Loophole” Texas Corp. Delaware Corp. Texas Corp. Gen. Partner Ltd. Partner (No Texas nexus) Limited Partnership Texas Operations Partnership not a taxable entity, Delaware Corp. not taxable (no nexus), and dividend income from Delaware Corp. sourced to location of payor (Delaware)

    5. Texas Margin Tax – Background • Solutions Considered • Tax the partnership • Tax the limited partner (attributed nexus) • Solution Adopted • Tax the partnership • Constitutional? • Texas Constitution Art. VIII, §24(a): “a tax on the net incomes of natural persons, including a person’s share of partnership and unincorporated association income…not take effect until approved by a majority of registered voters…” (known as the “Bullock amendment”)

    6. Texas Margin Tax – Background Old Law - “Geoffrey Loophole” Parent Co. Texas Corp. Delaware Intangible Holding Co. Royalty for use of Intangibles Texas Operations Intangibles • Delaware Intangible Holding Co. not subject to Texas franchise tax (no nexus) • Solution: combined reporting

    7. Texas Margin Tax - Comparison to Current Law

    8. Texas Margin Tax - Comparison to Current Law

    9. Texas Margin Tax - Comparison to Current Law

    10. Texas Margin Tax - Comparison to Current Law

    11. Texas Margin Tax - Comparison to Current Law

    12. Texas Margin Tax - Comparison to Current Law

    13. Texas Margin Tax - Comparison to Current Law

    14. Taxable Entities Partnership Corporation Banking Corporation Saving and Loan Association Limited Liability Company Business Trust Professional Association Business Association Joint Venture Joint Stock Company Holding Company Other Legal Entity “Combined Group” Non-Taxable Entities Joint Operating arrangements electing out of IRC subchapter K Sole proprietorships General partnership directly owned only by natural persons Passive entities Entity exempt under Ch. 171(B) Escrows REMICS (IRC § 860) Estate of Natural Person Certain: Grantor trusts Estates Family limited partnerships Passive investment partnerships Trusts REITS Texas Margin Tax – Taxable Entities

    15. Texas Margin Tax - Nontaxable Entities • Passive Entity § 171.0003 • Must be a general partnership, limited partnership or trust that is not a business trust • At least 90% of Federal gross income for measurement period must be: • dividends, interest, foreign currency exchange gain, certain payments with respect to notional principal contracts or financial instruments, option premium and income from LLCs. • positive distributive shares of partnership income • gain from the sale of real property, traded commodities and securities • bonuses, royalties, delay rentals from mineral properties and income from nonoperating mineral interests • No more than 10% of Federal gross income (presumably for the same measurement period) is from conduct of an active trade or business. (?) • Passive income not treated as active even if earned in an active business. (But Instructions for 2007 Information Reports are contrary) • Rent and income from mineral properties operated by an affiliated group member under a joint operating agreement are always active income.

    16. Texas Margin Tax - Nontaxable Entities • Family Limited Partnerships • § 171.0002(c)(4) . . . not taxable if: • A passive entity; and (?) • ≥ 80% owned directly or indirectly by members of same family, including ancestors and lineal descendants • A limited partnership formed under Texas or another state’s law or treated as a partnership for federal income tax purposes

    17. Texas Margin Tax - Non-Taxable Entities • Passive Investment Partnerships • § 171.0002(c)(5) & (6) . . . not taxable if: • A passive entity, and (?) • Formed under the limited partnership laws of Texas, another state or any foreign country. • Trusts • § 171.0002(c)(7) . . . not taxable if: • A passive entity, and (?) • Taxable as a trust under IRC § 641 • All beneficiaries are natural persons or 501(c)(3) charities • Not taxable as a “business trust” under § 301.7701-4(b); and • Described in 7701(a)(30)(e) of IRC.

    18. Texas Margin Tax - Non-Taxable Entities • REITS and “qualified REIT subsidiary entities” (IRC § 856 defined) • § 171.0002(c)(8) . . . not taxable unless: • REIT holds “any amount” of its assets in direct holdings of real estate not occupied by the REIT for business purposes. • An entity that holds a direct interest in real estate is not exempt as a REIT, even if owned by a REIT. • Grantor Trusts • § 171.0002(c)(1) . . . not taxable if: • A grantor trust as defined in IRC §§ 671 & 7701(a)(30)(E) [i.e., a “US” trust], and • All grantors are natural persons or 501(c)(3) charities, and • It is not a trust taxable as a business entity under Reg. § 301.7701-4(b).

