United States: Texas Letter Ruling Denies Capital Asset Or Investment Treatment For Goodwill And Government Permits And Licensing

On July 22, 2016, the Texas Comptroller of Public Accounts issued a letter ruling addressing the proper apportionment of gross receipts from the sale of substantially all of the assets of a company located in Texas to an entity incorporated in Delaware.1 Specifically, the ruling provides guidance on the apportionment of gross receipts from the sale of tangible personal property located in Texas at the time of sale, tangible personal property deployed outside the United States at the time of sale and certain legal and contractual rights, including goodwill, government permits and licensing. The ruling is noteworthy for its determination that goodwill, and perhaps government permits, are not treated as capital assets.

Background

An oil and gas services company located in Texas (Seller) sold substantially all of its assets to an entity incorporated in Delaware (Buyer). The terms of the sale were set forth in an asset purchase agreement. At the time of the sale, the business assets included tangible personal property located in Texas, tangible personal property deployed outside the United States and tangible personal property with an unlabeled location. The Seller also transferred a number of legal and contractual rights, including rights arising from government licenses and permits, goodwill and the value of Seller as a going concern.

Treatment of Tangible Personal Property

Under Tex. Tax Code Ann. Sec. 171.103(a)(1) and 34 Tex. Admin. Code Sec. 3.591(e)(29), transactions involving the sale of tangible personal property result in Texas receipts when the tangible personal property is delivered or shipped to a buyer in Texas. Furthermore, under 34 Tex. Admin. Code Sec. 3.591(e)(29)(A), delivery is complete upon transfer of possession or control of the property to the purchaser and location of title of passage is not relevant to the determination of Texas gross receipts. The Comptroller advised that under these rules, the sale by the Seller of tangible personal property located in Texas gives rise to Texas receipts. However, the sale by the Seller of the tangible personal property deployed to a foreign jurisdiction at the time of the sale does not give rise to Texas receipts.

Treatment of Legal and Contractual Rights

In addition to the tangible personal property, the Seller also sold a number of legal and contractual rights.2 34 Tex. Admin. Code Sec. 3.591(e) sets forth examples of what constitutes intangibles in Texas. While contract rights are not specifically enumerated as an intangible in the regulation, the Comptroller explained that it has consistently held that contract rights are intangibles.3 The Comptroller advised that the assets identified by the Seller as "Included Contracts" and "Insurance" are intangible assets. The Comptroller explained that under 34 Tex. Admin. Code Sec. 3.591(e)(21)(B), gross receipts from the sale of intangibles are apportioned based on the location of the payor, which is the payor's legal domicile.4 A corporation's legal domicile is its state of formation.5 Thus, the sale of the contract rights by the Seller constitutes the sale of an intangible asset, the receipts of which should be apportioned to Delaware, the state where the Buyer is incorporated.

Treatment of Other Intangibles

The taxpayer had requested that the remaining intangibles6 be apportioned under 34 Tex. Admin. Code Sec. 3.591(e)(2) as capital assets or investments and be reduced by the basis in the asset. The Comptroller advised that there was no evidence that the intangibles were investments or capital assets and no book value had been assigned to them. Therefore, the gross gains could not be offset against other capital losses.7

Allocation of Sales Price to Assets

The taxpayer also sought guidance on the correct allocation of the sales price to the specific assets sold in the agreement. The Comptroller explained that, under 34 Tex. Admin. Code Sec. 3.591(d)(4), when computing gross receipts for apportionment, a taxable entity is deemed to have elected to use the same methods that it used in filing its federal income tax return. Thus, the same valuation method used for federal income tax purposes should be used for the Texas apportionment calculations. As a result, the Texas value of the assets in the hands of the buyer will be the same as the federal value.

