Texas ALJ rules on interest, hedging income

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The Texas Comptroller of Public Accounts recently adopted a state administrative law judge (ALJ) decision finding that interest income generated from the sale of a taxpayer’s trading and merchandising business was unitary with the taxpayer’s business and therefore should be included in its total revenue calculation for Texas franchise tax purposes.¹ The ALJ also ruled that gross proceeds from commodity hedges should be excluded from the taxpayer’s Texas apportionment factor because the taxpayer did not hold the securities as inventory for federal income tax purposes.

Background The petitioner, a packaged food company, historically operated in three segments: consumer foods, international foods and food and ingredients. The food and ingredients segment of the petitioner’s business included a trading and merchandising business, along with other ancillary enterprises. In March 2008, the taxpayer entered into a sales agreement with an independent company to sell the trading and merchandising segment of its business. Completed in June 2008, the sale of the domestic entities was treated as a deemed sale of assets for federal income tax purposes. The petitioner did not retain any stake in the trade and merchandising business, and no longer operated in that line of business. Further, the petitioner did not share officers or directors with the new owners and there was no integration of executive or managerial personnel.

The sale of the business included the issuance of payment-in-kind debt (PIK notes), which produced approximately $64 million and $30 million of interest income for the fiscal years ending in 2010 and 2011, respectively. The petitioner reported the interest income as nonbusiness income on its 2011 and 2012 Texas franchise tax reports and deducted those amounts from its total revenue calculation.

During the course of its business, the petitioner regularly entered into futures purchase contracts (known as commodity hedges), to protect against price increases of the raw materials required to manufacture goods. The commodity hedges were legal agreements to buy or sell a particular commodity at a predetermined price at a specified time in the future. For federal income tax purposes, the petitioner recorded the net gain or loss from the settlement of its hedging transactions as part of its cost of goods sold, rather than as part of its revenue. The petitioner bought and sold the commodity hedges through various commodity exchanges located outside Texas.

The Comptroller audited the petitioner (as reporting entity for a combined group) for the 2011-2014 Texas franchise tax report years. In its 2011 and 2012 franchise tax reports, the petitioner deducted the interest income on the PIK notes from its total revenue calculation. For all report years at issue, the petitioner included the gross settlement proceeds from its commodity hedging in the denominator, but not the numerator of its Texas gross receipts factor. The Comptroller disallowed the deduction for the interest income and excluded the gross receipts from the denominator of its gross receipts factor. The petitioner disagreed with the Comptroller’s conclusions and requested a redetermination.

Decision The ALJ first considered the petitioner’s argument that the interest earned on the PIK notes was non-unitary income because it held the PIK notes as an investment and not as an operational asset. The ALJ reviewed the unitary business principle as established through U.S. Supreme Court case law, which requires a “definite link” or “minimum connection” between a state and the property it seeks to tax.² Regarding the minimum connection requirement, the ALJ noted that an operational asset may have a unitary connection with a taxpayer’s business in the state even if a unitary relationship does not exist between the payor and payee.³ Although the petitioner did not own any interest in the trading or merchandising segment after the sale of that business, the petitioner was unitary with that business prior to the sale. The ALJ reasoned that the sale of the trading and merchandising business generated the interest income, and that no interest income would exist without the sale of the unitary business segment. Accordingly, the ALJ found a sufficient unitary connection between the interest income and the sale of the business segment generating that income, and sustained the Comptroller’s inclusion of the interest income in the petitioner’s total revenue.

Next, the ALJ addressed the petitioner’s argument that the gross receipts from its commodity hedging activities should be included in the denominator of its gross receipts factor. The ALJ noted that under Texas law, the gross proceeds of the sale of a loan or security are considered gross receipts if they are treated as inventory of the seller for federal income tax purposes.⁴ Under audit, the Comptroller found that the petitioner listed the proceeds at issue on line 2 of its federal Form 1120 as costs of goods sold. Based on these facts, the ALJ concluded that the petitioner did not hold the securities as inventory for federal income tax purposes, and therefore could not include the gross proceeds from their sale as gross receipts from its entire business for apportionment purposes.

Commentary The Comptroller’s decision to include interest income generated from the sale of a unitary business segment in the petitioner’s total revenue is not surprising considering Texas’ adherence to the unitary business principle and settled U.S. Supreme Court case law on the subject. The ALJ found compelling the fact that the petitioner was unitary with its trading and merchandising segment prior to the sale of that business. Regardless of the fact that the petitioner was not unitary with either the buyer of the business or the business itself after the sale, it was the sale of the then-unitary segment of the business that eventually generated the interest income, leading the ALJ to conclude that the income was itself unitary and thus includable in the petitioner’s tax base.

Further, the Comptroller’s treatment of commodity hedging income for Texas franchise tax apportionment purposes provides guidance for taxpayers engaging in commodities hedging transactions that are included in the company’s cost of goods sold.⁵ Although the Comptroller reached the same result as several other states (including Pennsylvania⁶ and Illinois⁷ ) on the exclusion of receipts from hedging transactions from the sales factor, the Comptroller’s analysis hinged on the inclusion of the receipts in costs of goods sold, rather than the inclusion or exclusion of an income item from the revenue calculation.

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1 Comptroller’s Decision Nos. 114,432; 114,433; 114,434; 114,435, Texas Comptroller of Public Accounts, Aug. 15, 2019.
2 See MeadWestvaco Corp. ex rel. Mead Corp. v. Illinois Dept. of Revenue, 553 U.S. 16 (2008); Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
3 See Allied-Signal, Inc. v. Director, N.J. Division of Taxation, 504 U.S. 768 (1992); Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955).
4 TEX. TAX CODE § 171.106(f); 34 TEX. ADMIN. CODE § 3.591(e)(16).
5 It is interesting to note that had the hedging income been recorded as revenue, the inclusion of the gain or proceeds in the sales factor may have been allowed under certain circumstances. Additionally, the sourcing treatment of such income for purposes of the sales factor may have depended upon either the location of the payor, meaning the legal counterparty to the hedge (the commodity exchange), or potentially the location of the ultimate customer (the counterparty’s customer). If such locations could not be determined, a population sourcing method might have been employed. See 34 TEX. ADMIN. CODE § 3.591(e)(25). It should be noted that unlike most states, neither the Comptroller nor the taxpayer may raise alternative apportionment if the sourcing of an item results in a substantially diluted or inflated sales factor, something which could occur with respect to income arising from a highly active hedging function in which the proceeds are recorded as revenue.
6 The Pennsylvania Department of Revenue issued a bulletin in January 2019 clarifying that gross receipts, gain or loss from hedging transactions are excluded from both the numerator and denominator of the Pennsylvania sales factor because such transactions do not reflect the market for a taxpayer’s goods and services and are not held by the taxpayer for sale to customers in the ordinary course of business. Corporation Tax Bulletin 2019-01, Hedging and Foreign Currency Transactions, Pennsylvania Department of Revenue, Jan. 4, 2019.
7 The Illinois Department of Revenue recently amended its corporate income tax regulations to provide that any income, gain or loss from hedging transactions is properly excludable from the Illinois sales factor on the basis that they do not reflect the market for the taxpayer’s goods and services, unless the taxpayer’s books and records clearly identify the transaction as managing risk related to a particular or anticipated gross receipt item. 86 ILL. ADMIN. CODE § 100.3380(c)(6).

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