    19. Texas Margin Tax – Type of Tax • Tax imposed on each “taxable entity” that • does business in this state, or • is chartered or organized in this state • Not an “income tax” HB3 §21 (?) • Effect = P.L. 86-272 (restrictions on taxation of out-of-state entities) does not apply to the tax • Deductible in other states? • NB: is an income tax for financial reporting (FAS 109) purposes

    20. Texas Margin Tax – Measurement • Measurement Periods • Generally imposed for current calendar year based on business done in most recently ended prior accounting period (i.e., 2008 tax is based on 2007 FYE business) • Complicated rules regarding initial tax calculations for newly formed entities are retained. §§171.151-153, 171.201. • Additional tax on termination (a/k/a “exit tax”) is also retained. §171.0011 • Exit tax not imposed on a taxable entity that becomes a passive entity. §171.0011(e)

    21. Texas Margin Tax – Reporting Method • Combined Reporting Requirement • Required of all taxable entities that are part of an affiliated group that is engaged in a unitary business. Treated as a single taxable entity for margin tax purposes. § 171.1014

    22. Texas Margin Tax – Reporting Method • Affiliated Group Test - § 171.0001(1), (8) • Affiliated group = group of one or more entities in which a controlling interest is owned by a common owner or owners. • Controlling Interest = • Corporation: • ≥ 80% direct or indirect ownership of voting power; or • ≥ 80% direct or indirect ownership of beneficial ownership of voting stock (different than voting power?) • Other entities: • ≥ 80% direct or indirect ownership of capital, profits or beneficial interest.

    23. Texas Margin Tax –Reporting Method • Unitary Business Test § 171.0001(17) • Divisions or entities that are “sufficiently interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow of value to the separate parts.” • Factors • Whether activities of group members are in same general line of business or are steps in a vertically structured business • Whether members are functionally integrated through strong centralized management • Concept of unitary has been in franchise tax since § 171.1061 was added in response to Allied Signal, 504 U.S. 768 (1992)

    24. Corporation B Corporation A (Service Partner) 90% capital 20% profit 10% capital 80% profit Partnership Texas Margin Tax –Reporting Method • No common ownership of A or B. • Unitary with both A and B • Which group is partnership in? A’s, B’s or both?

    25. Texas Margin Tax –Reporting Method • Combined reporting required? Cf. IRC § 1563(a)(2) (lowest common ownership percentage).

    26. Texas Margin Tax – Basic Calculation A. Combined reporting required for certain affiliated groups. B. Cash Compensation limited to $300,000 per individual. C. Gross receipts for apportioning margin differ from total revenue.

    27. Texas Margin Tax – Calculation of Margin • Margin is generally the lesser of • 70% of taxable entity’s total revenue; or • Total revenue less, at entity’s election, either • Cost of Goods Sold (COGS) or • Compensation §171.101(a)(1) • Election to deduct either COGS or compensation is a year by year election and can be changed by filing an amended report. §171.101(d)

    28. Texas Margin Tax – Calculation of Margin • For corporations total revenue is the sum of the amounts on line 1(c) and 4 through 10 of the Form 1120

    29. Texas Margin Tax – Calculation of Margin • Corporate Subtractions: • bad debts • certain foreign income • income allocated to corporation from or by partnerships, S corporations, trusts, LLC’s and disregarded entities (avoids multiple taxation of same revenue) • Form 1120 Schedule C deductions (i.e., dividend received deductions, to extend dividends included in income) § 171.1011(c)(1)(B)

    30. Texas Margin Tax – Calculation of Margin • Partnerships • Total revenue is the sum of the amounts on lines 1(c) and 4 through 7 of Form 1065 and on lines 2 through 11 of Form 1065 Schedule K (see next slide) • Subtractions are similar to corporate subtractions • bad debts • certain foreign income • income allocated to partnership from or by another partnership, trust, LLC, disregarded entity and S corporation

