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May 2011 TAX POLICY NEWS
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FRANCHISE TAX

Hearings Summaries: Election Under Texas Tax Code Section 171.101, Determination of Taxable Margin

Following are summaries of four hearings related to the election to use cost of goods sold or compensation in determining margin. In each hearing, the taxpayer did not elect to use the cost of goods sold or compensation deduction in their original filing and then amended their report after the due date to use one of the deductions and claim a refund. In each hearing, the Administrative Law Judge upheld the Comptroller's rejection of the amended report and denial of the refund.

Hearing No. 103,083 (2010)
The taxpayer is a landscape, architecture, construction and management company in Texas. The taxpayer filed a 2008 franchise tax report using the 70 percent of total revenue calculation because it was the lowest margin amount based on the taxpayer's available information. The next year, the taxpayer filed an amended report using the cost of goods sold (COGS) deduction. The amendment resulted in a refund, which the Comptroller denied based on Rule 3.584(d)(1), and the taxpayer requested a refund hearing.

In the hearing, the taxpayer claimed that the original 2008 tax report was filed using the best information available, but a later review of the taxpayer's business and a redesign of the accounting system produced an accurate COGS calculation. The taxpayer cited the novelty of the revised tax and the lack of clear information on the Comptroller's website at the time the original report was filed as the reason there was no election of the COGS method in the original report.

Comptroller staff argued that the taxpayer's amendment is barred by Texas Tax Code Sections 171.101 (a) and (d), which state that an election to determine margin using the COGS method or the compensation method shall be made by the taxable entity on its annual report and the taxable entity shall notify the Comptroller of its election not later than the due date of the annual report. Staff contended that legislative history of Section 171.101(d) supports its position. Staff demonstrated that in 2007, the 80th Legislature, in House Bill 3928, deleted language that would explicitly permit a taxable entity to change its election and substituted the current language requiring that the election be made not later than the due date of the annual report.

The Administrative Law Judge determined that after the due date, an amended report may not be filed to change the method of computing margin to COGS or compensation and recommended that the claim for a tax refund be denied.

Hearing No. 103,450 (2010)
The taxpayer was a residential construction company during the 2008 report year, but subsequently ceased business operations. The taxpayer filed a 2008 franchise tax report using the E-Z Computation method. The next year, the taxpayer filed an amended report using the cost of goods sold (COGS) deduction. The amendment resulted in a refund, which the Comptroller denied based on Rule 3.584(d)(1) and the taxpayer requested a refund hearing.

In the hearing, the taxpayer argued that an out-of-state accountant was used to prepare and file the report. The accountant was unfamiliar with the revised franchise tax and used the E-Z Computation method even though the COGS calculation would have resulted in a lower tax liability. The taxpayer asserted that many taxpayers were confused about their compliance obligations and requested to be allowed to correct the error and claim the COGS deduction to which it was entitled.

Comptroller staff argued that the taxpayer's amendment is barred by Texas Tax Code Sections 171.101 (a) and (d), which state that an election to determine margin using the COGS method or the compensation method shall be made by the taxable entity on its annual report and the taxable entity shall notify the Comptroller of its election not later than the due date of the annual report. Staff contended that legislative history of Section 171.101(d) supports its position. Staff demonstrated that in 2007, the 80th Legislature, in House Bill 3928, deleted language that would explicitly permit a taxable entity to change its election and substituted the current language requiring that the election be made not later than the due date of the annual report.

The Administrative Law Judge determined that, after the due date, an amended report may not be filed to change the method of computing margin to COGS or compensation and the taxpayer's claim for a refund should be denied.

Hearing No. 103,807 (2010)
The taxpayer is an out-of-state corporation that filed a 2009 franchise tax report, due May 15, 2009, in September 2009, and reported margin as 70 percent of total revenue. In October 2009, the taxpayer filed an amended report changing its election from 70 percent of total revenue to the compensation calculation. The amendment resulted in a refund and the taxpayer submitted a refund request to the Comptroller's office. The Comptroller rejected the amended report and denied the refund claim. The taxpayer timely requested a refund hearing.

In the hearing, the taxpayer argued that the refund was improperly denied because the original franchise tax liability was erroneously paid.

Comptroller staff stated that Texas Tax Code Section 171.101(d) requires an entity to elect to use the cost of goods sold (COGS) or compensation calculation on the entity's annual franchise tax report no later than the report due date. Comptroller staff argued that the taxpayer may not amend its report to change the method of computing margin to a COGS or compensation calculation because such an amendment would allow the taxpayer to change its election after the report due date.

