Texas Franchise Tax: Net Losses Are Not Net Gains

On April 15, 2016, the Texas Supreme Court held that only net gains should be included in the apportionment factor of the Texas franchise tax. This reversed the opinion issued by the Thirteenth Court of Appeals to rule in favor of the taxpayer.

Texas imposes a franchise tax on taxable entities engaged in business in Texas. To determine the franchise tax base, the taxable entity begins with total revenue and deducts the greater of four general deductions: $1 million, cost of goods sold, compensation, or 30% of total revenue. The resulting figure is called “margin.”

The United States Constitution prohibits a state from imposing tax on activity beyond the state’s borders. To comply with this requirement, Texas law imposes the franchise tax only on the portion of “margin” attributable to business done in Texas. It does this by calculating a fraction equal to the taxable entity’s ‘Texas receipts’ divided by ‘receipts from everywhere.’ This fraction is called the “apportionment factor.” The issue in Hallmark was whether the apportionment factor included net losses arising from the sale of investments.

Hallmark Marketing Co., LLC v. Hegar held that a taxable entity should not include its net loss from the sale of investments in its apportionment factor. Texas Tax Code § 171.105(b) provides that “[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.” The Comptroller wrote Rule § 3.591(e)(2) to interpret this provision. It states, “[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.” Hallmark argued that the language of the Comptroller’s administrative rule conflicted with the language of the statute. Hallmark contended that the plain text of the statute did not require Hallmark to include the net loss in its apportionment factor.

The Court held that the “statute requires inclusion of ‘only the net gain,’ and under no reading can ‘net gain’ include a net loss.” As a result, Texas Tax Code § 171.105(b) does not require taxpayers to include a net loss from sale of investments and capital assets in its apportionment-factor denominator.

Comment: The Court’s holding creates an interesting issue for Texas taxpayers. Other sections of the Texas franchise tax statute include terms like “gains” and “net distributive income.” Notably, the term “gains” appears in the definition of passive entity, and “net distributive income” is used to describe a component of the compensation deduction. See Tex. Tax Code §§ 171.003(a)(2)(c) and 171.1013(a)(1) and (2). The Comptroller has written administrative rules that interpret these provisions to include losses. See 34 Tex. Admin. Code §§ 3.582 and 3.589. In light of the Hallmark opinion, a taxpayer could argue that the definitions of these terms in each of the Comptroller’s rules are invalid.