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October 2009 TAX POLICY NEWS
a monthly newsletter about Texas tax policy

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FRANCHISE TAX

Contract Manufacturing and Cost of Goods Sold

A taxable entity that contracts with an unrelated third party to manufacture goods to the taxable entity's specifications is not considered a producer of those goods for purposes of Texas Tax Code Section 171.002(c)(2).

An entity that is not considered a producer is limited to acquisition, storage, handling and other costs specified in Texas Tax Code Section 171.1012(d) as related to the entity's goods in determining its deduction for the cost of goods sold. Costs directly related to the production of goods that are typically allowed a producer, such as research, experimental, engineering and design activity costs, are not allowed as cost of goods sold for an entity that uses an unrelated third party to produce its goods.

FRANCHISE TAX

Initial Reports

Filing initial reports continues to be confusing for many Texas franchise taxpayers. To simplify the filing process, our agency, with the authority granted in Texas Tax Code Section 111.051, has changed the initial report due date for entities that become subject to the Texas franchise tax on or after Oct. 4, 2009.

Therefore, an annual report is the first franchise tax report that a taxable entity will file. This report will be due May 15 in the year following the calendar year the entity became subject to the tax. Entities that become subject to the franchise tax from Oct. 4, 2009, through Dec. 31, 2009, have a 2010 annual report due on May 17, 2010. Entities that become subject to the franchise tax during calendar year 2010 have a 2011 annual report due on May 16, 2011, and so on.

The first annual report will be based on the accounting period beginning on the date the entity became subject to the franchise tax and ending on the last accounting period ending date used for federal income tax reporting purposes in the calendar year before the year the report is originally due.

Example: A taxable entity is formed on Nov. 1, 2009, and has a calendar year end. The entity's first franchise tax report is due on May 17, 2010, for the privilege period Nov. 1, 2009, through Dec. 31, 2010, and is based on an accounting period beginning Nov. 1, 2009, and ending Dec. 31, 2009. The entity's next franchise tax report is due May 16, 2011, for the privilege period Jan. 1 through Dec. 31, 2011, and is based on an accounting period beginning Jan. 1, 2010, and ending Dec. 31, 2010.

A taxable entity that has a federal tax year end date that is prior to the franchise tax responsibility begin date for the first franchise tax report filed will file a one-day No Tax Due Information Report with zero revenue. (A Public Information Report, Ownership Information Report, Affiliate Schedule, etc. must also be filed as applicable.)

Example: A taxable entity begins doing business in Texas on Oct. 5, 2009, and has a federal tax accounting year end of Aug. 31. The entity's first franchise tax report is due on May 17, 2010, for the privilege period Oct. 5, 2009, through Dec. 31, 2010, and is based on an accounting period beginning Oct. 5, 2009, and ending Oct. 5, 2009, which results in a zero report. The entity's next franchise tax report is due May 16, 2011, for the privilege period Jan. 1, 2011, through Dec. 31, 2011, and is based on the accounting period Oct. 5, 2009, through Aug. 31, 2010.

A taxable entity that ends its franchise tax responsibility in the same year that it became subject to the tax will not owe an annual report the following year; instead, the entity will owe a final report for the year it ends its responsibility, due 60 days after its ending date.

Example: An entity becomes subject to the franchise tax on Oct. 15, 2009, and ends its franchise tax responsibility on Nov. 30, 2009. The entity will not owe a 2010 annual report; instead, the entity will owe a final report, due on Jan. 29, 2010, for the period beginning on Oct. 15, 2009, and ending on Nov. 30, 2009.

Annual extension requirements will apply for all annual reports, including the first annual report. On the first annual report, the option to pay 100 percent of the prior year's tax is not available.

Tax Rule 3.584 will be amended to reflect this new policy.