The Administrative Law Judge (ALJ) determined that the election to compute margin using the COGS or compensation method on a taxable entity's annual franchise tax report can be made no later than the due date, as specified in Tax Code Section 171.101(d). The ALJ affirmed the Comptroller's decision to reject the amended report and deny the refund, as the taxpayer failed to demonstrate that the tax was paid erroneously.

Hearing No. 104,076 (2011)
The taxpayer is a hardscape construction contractor that provides paving surfaces, masonry and stucco surfaces, fences, water features, etc. to landscapers and builders. The taxpayer files a combined group report with an affiliated entity. In 2009, the taxpayer filed a combined report that included both entities' revenue and a cost of goods sold value, but the taxpayer inadvertently reported only one entity's cost of goods sold amount. The consequence of the reporting error was that the combined group's taxable margin was lower when it was calculated based on 70 percent of total revenue than it was when calculated based on cost of goods sold. Therefore, the taxpayer used the 70 percent of total revenue value to calculate the franchise tax due.

After Nov. 15, 2009, the extended due date, an amended report was prepared to include the second entity's cost of goods sold resulting in a taxable margin that was lower when calculated based on the cost of goods sold deduction. The amended report was rejected by the Comptroller and the related refund claim was also denied.

In the hearing, the taxpayer contended that its amended report should be accepted because it was filed to correct a mistake. The taxpayer also contended that the report form is flawed because it does not allow taxpayers to affirmatively make a required taxable margin election.

Comptroller staff concedes that the cost of goods sold amount reflected in the taxpayer's original report was mistakenly understated, but contends the amended report must be rejected because it changes the taxable margin calculation from 70 percent of total revenue to the cost of goods sold method after the report due date which is not allowed under Tax Code Section 171.101(d).

The Administrative Law Judge (ALJ) found that the taxpayer's amended report was properly rejected and recommended the refund denial be affirmed because the clear intent of Tax Code Section 171.101(d) is to prohibit franchise tax report amendments, filed after the annual report due date, that change the computation of margin from the 70 percent baseline method to the cost of goods sold or compensation deduction method.

The ALJ also found that the taxpayer's contention that the report form is flawed because it does not allow a taxpayer to affirmatively make the election is not supported. Although it is true that the 2009 report does not include an election check-box or something similar, Rule 3.584(d)(1) provides that taxpayers make the election by filing the report using one method or the other.

INSURANCE TAX

Volunteer Fire Department Assistance Fund Assessment — It's That Time Again

The Texas Forest Service administers the Volunteer Fire Department Assistance Fund to provide rural fire departments with assistance, training and funding to purchase equipment and train personnel. An assessment on a property and casualty insurer's net direct premiums in specific categories in proportion to the premiums of all licensed companies for these categories funds the program. The Comptroller administers the assessment under Chapter 2007, Insurance Code.

The Legislature authorized $15 million for the original assessment in 2001. In 2007, the Legislature increased the assessment to $30 million and repealed the expiration of the program, originally set as Sept. 1, 2011.

An insurer may recover the assessment by including it as an expense in a rate filing or by directly charging policyholders as provided under Section 2007.005, Insurance Code.

The Comptroller's office will be mailing billings by the end of May. The assessment is due Aug. 1, 2011.

All property and casualty insurers licensed to do business in Texas (including stock companies, farm mutual companies, county mutual companies, Lloyd's Plans and reciprocal or interinsurance exchanges) are subject to the assessment if they write homeowners insurance, fire insurance, farm and ranch owners insurance, private passenger auto physical damage insurance, commercial auto physical damage insurance or commercial multi-peril insurance.

SALES TAX

Disaster Relief for Texas Wildfire Victims

In response to the wildfires ravaging many parts of Texas, the Governor has issued a proclamation declaring a disaster in certain counties in Texas.

Because of this disaster declaration, purchasers can claim an exemption from sales tax on separately stated charges for labor to repair or restore real or personal property damaged as the result of a wildfire. The materials and equipment that are used in the performance of the repairs continue to be taxable.

The exemption allowed under Tax Code Section 151.350 applies only to charges for labor to repair or restore damage resulting from the condition that caused the area to be declared a disaster area. Therefore, the exemption authorized by this disaster proclamation is limited to damage caused by a wildfire in a county declared a disaster area and does not extend to repairs to personal property, a building or other improvement to realty damaged by other sources. There is no time limit or expiration date on how long a purchaser has to claim an exemption on labor charges related to a declared disaster.

