On August 30, 2019, the Texas Comptroller of Public Accounts (Comptroller) adopted amendments to its franchise tax reports and payment rule codified at 34 TAC Section 3.584. The amendments add definitions of "produce" and "product," which are intended to aid in determining whether a taxpayer qualifies as a retailer or wholesaler. Under the new definition of "produce," certain taxpayers will no longer be considered a "retailer" or "wholesaler," which will result in these taxpayers no longer qualifying for the lower 0.375% tax rate for retailers and wholesalers. Instead, these taxpayers will be subject to the higher 0.75% general tax rate.

The amended rule takes effect September 4, 2019.

Defining "produce" and "product" in 34 TAC Section 3.584 Reports and Payments

Section 3.584 generally allows retailers and wholesalers to claim the 0.375% franchise tax rate unless they or their affiliates produce a product that they sell. The original version of Rule 3.584, however, did not define the terms "produce" and "product."

New subsection 3.584(b)(3) adds a definition of "produce," which is defined as "[t]o construct, manufacture, install during the manufacturing or construction process, develop, mine, extract, improve, create, raise, or grow either a product or a component of a product." Under the new rule, an entity also produces a product if it or an affiliate:

• Asserts a software copyright over the product or a component of the product
• Asserts a patent right under US or comparable foreign law over the product, a component of the product, or the packaging of the product

or

• Produces a component of the product, or modifies an acquired product, unless the entity can demonstrate that the component or modification does not increase the product's sales price by more than 10%

An entity does not produce a product it sells under the rule if an unrelated party manufactures the product and all the product's components to the entity's specifications. In explaining the rule change, the Comptroller's office stated that it believes that "[a] taxable entity should not be able to claim the cost-of-goods-sold deduction on goods that it 'produces,' while simultaneously claiming it does not 'produce' the same goods for purposes of determining qualification for the reduced rate." The Comptroller further indicated in its explanation of the rule change that it "will apply subsection 3.584(b)(3) to reports originally due on or after the effective date of the rule amendment, to the extent that the guidance in subsection 3.584(b)(3) may be inconsistent with prior [C]omptroller interpretations."

New subsection 3.584(b)(4) defines "product" to mean "tangible personal property acquired or produced for sale." Tangible personal property includes personal property perceptible to the senses; films, sound recordings, videotapes, live and prerecorded TV and radio programs, books, and other similar products, regardless of the means or method of distribution or medium in which the property is embodied; and computer programs. Tangible personal property does not include intangible property or services.

Other amendments to section 3.584 do the following:

• Provide that selling telephone prepaid calling cards is not providing telecommunications services for purposes of determining whether an entity is primarily engaged in retail or wholesale trade
• Modify the definition of "unrelated party" to mean, in regard to a taxable entity, "an entity that for any period during which the entity does not meet the requirements to be a member of the same affiliated group, as defined in [34 TAC] Section 3.590(b)(1) … (relating to Margin: Combined Reporting), as such taxable entity"
• Extend the period before a determination is final to 60 days (from 30 days) after the date the notice of determination is issued
• Extend the period in which a petition for redetermination must be filed to 60 days (from 30 days) after the date the notice of determination is issued, or the redetermination is barred
• Provide that a petition for redetermination becomes final at the time a contested case is final under Tex. Gov. Code, Ch. 2001 (from 20 days after service of the notice of the decision)

Implications

The changes to 34 TAC Section 3.584, specifically the new definition of "produce," will cause certain taxpayers to no longer be considered a "retailer" or "wholesaler" and, in turn, no longer be eligible for the lower tax rate. Generally, a taxable entity that sells goods produced by another entity is eligible for the reduced franchise tax rate when it is "primarily engaged in retail or wholesale trade."

The Comptroller considered comments from interested parties regarding subsection 3.584(b)(3), including that the references to software and patents contradict prior guidance, add distinctions not in the statute, and are more appropriate for legislative action, among others. In response, the Comptroller determined that adding subsection 3.584(b)(3) is within its delegated rule-making authority; because "produce" is not statutorily defined for franchise tax purposes, adding the definition is appropriate to provide guidance to taxpayers and Comptroller personnel.

As for the comment that the references to software and patents contradict prior guidance, the Comptroller noted that taxpayers do not have "a vested right in the continuation of a safe-harbor that was originally created by rule" and that it could change the rule. It is not yet known whether the validity of subsection 3.584(b)(3) will be challenged as exceeding the provisions of the statute.

EY will continue to monitor these developments, and issue additional Tax Alerts as needed.

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