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Texas amends franchise tax nexus regulations

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Effective Dec. 29, 2019, the Texas Comptroller of Public Accounts amended the Texas Administrative Code to establish a “bright-line” nexus threshold for franchise tax purposes.1 Accordingly, for any federal income tax accounting period ending in 2019 or later, a foreign (non-Texas) taxable entity will be subject to Texas franchise tax if the entity has gross receipts from business done in Texas of $500,000 or more, even if the entity does not have physical presence in the state. This amendment applies to franchise tax reports due on or after Jan. 1, 2020.

Background Historically, the Texas Comptroller has applied a physical presence standard for determining nexus for franchise tax purposes. Prior to the recent amendment, a taxable entity was generally subject to franchise tax only when physical presence existed in the state.2

The Comptroller amended its nexus regulation in response to the U.S. Supreme Court’s ruling in South Dakota v. Wayfair, Inc.3 The Wayfair decision concluded that sales tax nexus may result from sales activity exceeding certain economic thresholds in a state even if an entity has no physical presence in that state. As a result, remote sellers who previously were not required to collect and remit sales and use taxes, could be required to start collecting these taxes on their sales. While the Wayfair ruling specifically addressed sales tax, many states have long asserted that physical presence was not required to establish nexus for income, franchise or gross receipts tax purposes. Texas now joins a growing list of states which apply an economic nexus threshold to their respective franchise tax or income tax regimes.

Economic nexus defined The amended regulation establishes and defines an economic nexus standard and provides guidance on the beginning date that the nexus standard is met.4 Additionally, the amendment presumes that a foreign taxable entity with a Texas sales and use tax permit has nexus in Texas and is subject to the franchise tax.5 Under the amended regulation, a foreign entity begins doing business in the state on the earliest of: (i) the date physical presence is established; (ii) the date the entity obtains a sales and use tax permit; or (iii) the first day of the federal income tax accounting period in which the entity had gross receipts in Texas exceeding the economic nexus threshold of $500,000. 6

Commentary The inclusion of an economic nexus standard for Texas franchise tax purposes marks a significant change to the state’s long-held position that physical presence was required for franchise tax nexus purposes. Taxpayers and practitioners alike will need to consider the issues raised by the amendments to the Texas Administrative Code.

Remote sellers of tangible personal property The amendments will have a significant impact on remote sellers of tangible personal property to Texas customers. While in most states such activities are protected against the imposition of income tax under federal Public Law (P.L.) 86-272,7 the Comptroller has long held and the nexus regulation specifically provides that P.L. 86-272 does not apply for franchise tax purposes.8

Combined reporting implications Taxpayers filing as part of a unitary combined group must also evaluate the impact of economic nexus even if the group has historically filed in the state. As Texas follows the Joyce apportionment approach,9 the receipts of taxable entities without nexus individually in Texas are excluded from the apportionment numerator but included in the denominator.10 Subsequent to the imposition of the economic nexus threshold, combined groups may have excluded entities due to a lack of physical presence in the state that will now need to be included in the apportionment factor. Each individual entity should be considered a separate entity to determine if Texas receipts exceed the $500,000 threshold or if a sales and use tax permit has been obtained.11

Service providers The amendment to the Comptroller’s nexus regulation is based on gross receipts from business done in Texas as determined under the Comptroller’s apportionment regulation. Notably, Texas sources receipts from services based on the location where the work is performed. If services are performed both within and outside the state, such receipts are Texas receipts on the basis of the fair value of the services rendered in Texas.12 As receipts from the remote performance of services could trigger the nexus threshold, taxpayers should closely evaluate the connection of the services to the state and the fair value measurement to determine if such services establish economic nexus.

Financial services industry Financial institutions and entities providing investment advisory services are another group of taxpayers that may be significantly impacted by the economic nexus threshold contained in the amended regulation. Under the state’s apportionment statute, receipts from the sale of services to or on behalf of a regulated investment company are sourced by looking through to the location of the regulated investment company’s underlying shareholders.13 Accordingly, an out-of-state financial service entity that generates revenue through asset management fees to a regulated investment company may have Texas-sourced receipts based on the location of its underlying investors.

Similarly, Texas has unique provisions for the sourcing of receipts from the sales of loans, securities and other intangibles. Such receipts are sourced based on the state’s “location of payor” rules.14 Accordingly, some non-Texas based financial service entities may exceed the $500,000 receipts threshold based on the location of their investors and/or the location of their trading counterparties.

Sales and use tax permit registration The Comptroller’s regulation, which presumes that the obtaining of a sales and use tax permit automatically results in the opening of a franchise tax account, could cause certain remote sellers some concern. The Comptroller will issue a letter notifying taxpayers of their franchise tax account and their filing obligation. Included with the letter, the Comptroller has instructed taxpayers to complete and submit Form AP-114, Texas Nexus Questionnaire. The questionnaire includes a variety of questions, and requests that the taxpayer provide the earliest date there was a physical presence in the state and the actual date of any tax accounting period in which receipts exceeded $500,000 in the state. If the date provided in response to these questions is before the current-year filing obligation, the state may require prior year returns to be filed. Noncompliance in the state may result in a forfeited franchise account status.

ASC 740 implications Generally, Texas franchise tax is regarded as an income tax for income tax provision purposes under ASC 740. As previously stated, Texas regulations specifically provide that P.L. 86-272 protection does not apply to the franchise tax.15 Accordingly, all entities selling into or conducting business in Texas should evaluate the impact of the new economic nexus thresholds on their income tax provision. Even taxpayers in loss positions for federal or state income tax purposes may have substantial liabilities in Texas.


 
1 34 TEX. ADMIN. CODE § 3.586(f).
2 Certain exceptions applied under 34 TEX. ADMIN. CODE § 3.586(c)(11) for taxpayers in the financial services industry where “loan production activities” were performed by other parties, thereby generating nexus irrespective of the taxpayer’s physical presence in the state.
3 138 S. Ct. 2080 (2018).
4 34 TEX. ADMIN. CODE § 3.586(f), (g).
5 34 TEX. ADMIN. CODE § 3.586(e).
6 34 TEX. ADMIN. CODE § 3.586(g).
7 P.L. 86-272, codified at 15 U.S.C. §§ 381-384, is a federal law that prohibits a state from imposing an income tax if the only in-state activity of the out-of-state person is the solicitation of orders for sales of tangible personal property where the orders are sent outside the state for approval or rejection and are filled by shipment or delivery from a point outside the state.
8 34 TEX. ADMIN. CODE § 3.586(i).
9 Many states follow Joyce, a California State Board of Equalization decision, whereby sales made to the taxing state’s customers by a unitary group member that is not subject to tax in the state are not includible in the numerator of the group’s sales factor in the state, even though other members of the unitary group are subject to tax in the taxing state. Appeal of Joyce Inc., Dkt. No. 66-SBE-070 (Cal. State Bd. of Equal. Nov. 23, 1966).
10 34 TEX. ADMIN CODE § 3.590(d)(5)(B).
11 34 TEX. ADMIN CODE § 3.586(c).
12 34 TEX. ADMIN. CODE § 3.591(e)(26).
13 TEX. TAX CODE ANN. § 171.106(b).
14 34 TEX. ADMIN. CODE § 3.591(e)(16).
15 34 TEX. ADMIN. CODE § 3.586(i).



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