For more information, see Disasters and Texas Sales Tax (Pub. 94-182), as well as the Comptroller's Disaster Resources section of our website for more information. Additional resources regarding Texas' response to the wildfire threat can be found in the Texas Wildfires section of the Governor's Office website.

SALES TAX

Spring is in the Air

Spring is in the air and for many of us, that means it's time to put on the gardening gloves and break out the shovel. It also means it's time to get the grass and the swimming pool in shape, so to help sellers and purchasers stay "out of the weeds" of sales tax when purchasing seasonal products and services, here are some reminders of what is taxable and what is not.

Flowers, Vegetables, Shrubs and Trees

Seeds and Bulbs

Seeds for annual and perennial plants grown to produce food for humans are exempt. See Tax Code Section 151.316(a)(5). Examples of exempt seeds include those for vegetables, fruits and culinary herbs. A Texas Sales and Use Tax Exemption Certificate (Form 01-339 back) (PDF, 57KB) is not required for purchasing these types of seeds.

Seeds that are used to produce feed for farm or work animals (such as chickens, cows, horses and mules) are also exempt. For example, a rancher may claim an exemption on the purchase of grass seed that will be planted in a pasture used for cattle grazing.

Flower bulbs, flower seeds and seeds for non-edible plants, however, are generally taxable. But, persons who grow and sell the agricultural products grown from these seeds in the regular course of business may claim an exemption from the tax by providing the seller with a properly completed exemption certificate at the time of purchase. For example, a company that sells turf may claim an exemption on the purchase of grass seed.

Plants, Trees and Shrubs

Annual plants that produce food for humans are exempt from tax. An exemption certificate is not required.

An annual plant is a plant that usually germinates, flowers and dies in a year or season. Tomatoes, corn, lettuce and peas are examples of annual plants that qualify for this exemption.

Perennial plants, including plants that produce food for humans, are not exempt from sales tax. A perennial plant is a plant that lives for more than two years or produces in successive years. Examples of perennial plants include blueberries, raspberries, blackberries, strawberries and grapes.

Perennial plants are, however, exempt when they are purchased by a person engaged in the business of selling the product of the plants in the regular course of business or when they are sold to a purchaser who is in the business of reselling the plants. A purchaser who buys perennial plants for resale must issue a Texas Sales and Use Tax Resale Certificate(Form 01-339 front) (PDF, 57KB) to the seller in lieu of the tax. A purchaser buying perennial plants that will be used to grow food products for sale should issue an exemption certificate.

Trees, including fruit and nut trees, are also taxable. Trees, however, are not taxable when sold to a commercial grower who sells the fruit or nuts or to a person engaged in the production of timber for sale. The commercial grower must issue an exemption certificate to the seller in lieu of the tax when purchasing the trees.

Supplemental Nutrition Assistance Program (SNAP)

Texas law exempts items that are purchased legally as part of the Supplemental Nutrition Assistance Program (SNAP), formerly known as the food stamp program. Eligible SNAP purchases are not limited to grocery items. Seeds and live vegetable plants, fruit trees, grape vines and fruit-producing shrubs make the list of items SNAP will pay for.

The vendor must be approved as a vendor participating in the SNAP program. Large department stores that carry groceries and have a garden center often participate in the SNAP program and list their live herbs, vegetable plants, fruit trees and shrubs as allowable SNAP purchases. Seeds for growing produce are also eligible.

Landscaping and Lawn Care Services

Landscaping and lawn care services are taxable real property services. Taxable landscaping and lawn care services include any work done to maintain or improve lawns, yards and ornamental plants and trees, such as tree trimming and lawn mowing. The total amount charged for landscaping and lawn care services is subject to tax, including any charges for travel or equipment, even if separately stated.

Local Tax on Landscaping and Lawn Services

State and local sales taxes are due on landscaping and lawn care services. The local sales taxes due (city, county, special purpose district or transit) should be collected according to the location of the service provider's place of business. If the total sales tax rate at the service provider's place of business is less than 8.25 percent, local use taxes based on the location where the service is performed may also apply.

For example, assume a service provider located in Bastrop County (outside a city, special purpose district or transit) landscapes a yard in the city of Elgin. The sales tax rate at the service provider's place of business is 6.75 percent (6.25 percent state tax, plus .5 percent county tax). The sales and use tax rate in Elgin is 8.25 percent (6.25 percent state tax, plus .5 percent county tax, plus 1.5 percent Elgin city tax). Since the service provider is engaged in business in Elgin, he must collect 8.25 percent tax: 6.25 percent state tax, .5 percent Bastrop County tax and 1.5 percent Elgin city tax.