Commentary

This ruling by the Comptroller is noteworthy for its determination that goodwill, and perhaps government permits, are not treated as capital assets. This determination gives rise to confusion because a capital asset is defined in Texas as "[a]ny asset, other than an investment, that is held for use in the production of income, and that is subject to depreciation, depletion or amortization."8 The Comptroller implies that, at least in this ruling, goodwill and other intangibles at issue (including government permits) are not held for use in the production of income, and are not amortized. The Comptroller's logic is unclear, especially in light of the fact that Internal Revenue Code Section 197, adopted by Texas for purposes of the franchise tax, defines goodwill and government permits as amortizable assets.9 By departing from its previous policy in this ruling, taxpayers should be aware that the Comptroller has taken an aggressive position that could justify filing under either the established policy (goodwill, permits and licenses are capital items and can be offset against other capital items) or the new policy (these assets must be treated at gross value) which, if it survives, may be challenged and potentially overturned by the courts.

In Hallmark Marketing Co. v. Hegar,10 the Texas Supreme Court held that the Comptroller cannot offset net losses from sales of capital assets and investments against other gross receipts in determining the Texas franchise tax sales factor denominator. In Hallmark, the Comptroller sought to offset capital losses against other gross receipts in the denominator to increase the Texas apportionment factor. In this ruling, the Comptroller has resorted to disqualifying the intangible assets from capital asset treatment to prevent the taxpayer from offsetting its revenues. Taxpayers should be aware that the law in the area of netting gross receipts in Texas is unsettled, somewhat contradictory, and potentially hangs on very thin threads.

Finally, in the ruling, the Comptroller promises a prospective revision to its rule11 "to clarify the definition of 'investment.'" Thus, this ruling may be interpreted to be based on a future version of the rule (potentially applicable on a retroactive basis) rather than the current promulgated version of the rule. If this is the case, the Comptroller would be setting an unfortunate precedent in basing a ruling on a future version of a rule that has yet to be promulgated.

Footnotes

1 Letter Ruling No. 201607948L, Texas Comptroller of Public Accounts, July 22, 2016.

2 The ruling lists these rights as: (1) rights under a joint development agreement for advanced oil production technology with a large oil company; (2) rights under a field services contract with a large oil company; (3) rights under a master agreement for provision of services with a large oil company; (4) rights under an agreement with a large oil company to provide inspections services; (5) rights under confidentiality agreement with the manufacturer of Seller's proprietary technology; (6) rights arising from all government authorizations and pending applications for government authorizations, including rights arising from consent, license, franchise, permit, exemption, clearance, or registration granted; (7) rights and interests arising from insurance on Seller or its assets in the event of causality or liability; (8) all goodwill associated with Seller or the assets purchased from Seller; and (9) residual value created by Seller as a going concern.

3 Citing to Letter Ruling No. 9205L1173C11, Texas Comptroller of Public Accounts, May 22, 1992 and Letter Ruling No. 9404L1356C11, Texas Comptroller of Public Accounts, April 1, 1994.

4 34 TEX. ADMIN. CODE § 3.591(b)(8).

5 34 TEX. ADMIN. CODE § 3.591(b)(7).

6 Goodwill, the value of Seller as a going concern, and rights arising from all government authorizations and pending applications for government authorizations, including rights arising from consent, license, franchise, permit, exemption, clearance or registration granted.

7 The ruling does not indicate specifically how the Seller wanted to offset capital gains and losses, but it should be noted that a capital offset may have been available to Seller if the proceeds from the sale of goodwill and government licenses were found to be capital gains. While the facts state that there was no basis in the goodwill, Seller potentially had alternative arguments regarding the valuation of the basis not raised in the ruling as a means to reduce the gain.

8 34 TEX. ADMIN. CODE § 3.591(b)(1).

9 IRC § 197(d)(1)(D).

10 Hallmark Marketing Co. v Hegar, 488 S.W.3d 795 (Tex. 2016). For a discussion of this case, see GT SALT Alert: Texas Supreme Court Nixes Netting Investment Losses Against Other Receipts.

11 The Comptroller referenced "Rule 3.291," a sales tax rule, when determining that it would change the definition of "investment." The Comptroller likely intended to refer to "Rule 3.591" instead, which was referenced throughout the letter.

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