Texas: Proposed Rule Addresses When Taxable Entities Produce Goods for Sale

On June 21, 2019, the Texas Comptroller filed amendments to Rule 3.584 in the Texas Register. Rule 3.584, entitled Margin: Reports and Payments, addresses many aspects of computing taxable margin and the various franchise tax rates. Most of the proposed revisions affect the definition of when a taxable entity is considered “primarily engaged in a retail or wholesale trade.”  Under Texas law, taxable entities that are primarily engaged in retailing or wholesaling activities are subject to a reduced franchise tax rate.  A taxpayer is generally considered engaged in a retail or wholesale trade if three conditions are met: (1) the total revenue from the taxable entity's activities in retail and wholesale trade is greater than the total revenue from its activities in trades other than retail and wholesale trade; (2) less than 50 percent of the total revenue from the taxable entity's activities in retail or wholesale trade comes from the sale of products the taxable entity produces or products produced by an entity that is part of an affiliated group to which the taxable entity belongs; and (3) the taxable entity does not provide retail or wholesale utilities, including telecommunications services, electricity, or gas. One of the proposed amendments to the rule provides that selling telephone prepaid calling cards is not providing telecommunications services.

However, most of the substantive proposed changes to Rule 3.584 address when a taxable entity is considered to produce goods or products. A new definition of the term “produce” means to construct, manufacture, install during the manufacturing or construction process, develop, mine, extract, improve, create, raise, or grow either a product or a component of a product. The proposed rule provides that “a taxable entity produces a product that it sells if the taxable entity or an entity that is part of an affiliated group to which the taxable entity also belongs: (i) asserts a software copyright on the product or a component of the product; (ii) asserts a patent right under Title 35 of the United States Code or comparable law of any other foreign jurisdiction with respect to the product, a component of the product, or the packaging of the product; or (iii) produces a component of the product, or acquires the product and makes a modification to the product, unless the taxable entity can demonstrate that the component or modification does not increase the sales price of the product by more than 10 percent.”

Except as provided above (e.g., when a taxable entity asserts a patent or software right over the product), a taxable entity will not be considered to produce a product that it sells if an unrelated party manufactures the product and all components of the product to the taxable entity’s specifications.  The proposed regulation also adopts a  definition of “tangible personal property”--(i) personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner; (ii) films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and other similar property embodying words, ideas, concepts, images, or sound, without regard to the means or methods of distribution or the medium in which the property is embodied, for which, as costs are incurred in producing the property, it is intended or is reasonably likely that any medium in which the property is embodied will be mass-distributed by the creator or any one or more third parties in a form that is not substantially altered; and (iii) a computer program, as defined.

The comments in the Texas Register provide some additional clarity on the proposed changes and generally provide that they will be applied prospectively if inconsistent with prior Comptroller determinations. Per the comments, a taxable entity cannot claim a COGS deduction on goods that it "produces," while simultaneously claiming it does not "produce" the same goods for purposes of determining qualification for the reduced rate. Other changes are intended to make clear that a “taxable entity that asserts a software copyright or patent right on a product or component of a product, produces the product.” A taxable entity that produces a component of the product, or acquires the product and makes a modification to the product, produces the product unless the ten percent safe harbor for de minimis production activities applies.  In sum, by expanding the instances where taxpayers will be deemed to produce goods, these revisions appear to narrow the instances when taxpayers will be eligible for the reduced rate. Comments are being accepted on the proposed rule for the 30-day period after the June 21, 2019 publication date. Please stay tuned to TWIST for future updates on Rule 3.584.