See Guidelines for Collecting Local Sales and Use Tax (Pub. 94-105) (PDF, 827KB) for more information on how local use taxes are collected.

Landscaping by the Self-Employed

Lawn care and landscaping are nontaxable when done by a self-employed individual who:

  • does the actual lawn care or landscaping services;
  • has no employees, partners or other persons providing the services; and
  • has gross receipts from lawn care or landscaping services of $5,000 or less during the most recent four calendar quarters.

If a service provider's receipts from landscaping and lawn care exceed $5,000 during the most recent four calendar quarters, he must begin collecting tax on these services on the first day of the quarter after the threshold is exceeded. When the gross receipts from these services fall to $5,000 or below for the most recent four calendar quarters, the exemption resumes on the first day of the next quarter. See Tax Code Section 151.347 more information.

Collecting Tax on Construction Activities Performed in Connection with Landscaping Services

Landscaping and lawn care services do not include the construction or repair of decks, retaining walls, fences or pools, or the installation of underground sprinkler systems. These activities are considered either new construction, or repair or remodeling of real property. If a single job consists of both construction and landscaping activities, the service provider should separately state landscaping charges from charges for new construction or for repair or remodeling because different taxability rules, and in some cases, local tax rates apply.

Nonresidential real property repair or remodeling is a taxable service. The service provider must collect sales tax on the total charge to the customer for materials, labor and other expenses. The service provider may issue a Texas Sales and Use Tax Resale Certificate (Form 01-339 front) (PDF, 57KB) to the supplier when purchasing materials transferred to the customer. Refer to Rule 3.357 regarding nonresidential real property. Local sales taxes for nonresidential repair or remodeling are based on the location of the jobsite, not the service provider's place of business. See Tax Code Sec. 323.203(m).

No tax is due on labor to repair or remodel residential real property or to build new improvements to realty (residential or nonresidential). The type of contract determines how tax is paid on the materials incorporated into the realty.

If the construction contract is lump sum (one charge, including labor and materials), the contractor pays tax when purchasing the materials and does not collect tax from the customer. If the contract is separated (separate charges for labor and materials), the contractor collects sales tax from the customer on the charges for materials but not for labor. Sales tax due on the charges for materials under a separated contract is calculated based on the location of the jobsite. A separated contractor may purchase the building materials tax-free by issuing a resale certificate to suppliers in lieu of tax. Refer to Rule 3.291 on contractors for more information.

A person who performs both landscaping and construction activities in the same job must separately state the charges and collect tax according to the charges on the invoice. In the examples below, the tax rate for the service provider's place of business is 7.25 percent. The tax rate for the jobsite is 8.25 percent.

Example A: Invoice for a job which includes an $800 charge for new deck construction under a lump sum contract, and a $500 charge for landscaping service.

Landscaping service$500.00
Tax (7.25 percent sales tax)
Additional local use tax up to 1.0 percent may be due.
36.25
New deck construction (Lump Sum Contract)800.00
Total$1336.25

Example B: Invoice for a job which includes a charge for new deck construction under a separated contract ($200 for materials, $600 for labor) and a $500 charge for landscaping service

Landscaping service$500.00
Tax (7.25 percent sales tax)
Additional local use tax up to 1.0 percent may be due.
36.25
Materials for new deck construction (Separated Contract)200.00
Tax (8.25 percent)16.50
Labor for new deck construction (Separated Contract)600.00
Total$1352.75

Example C: Invoice for a job which includes an $800 charge for nonresidential deck repair (taxable service) and a $500 charge for landscaping service

Landscaping service$500.00
Tax (7.25 percent sales tax)
Additional local use tax up to 1.0 percent may be due.
36.25
Nonresidential deck repair800.00
Tax (8.25 percent)66.00
Total$1402.25

Dirt and Stepping Stones

Purchases of stone or rock that is cut, crushed or mixed with other products, such as processed soil or dirt, sand or gravel, are taxable as processed materials. But, purchases of unprocessed dirt, sand, gravel, stone, rock or similar materials are not taxable. Dirt, sand, rocks and gravel that are merely sorted, sized, screened, washed or dried are not considered processed materials and have been exempt from sales tax since June 1988.

A person performing a taxable real property service, such as landscaping, may issue a resale certificate instead of paying tax on the purchase of processed materials that will be incorporated into a customer's real property as part of the taxable service. See Rule 3.356 for more information about real property services. A person performing a nontaxable service must pay tax on processed materials.