    31. Texas Margin Tax – Calculation of Margin

    32. Texas Margin Tax – Calculation of Margin • Other Entities • Margin is computed in a manner substantially similar to rules for corporations and partnerships as determined by Comptroller rules. §171.1011(c)(3) • Consolidated group members • Corporations that are part of consolidated Federal returns compute margin as if a separate federal return had been filed (which will then be combined with other members of the Texas combined report). §171.1011(d)

    33. Texas Margin Tax – Calculation of Margin • Provisions to Avoid Double-Counting • Deduction for Income from Pass-Through Entities • Taxable entity can deduct net income from federal pass-through and disregarded entities. §171.101(c)(1)(B)(iii), (iv) • Can’t exclude income from a passive entity (PE) §171.1011(e) • Note: Owners can election to pay tax on behalf of the pass-through entity. §171.1015. • Exclusion of income from passive entity • Margin of taxable entity does not include income from a passive entity (PE) not in a combined report to the extent attributable to margin of a taxable entity. §171.1011(e) • Applies when taxable entity owns a PE, which in turn owns a lower-tier pass-through taxable entity (a PE “sandwich”)

    34. Texas Margin Tax – Calculation of Margin • Provisions to Avoid Double-Counting (con’t) • Flow-through funds §171.1011(f) – (g-3) • Items mandated by law or fiduciary duty (e.g., sales tax). • Items mandated by contract involving only the following: • Sales commissions to non-employees • Tax basis of securities underwritten • Subcontracting payments for services, labor, or material provided in connection with real property construction or surveying • Lending institution’s proceeds from loan principal repayments • Tax basis of securities and loans sold • Legal services entity’s flow through funds and reimbursements for out-of-pocket costs • Flow-through funds exclusion is not applicable if receipt is paid to an affiliated group member §171.1011(g)

    35. Texas Margin Tax – Calculation of Margin • Provisions to Avoid Double-Counting (con’t) • Staff leasing company can exclude payments received from clients for wages etc. of assigned employees §§171.1011(k), 171.0001(11) • Management companycan exclude reimbursements of costs incurred to conduct the business of the managed entity, including wages and cash compensation §§171.1011(m-1), 171.0001(11) • Other Revenue Exclusions • Dividends and interest on federal obligations §171.1011(m)

    36. Texas Margin Tax – Calculation of Margin • Health Care Providers §171.1011(n) • Exclude from revenue payments received • under Medicaid program, Medicare program, Indigent Health Care and Treatment Act, and Children’s Health Insurance Program (CHIP); • for professional services provided in relation to a workers’ compensation claim; and • for professional services provided to a beneficiary rendered under the TRICARE military health system. • Exclude from revenue the cost for uncompensated care • Health care provider = taxable entity that participates as a provider in programs listed above

    37. Texas Margin Tax – Calculation of Margin • Health Care Institution §171.1011(o) • Excludes from revenue 50% of the amounts that can be excluded by a health care provider • Federal Facilities Operator §171.1011(q) • Exclusion for revenue received from the operation of a facility on federal property or to house U.S. armed forces • Small Oil and Gas Producers §171.1011(r) • Exclusion for revenue from oil and gas produced from small oil and gas wells on days when WTI <$40/bbl and gas <$5/MMBtu

    38. Texas Margin Tax – Calculation of Margin • Cost of Goods Sold (COGS) Deduction §171.1012 • Goods = real or tangible personal property sold in the ordinary course of business • "Production" includes construction, installation, manufacture, development, mining, extraction, improvement, creation, raising, or growth • COGS generally computed in accordance with federal methods, including IRC §263A

    39. Labor costs and materials Handling and storage costs (including pre- and post-production costs) Depreciation, depletion, and amortization Rental or lease expenses for equipment, facilities or real property directly used for production of goods (including IDC and dry hole costs) Repair and maintenance of production equipment, facilities and real property Research, experimentation, engineering, and design activities related to production of goods Geological and geophysical exploration costs Taxes on materials and services Cost of producing or acquiring electricity sold Partnership contributions to fund production of goods distributed in-kind to the contributing partner Deterioration, obsolescence, spoilage, or abandonment Insurance on production equipment, facilities and goods Utilities Quality control Cost of acquiring rights to produce goods Texas Margin Tax – Calculation of Margin • COGS includes all direct costs of acquiring or producing the goods, including:

    40. Texas Margin Tax – Calculation of Margin • Indirect/Overhead Costs • COGS includes indirect or administrative overhead costs allocable to the acquisition or production of goods • Limited to 4% of total indirect or administrative overhead costs • Includes all mixed service costs, such as security services, legal services, data processing services, accounting services, personnel operations, and general financial planning and financial management costs

    41. Texas Margin Tax – Calculation of Margin • Items specifically excluded from COGS include: • Selling costs • Distribution costs • Advertising costs • Idle facility expense • Rehandling costs • Successful and unsuccessful bidding costs • Interest • Income taxes • Strike expenses • Officers’ compensation • Costs of facilities on federal government property and housing military • Compensation paid to undocumented workers

    42. Texas Margin Tax – Calculation of Margin • Special COGS Rules • Lending institution’s COGS = interest expense §171.1012(k) • Certain rental activities • Motor vehicle, heavy construction equipment, and railcar rolling stock rental and leasing treated as selling for purposes of deduction cost of goods sold. §171.1012(k-l) • Arm’s length standard • Costs paid to a member of payor’s affiliated group but not included in payor’s combined group are deductible only if made in a transaction at arm’s length. §171.1012(l) • Appears to disallow deduction completely, not just the amount in excess of arm’s length.

    43. Texas Margin Tax – Calculation of Margin • Compensation Deduction §171.1013 • Compensation generally includes: • Wages and cash compensation paid to employees, officers, directors, owners, and partners • limited to $300,000 per person (CPI adjusted in 2009) plus • Federally deductible cost of benefitsfor such persons (including workers compensation, health care, and employer contributions to health savings accounts and qualified retirement plans) • No deduction for payments to undocumented workers

    44. Texas Margin Tax – Calculation of Margin • Wages and Cash Compensation • Generally, Form W-2, Box 5 Medicare wages and tips (includes deferred compensation) • Net distributive income of natural persons from partnerships, trusts, and S corporations (including LLCs treated as a partnership or S corporation) • Stock awards and stock options deducted for FIT purposes §171.1013(a)

    45. Texas Margin Tax – Calculation of Margin • Staff Leasing Companies §171.1013(d), (e) • Leasing company deducts compensation only for its own employees, and not for assigned employees • Client company deducts payments to leasing company for wages and benefits of assigned employees as if the assigned employees were actual employees of client • Cannot deduct any administrative fee • Cannot deduct any other amount, including payroll taxes • Leasing company revenue exclusion is in §171.1011(k)

    46. Texas Margin Tax – Calculation of Margin • Management Companies §171.1013(f), (g) • Management company can’t deduct compensation costs that are reimbursed by a managed entity • Managed entity deducts reimbursements made to management company for compensation of leased employees as if the reimbursements were paid to employees of the managed entity • Cannot deduct any administrative fee • Cannot deduct any other amount, including payroll taxes • Management company revenue exclusion is in §171.1011(m-1)

    47. Texas Margin Tax – Calculation of Margin • Federal Facilities Operators §171.1013(h) • Can’t include as wages or cash compensation amounts paid to an employee associated with the operation of a facility on federal property or for housing U.S. armed forces • Federal facilities operators’ revenue exclusion is in §171.1011(q)

    48. Texas Margin Tax – Calculation of Margin • Combined Reporting §171.1014 • A combined group is a single taxable entity • Total revenue for the combined group is sum of each member’s separate revenues less intragroup revenues. • Single COGS v. compensation deduction election; applies to all members • Deduction is sum of each member’s separate COGS or compensation, less COGS or compensation paid to another group member • May elect to include in the combined group an “exempt entity” that would be in the group if it were not exempt

    49. Texas Margin Tax – Basic Calculation A. Combined reporting required for certain affiliated groups. B. Cash Compensation limited to $300,000 per individual. C. Gross receipts for apportioning margin differ from total revenue.

    50. Texas Margin Tax – Apportionment • Basic rules remain unchanged. • Single factor apportionment based on ratio of Texas receipts to total receipts. §171.106(a) • Generally, receipts for apportionment include only receipts considered in calculating margin. §171.1055 • Statute allocating non-unitary income to commercial domicile is repealed. Former §171.1061 (Effect is unclear) • Throwback statute is repealed. Former §171.103(a)(1) and §171.1032(a)(1)