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Texas rules on sale of non-inventory securities

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On Oct. 14, 2021, the Texas Court of Appeals ruled that a taxpayer could only include the net gain from the sale of non-inventory securities in its sales factor, instead of the gross proceeds.1 The taxpayer purchased and sold the securities to manage risk with respect to the value of the taxpayer’s overall inventory, and such securities were not sold to customers in the ordinary course of the taxpayer’s business.

Background The taxpayer, which refines crude oil and sells gasoline, jet fuel, lubricants, petrochemicals, and petroleum-based industrial products, owned and operated three crude oil refineries during the 2008 and 2009 tax report years, one of which was located in Texas. The taxpayer filed a Texas combined group return that included a subsidiary trading company in the combined group. The trading company traded commodity futures contracts and options on commodity futures contracts. The purpose of the trading activity was to manage the risks associated with the fluctuation in the value of the taxpayer’s overall inventory. The futures contracts and options in question met the Texas franchise tax definition of “security.”2 The trading company bought and sold these securities on the New York Mercantile Exchange and the Intercontinental Exchange, and none of the trading activity took place in Texas. Since the securities were not sold to customers in the regular course of business, the trading company did not hold these securities as inventory, and hence they were characterized as “non-inventory securities.”

The trading company made an election under Internal Revenue Code (IRC) Sec. 475(e) and (f), which allowed it to apply mark-to-market accounting rules to the non-inventory securities, and to treat the gains or losses from the non-inventory securities as ordinary income rather than capital gains or losses. For federal income tax purposes, gains and losses from the sale of the non-inventory securities were reported on the taxpayer’s Form 4797, which flowed to page 1, line 9 of the taxpayer’s 2007 and 2008 federal income tax returns.

For the 2008 and 2009 Texas franchise tax report years, the taxpayer included the gross proceeds from the trading company’s non-inventory securities in the denominator of the Texas apportionment factor. Since none of the trading activity took place in Texas, the taxpayer did not allocate any receipts related to the trading activity in the numerator of the apportionment factor. The Comptroller disagreed with this treatment, contending that only the net gain should have been included in the denominator, as opposed to the gross proceeds. The taxpayer paid approximately $2 million in additional taxes and protested the Comptroller’s determination, which was upheld by the Travis County District Court and appealed to the Texas Court of Appeals.

Treatment of securities as net gain Historically, Texas generally required that only the net gain from the sale of securities be included in the apportionment factor.3 However, Texas provides an exception to the general rule if the securities are treated as inventory for federal income tax purposes. Tex. Tax Code Sec. 171.106(f) provides that “notwithstanding section 171.1055, if a loan or security is treated as inventory of the seller for federal income tax purposes, the gross proceeds of the sale of that loan or security are considered gross receipts.”

The taxpayer argued that while its securities are not inventory, the election of mark-to-market accounting on its non-inventory securities resulted in the treatment of such securities as inventory for federal income tax purposes, and the consequent treatment of the gains and losses from such securities as ordinary income instead of capital gain. Further, the taxpayer also pointed out that the mark-to-market rules would treat the non-inventory securities on hand at the end of the year as if they were sold at year-end for federal income tax purposes. This tax treatment is the same as the tax treatment that would be applied to a dealer’s inventory securities.

The Comptroller countered these arguments by claiming that the non-inventory securities were not “treated as” inventory securities under the IRC. Instead, the Comptroller argued that the taxpayer’s securities were treated as non-inventory securities which the taxpayer elected to account for using mark-to-market rules. The Comptroller further argued that the decision hinged not on whether the securities can use mark-to-market accounting, but rather if, under the IRC, the securities were considered to be inventory, which in this case the taxpayer had conceded they are not.