A charge to a customer for unprocessed materials that are incorporated into the customer's real property as part of a taxable real property service, such as landscaping, becomes taxable as part of the total charge for the taxable service. A charge to a customer for unprocessed materials that are incorporated into the customer's real property as part of new construction (under either a lump-sum or separated contract), such as a rock wall, is not taxable. See Rule 3.291 for more information about contractors who add new improvements to real property.

Swimming Pool Cleaning and Repair

Pools and Spas

An in-ground pool or spa permanently attached to real property is considered an improvement to real property. Therefore, in-ground swimming pool and spa cleaning services are taxable real property maintenance services under Texas Tax Code Section 151.0101 and Rule 3.356(a)(7).

Sales tax is due on the total charge for in-ground pool and spa cleaning services, including charges for labor and supplies. The service provider may issue a Texas Sales and Use Tax Resale Certificate(Form 01-339 front) (PDF, 57KB) to a supplier to purchase tax free the chemicals that will be left in a customer's pool, but should pay tax on items such as chemical testing kits, pool vacuums, screens and brushes that are used to perform the service.

Charges for repairs to in-ground pools and spas are taxed differently than cleaning and maintenance services. For residential in-ground pools or spas, no sales tax is due on labor to repair a pool liner, pump, filter or heating system. Under a separated contract, which has materials billed separately from labor, the repairperson is considered the retailer of all materials physically incorporated into the pool or spa. The repairperson is reselling those materials and must collect sales tax from the customer on any incorporated parts and materials. The repairperson may purchase these items tax free by providing suppliers a properly completed resale certificate in lieu of paying the tax. If the repairperson paid tax on purchases of incorporated materials (instead of purchasing them tax free), the repairperson would still be required to collect tax from the customer on the materials, but would be allowed a credit on the sales tax return for taxes paid on those materials.

Under a lump-sum contract or invoice, the labor and materials are billed as a single charge. The repairperson may not charge sales tax to the customer for residential pool or spa repair. The lump-sum charge, however, may be set to cover all the costs the repairperson incurs, including the tax paid on the incorporated materials. The repairperson must pay tax on all the incorporated materials when purchased from suppliers or accrue tax on materials removed from a tax-free resale inventory.

See Rule 3.291 for information about the repair or remodeling of residential real property by contractors.

For nonresidential or commercial in-ground pools or spas, such as at hotels or health clubs, the total charge (including labor and parts) to repair the pool is taxable. See Rule 3.357 for more information regarding repair, remodeling and restoration of nonresidential real property.

Above-ground pools and spas without a permanent attachment to realty (such as decking or in-ground plumbing to fill and drain the pool or spa) are considered tangible personal property. The total charge (including labor and materials) to install or repair such an above- ground pool or spa is taxable on both residential and nonresidential property. See Rule 3.292 for more information about the repair, remodeling, maintenance and restoration of tangible personal property.

A resale certificate is required to properly document items purchased for resale.

RECENTLY PROPOSED RULES

Motor Fuel Tax - Rule 3.443 Diesel Fuel Tax Exemption for Water, Fuel Ethanol, Biodiesel, Renewable Diesel, and Biodiesel and Renewable Diesel Mixtures

The following rule was submitted for filing with the Secretary of State with a publication date of May 13, 2011. The comment period ends 30 days after publication.

Rule 3.443 - Diesel Fuel Tax Exemption for Water, Fuel Ethanol, Biodiesel, Renewable Diesel, and Biodiesel and Renewable Diesel Mixtures

Crude Oil Production - Rule 3.32 Exemption of Oil Incidentally Produced in Association with the Production of Geothermal Energy

The following rule was submitted for filing with the Secretary of State with a publication date of May 27, 2011. The comment period ends 30 days after publication.

Rule 3.32 - Exemption of Oil Incidentally Produced in Association with the Production of Geothermal Energy

Natural Gas - Rule 3.24 Exemption of Gas Incidentally Produced in Association with the Production of Geothermal Energy

The following rule was submitted for filing with the Secretary of State with a publication date of May 27, 2011. The comment period ends 30 days after publication.

Rule 3.24 - Exemption of Gas Incidentally Produced in Association with the Production of Geothermal Energy

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 website.

Contributors to This Month's Issue

Robin Corrigan, Janaha Crawford, Lisa Davis, John Huffman, Lavonne Key, Carol McAnnally, Lindey Osborne, Jerry Oxford, Jo Samuel, Viki Smith, Karen Snyder, Jennifer Specchio and Karen Specht

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