INSURANCE TAX

Insurance Tax Electronic Reporting Update

Beginning tax year 2008, taxpayers can submit their insurance premium tax reports electronically. Taxpayers who paid $50,000 or more in premium taxes for the previous tax year are required to electronically file their reports using the Comptroller's Webfile system. The electronic reporting system is available to use voluntarily by all taxpayers submitting premium tax data. This Web-based system also allows taxpayers to submit payment(s) by credit card, electronic check or, if enrolled, via TexNet, the state's electronic funds transfer system. Taxpayers for whom electronic payment is mandatory must use TexNet to make payment.

Taxpayers for whom electronic filing was mandatory for the 2008 tax year will no longer receive a paper report form from the Comptroller's office, whether the taxpayer filed electronically or not. Voluntary electronic filers who report twice using the Webfile system will no longer receive paper forms. We will send an e-mail to the address registered with the Webfile system to remind taxpayers of upcoming tax filing deadlines.

Taxpayers who are subject to mandatory electronic reporting and who fail to report electronically are subject to a 5 percent penalty.

The Webfile system is available 24 hours a day, seven days a week. For additional information regarding Webfile, visit the Comptroller's Window on State Government Web site or call us at (800) 442-3453.

Stay tuned for information regarding the electronic reporting of maintenance taxes.

SALES TAX

IV Systems and Catheters — Use-Based Exemption or Product-Based Exemption?

The Comptroller's office has received questions regarding the clarification of policy expressed in the May 2008 Tax Policy News article, "Catheters - Infusion versus Intravenous," particularly whether a catheter that delivers contrast medium into an artery during a medical procedure qualifies for exemption as an intravenous (IV) system.

Tax Code Section 151.313(a)(15) provides an exemption from tax for IV systems, supplies and replacement parts used in the treatment of humans. Examples of IV system components and supplies include access ports, adapters, bags and bottles, clamps, needles, poles and volumetric chambers. A purchaser must give an exemption certificate to the seller stating that the components and related supplies are for IV systems used in treating humans.

In addition, Tax Code Section 151.313(a)(4) exempts hypodermic syringes and needles from sales and use tax. IV systems and hypodermic syringes can be used to deliver drugs and medicines into the human body. The statutes, however, do not exempt those items only when used to administer medication; nor does the Tax Code provide an exemption for all equipment and supplies used to deliver drugs and medicines into the human body. For example, there is no exemption for intra-arterial, intramuscular or subcutaneous delivery systems. The statutory exemption for IV systems is a product-based exemption for specific equipment, not a use-based exemption for any equipment that delivers or infuses drugs or medicines into a human body. For sales and use tax purposes, the IV system exemption under 151.313(a) (15) does not include items used to deliver medications or fluids into the human body through an artery, muscle or other bodily passageway or cavity. "Intravenous" is defined in Merriam-Webster's Dictionary to mean, "situated, performed, or occurring within or entering by way of a vein." Therefore, in order for an item to qualify for exemption as an IV system, it must be a component part of a system that is delivering fluids, drugs or medicines into a vein.

The taxability of a catheter is generally determined based on both its characteristics and its use. While a catheter can be inserted intravenously, it can also be inserted into arteries, other passageways or body cavities. A catheter that is a component part of an IV system qualifies for exemption under Tax Code Section 151.313(a) (15). A catheter used to deliver drugs, medicines or other fluids into the body by other methods does not qualify for exemption as an IV system. For example, an epidural catheter is not exempt as part of an IV system because it is not inserted into a vein to infuse drugs or medicines. Similarly, an apparatus or piece of equipment that is used to perform a medical procedure (e.g. angioplasty), and that may also infuse a drug or medicine such as contrast medium into the body, is not considered an IV system.

A catheter can also qualify for exemption as a prosthetic device under 151.313(a)(5). For example, catheters used in gastro-intestinal feeding, or Foley catheters placed in the body to drain and collect urine from the bladder, qualify for exemption as prosthetic devices because the catheters take the place of a body part or function. A catheter used to excise and retrieve plaque from diseased coronary arteries, however, is taxable as a medical tool used by a health care provider.

