The Texas Comptroller of Public Accounts recently proposed amendments to 34 Tex. Admin. Code 3.584 relating to the reduced rate available under the Texas Franchise Tax for retailers and wholesalers. These proposed revisions, which appear to formalize elements of informal guidance issued in August of 2015, have the potential to substantially impact a great number of businesses, specifically in the information technology and pharmaceutical industries.
The Texas Franchise Tax is imposed on taxable business entities, including corporations, partnerships and limited liability companies, doing business in the state of Texas. The generally applicable tax rate is 0.75 percent of “taxable margin”—which is itself computed under a complex set of statutes and regulations—however, the rate is reduced to 0.375 percent for entities “primarily engaged in retail or wholesale trade. To qualify for the reduced rate, a business must meet two statutory thresholds: first, it must earn more revenue from retail or wholesale trade activities than it earns from all other business activities; and second, it must earn less than 50 percent of its retail or wholesale trade revenues from the sale of products it or an affiliate entity produces. Tex. Tax Code § 171.002(c). The current version of Rule 3.584 (the Rule) clarifies that, for purposes of the second statutory threshold, a product is not considered to be produced by the retailer if “modifications made to the acquired product do not increase its sales price by more than 10 percent.” In other words, there is a safe harbor under the Rule for retailers who make some modifications to products they sell; so long as those modifications do not increase the product’s sale price by more than 10 percent, the sales of those products will not factor into the second statutory threshold. This is currently the only guidance provided by regulation regarding the scope of the “primarily engaged in” standard.
While much of the Comptroller’s proposed rule change is not controversial (as many sections merely conform the Rule to recent legislative changes), the Comptroller’s proposed revisions to Rule 3.584 also make a number of significant changes that have not been contemplated by recent legislation. First, the language of the Rule addressing the 10 percent safe harbor is changed to provide that “[a] taxable entity produces the product that it sells if the taxable entity acquires the product and makes modifications to the product that increase the sales price of the product by more than 10 percent.” See proposed Rule 3.584(b)(2)(C)(i). In other words, the safe harbor has been transformed into a ceiling—now, rather than being protected from the risk of crossing the second 50 percent threshold, the retailer will affirmatively become a producer if it makes modifications that increase the product’s sales price by more than 10 percent.
Even more significantly, proposed Rule 3.584 provides that a retailer is considered to produce the products it sells if the business “manufactures, develops, or creates tangible personal property that is incorporated into, installed in, or becomes a component part of the product that it sells.” See proposed Rule 3.584(b)(2)(C)(ii). The proposed Rule offers two examples: (1) a business produces a computer program, such as an application or operating system, that is installed in a device that is manufactured by a third party; and (2) a business produces the active ingredient in a drug that is manufactured by an unrelated party. In both instances, the business producing the incorporated feature or part is considered to have produced the product itself, regardless of the value that the feature or part adds to the product and regardless of who actually manufactures the product or installs the feature or part.
Proposed Rule 3.584 is not supported by the statutory language of Texas Tax Code Section 171.002, which sets forth the reduced rate and the definition of “primarily engaged in retail or wholesale trade.” The statute and current Rule 3.584’s focus on “production” is meant to disqualify entities that are actually manufacturers (i.e., companies that sell items they themselves produce) from the reduced rate. However, the revised Rule clearly risks excluding companies that are actually retailers—but that develop certain component parts of the items they sell and outsource the installation of these components and the manufacturing of the product to a third party—from the reduced rate to which they are statutorily entitled. Furthermore, the proposed Rule does not comport with the common sense meaning of the term “produced,” which has previously been interpreted to mean making a physical change to the item, rather than merely adding intangible property such as software to the item. Practically, the proposed revisions to Rule 3.584 will likely have the undesirable effect of stifling technology and pharmaceutical development by Texas taxpayers.
The comptroller is currently considering comments from interested parties, and it is expected that the proposed revisions to Rule 3.584 will be published in the Texas Register the week of April 18, 2016. We plan to closely monitor this Rule through the promulgation process and will publish updated posts on its status as needed.