The Court of Appeals held that only the net proceeds from the sale of the non-inventory securities could be included in the Texas apportionment factor. The court reasoned that since the Texas legislature created an exception to the general rule that only the net gain from the sale of securities could be included in the apportionment factor, there must be a distinguishing characteristic between a seller’s inventory securities and a seller’s non-inventory securities. The court disagreed with the taxpayer’s argument that the distinguishing characteristic is that the sale be treated as ordinary income because there are other non-inventory securities that are treated as ordinary income without the election under IRC Sec. 475(e) and (f). For example, IRC Sec. 475(a)(2) requires that a dealer’s non-inventory securities be accounted for in the same manner as its inventory securities. A dealer must mark both inventory and non-inventory securities to market and recognize the sale of both as ordinary income. As a result, the court held that the distinguishing characteristic must be whether the securities were held for sale in the seller’s ordinary course of business. In this case, since the taxpayer acknowledged that the securities were not held for sale in the ordinary course of business, only the net proceeds from these sales could be included in the taxpayer’s apportionment factor.

Commentary The Court of Appeals’ decision, which is being appealed by the taxpayer, is in line with prior rulings and Comptroller positions that place emphasis on the classification of securities as “inventory of the seller for federal income tax” in order to be afforded gross proceeds treatment under Tex. Tax Code Sec. 171.106(f). The decision hinted at, but did not explicitly cite, additional statutory support for this determination that provides specific authority for including only certain federal income tax line items in the Texas franchise tax base. For corporate taxpayers determining the franchise tax base, Texas requires that taxpayers report gross receipts as reported on lines 1c, and 4-10 of the federal income tax return, with certain modifications.4 As the court pointed out, Texas also requires that the Texas apportionment denominator equal total gross receipts, again with certain modifications.

For federal income tax purposes, the taxpayer reported the trading company’s net proceeds from the sale of the non-inventory securities on line 9 of the federal income tax return. Although the decision does not state this, presumably, for purposes of calculating the Texas tax base, the taxpayer included the net proceeds from the federal income tax return, not the gross proceeds. However, for apportionment purposes, the taxpayer tried to include the gross proceeds from the sale of the non-inventory securities. This non-parallel treatment would have led to a significant difference between the taxpayer’s franchise tax base and its apportionment factor denominator, which would not have been supported by either the Texas statutes or regulations. While such a divergence may be permitted for securities treated as inventory, the state continues to heavily scrutinize federal classifications of inventory under IRC Sec. 475.

The court pointed out that the taxpayer reported the sale of the securities on line 9 of its federal income tax return, not on line 1 of the return where proceeds from the sale of inventory would normally be reported. Despite the taxpayer’s reflection of the sale on line 9, the taxpayer still tried to reclassify such sales as inventory in Texas through its IRC Sec. 475(e) and (f) elections. By doing so, the taxpayer failed to adhere to the Texas provision generally requiring a taxpayer’s apportionment factor denominator to equal its franchise tax base. To have prevailed in this case, the taxpayer would have had to more adequately demonstrate that the securities in question constituted inventory for federal income tax purposes rather than hedging transactions, and explained why its franchise tax base differed so substantially from its apportionment factor denominator.



1 CITGO Petroleum Corp. v. Hegar, Texas Court of Appeals (Austin), No. 03-21-00011-CV, Oct. 14, 2021.
2 TEX. TAX CODE ANN. § 171.0001(13-a), which defines security (for purposes of several Texas provisions, including TEX. TAX CODE ANN. § 171.106(f)), in the same manner as IRC § 475(c)(2), and includes instruments described by IRC § 475(e)(2)(B), (C), and (D).
3 See TEX. TAX CODE ANN. § 171.105(b), which states that if 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,” and TEX. TAX CODE ANN. § 171.1055(a), which states that with respect to apportionment, receipts excluded from total revenue are likewise excluded from the apportionment factor. It should be noted that for reports due prior to January 1, 2021, a taxpayer could net gains and loss transactions (but not below zero) in determining the amounts to include both for numerator and denominator purposes. However, pursuant to amendments to 34 TEX. ADMIN. CODE § 3.591(e), the Comptroller contends that only gains are includable for apportionment purposes and such gains cannot be offset by losses for reports due on or after January 1, 2021.
4 TEX. TAX CODE ANN. § 171.1011(c).



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