Statutory exemptions from taxation are subject to strict construction because they place a greater burden on other tax-paying businesses and individuals. See Bullock v. National Bancshares Corp., 584 S.W.2d 268 (Tex. 1979) and Teleprofits of Texas v. Sharp, 875 S.W.2d 748 (Tex. Civ. App. - Austin, 1994). A catheter is not, in and of itself, an IV system. Therefore, a catheter does not qualify for the IV systems exemption on its own. A catheter that is a component part of an IV system or prosthetic device will, however, qualify for exemption.

SALES TAX

Motor Vehicle Repair and Maintenance Shops, Oil Change and Lube Businesses

When an automotive repair or maintenance shop bills a customer one amount for both labor and materials (a lump-sum charge), the shop should not collect tax on that charge. The shop must pay sales tax on all equipment, parts, supplies and materials used to perform the service, but the shop may not bill the customer directly for the sales tax paid on those items. Instead, the shop may build those costs into the lump-sum charge for the service.

A shop that bills separately for parts and labor must collect tax from its customers on the separately stated charge for the parts. The shop can purchase parts tax free by providing a resale certificate (PDF, 76KB) to suppliers.

If there is a contract (including a bid or estimate) to perform the repair, the contract terms determine the type of billing. If the contract is for a lump-sum amount, invoices separating charges for parts from labor will not change a lump-sum billing into a separated billing unless required by the terms of the contract.

A shop that wants to charge a customer a lump-sum amount for an oil change, but separates charges for some additional repair, should use one invoice for the oil change and another for the repair. Alternatively, the shop can put the lump-sum oil change on one line of the invoice, not break down those "lump sum" charges anywhere else on the invoice and then separate the charges for repair labor and repair materials and parts. The shop must also separately state a charge for tax on the materials and parts used in the repair.

Because the shop is responsible for paying tax on the parts under a lump-sum charge, and the customer is responsible for paying tax for separately stated charges, the invoice must clearly state each service and charge.

Examples

An auto parts supplier, Auto Parts Inc., sells oil and filters to lube shops for $20.

There are two lube shops in town: ABC Lube and XYZ $39.90 Lube.

ABC Lube bills its customers using separated contracts and XYZ $39.90 Lube uses lump-sum contracts.

ABC Lube

When ABC Lube goes to Auto Parts, Inc. to buy oil and filters, it will present a resale certificate and buy the oil and filters for $20 without tax. ABC Lube can either sell the oil and filters to its customer at cost and charge tax on that amount, or as in this example, mark the price up and charge tax on that amount. The customer could be presented a bill that looks like this:

Oil$12.00
Oil Filter$11.00
Tax on oil and filter at 8.25%$1.90
Total Charge for Parts$24.90
Labor$15.00
Total Charge$39.90

XYZ Lube

When XYZ Lube goes to Auto Parts, Inc. to buy the oil and filter it will pay tax on its purchase, bringing its cost of the oil and filter to $21.65, if the tax is 8.25 percent. That amount will presumably be built into its lump-sum charge. The customer could be presented with a bill that looks like this:

Charge for oil change: $39.90

Note that XYZ Lube does not charge tax on a lump-sum contract because it has already paid tax to its supplier, Auto Parts, Inc.

How ABC Lube Could Run Into Trouble

ABC Lube must be careful not to use a lump-sum contract by combining the charges for the oil filter and the labor on its invoice to the customer. If ABC Lube had charged its customer the right amount of tax ($1.90), but combined the charges of $23 for the oil filter and $15 for labor, it might have presented a bill to its customer that looked like this:

Charge for oil change$38.00
Tax on oil filter at 8.25%$1.90
Total Charge$39.90

This method would result in an assessment of $1.65 to ABC Lube since it should have paid tax to Auto Parts, Inc. of $20 x 8.25 percent if it were to use a lump-sum contract. Also, the invoice to the customer is confusing because the tax, while stated at 8.25 percent, appears to have been levied at 5 percent. Under this scenario, the tax levied by ABC Lube would be considered "error tax" that the customer should not have been required to pay under a lump-sum contract. This invalid tax assessment does not substitute for the tax that ABC Lube should have paid as the customer under a lump-sum contract.

SALES TAX

Senate Bill 575 and Local Sales and Use Tax on Residential Use of Gas and Electricity

Senate Bill 575 (81st Legislative Session, 2009) amended Tax Code Chapter 321 to allow certain special purpose districts to impose local sales and use tax on the residential use of gas and electricity.

Effective Jan. 1, 2010, the board of directors of a fire control, prevention and emergency medical services district, or a crime control and prevention district located in all or part of a municipality that imposes a tax on the residential use of gas and electricity, will be allowed to take actions necessary to impose the tax throughout the district.

A qualifying district's board of directors, by order or resolution adopted in a public hearing held on or after Jan. 1, 2010, by a vote of a majority of the board's membership, may impose, exempt or reimpose sales and use tax on receipts from the sale, production, distribution, lease, or rental of, and the use, storage, or other consumption within the district of, gas and electricity for residential use.

A district that adopts an order or resolution imposing, exempting or reimposing sales and use tax on the residential use of gas or electricity must:

1) send a copy of the order or resolution to the Comptroller by U.S. Postal Service certified or registered mail;

2) send a copy of the order or resolution and a copy of the district's boundaries to each gas and electric company whose customers are subject to the tax by U.S. Postal Service certified or registered mail; and

3) publish notice of the order or resolution in a newspaper of general circulation in the district.

The earliest date that a tax adopted in the first calendar quarter of 2010 will become effective is July 1, 2010. As provided under Tax Code Section 321.102, a tax becomes effective on the first day of the calendar quarter following the expiration of the first complete calendar quarter occurring after the date on which the Comptroller receives a copy of the order or resolution. This means that if a board votes to impose the tax and notifies the Comptroller during the first calendar quarter of 2010, the tax cannot become effective until after the second quarter of 2010 has passed.

For example, the board of a fire control, prevention and emergency medical services district votes to impose the tax at a public hearing held Jan. 2, 2010. The Comptroller receives a copy of the order by certified mail on Jan. 4, 2010. The calendar quarter in which the Comptroller receives notification ends March 31, 2010; the additional calendar quarter lapse provided by 321.102 expires June 30, 2010. Therefore, the tax becomes effective July 1, 2010, the first day after the additional calendar quarter lapse.

The rate of the sales and use tax that a district may impose on the residential use of gas and electricity within the district is equal to the tax rate adopted by the district on all other sales of taxable items.

In a district that imposes the tax, only the municipal and qualifying special purpose district tax rates should be used to calculate the total sales tax rate that a utility should collect from residential customers.

The Local Sales and Use Tax on Residential Use of Gas and Electricity section of our Web site has more information, including a list of the special purpose districts that will be eligible to impose the tax beginning in 2010.

RECENTLY PROPOSED RULES

The Comptroller's office filed the following rules with the Texas Secretary of State for publication in the Sept. 18, 2009, issue of the Texas Register. The comment period begins 30 days after publication.

Motor Fuel Tax

§3.438 Signed Statements for Purchasing Dyed Diesel Fuel Tax Free

§3.439 Motor Fuel Transportation Documents

Property Tax Administration

§9.3044 Appointment of Agents for Property Taxes

§9.415 Applications for Property Tax Exemptions

ABOUT THE NEWSLETTER

The Comptroller's office publishes this newsletter to keep you informed about state taxes. Tax questions can be complicated, so please use these summaries as guidelines only.

For a Copy of a Proposed Rule

For a copy of a proposed rule or information about a proposed rule, write to Bryant Lomax, Tax Policy Division, 1700 North Congress Avenue, Austin, Texas, 78701-1436, or submit a request via Texas Tax Help.

For Publications, Rules or Other Tax Information

For a wealth of tax information sorted by tax type or by subject matter, please visit the Texas Taxes section of our Web site.

Contributors to This Month's Issue

Teresa Bostick, Robin Corrigan, Gary Johnson, Carol McAnnally, Jerry Oxford, Viki Smith, Karen Snyder, and Jennifer Specchio

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