The Texas Comptroller of Public Accounts held its annual briefing in Austin on September 17 and provided taxpayers with updates regarding audit staffing shortages, pending litigation, recent guidance and related topics.

Solutions for a Texas-Sized Audit and Hearings Backlog

Audit Assistant Director Rosie Julius said that the agency continues to struggle with staffing issues due to increased hiring competition from oil and gas industry, consultancies and the IRS. The Comptroller is roughly 100 auditors short of its target staffing level and hopes to alleviate the problem with changes to its qualification requirements, hiring cycles and office-specific staffing targets. In the past five years, staffing levels at the audit division have fluctuated from a high of 589 to a low of 445, and the Comptroller’s audit volume targets do not change when staffing levels drop. Given the influx of new, inexperienced auditors, taxpayers are encouraged to reach out to audit supervisors if they experience service issues.

The Audit Division implemented the following procedures this year to help increase the efficiency of audits, such as:

• Bringing forward assignments that use prior audit findings and error percentages to apply to current audit period. (Not available for assignments that were previously settled).
• Redistributing audits from the Dallas and Houston offices to other offices with staffing ability (or remote auditors), but assigning local auditors for taxpayers that want field visits.
• Using contract tax examiners for smaller audits. These 35 contractors have completed 1,055 assignments and refunds in FY 2024. Notably, these contractors have used personal email addresses and computers, which raised privacy concerns for some taxpayers.
• Allowing auditors to approve or deny the research and development (R&D) credit rather than requiring all R&D credit issues to be handled by HQ staff. (Although HQ still appears to be heavily involved in many R&D cases).

The Audit Division is supported by the new Tax Resolution Section of the Hearings Division, which Senior Counsel for Tax Resolutions Matt Jones recently transferred to. This section also offers Independent Audit Review Conferences (IARC), which can help resolve audits before they are billed. The approximate turnaround time for a decision after an IARC is 90 days from the date of the conference but has been quicker recently due to the low volume of conferences.

Hearings and Tax Litigation General Counsel Jim Arbogast said that a number of R&D hearings are pending and his division is working on reducing the high amount of “aging” cases that have been pending over two years. Tax Hearings Attorney Supervisor Dan Neuhoff added that since September 2021, the number of total hearings has crept up to about 1,700 for a staff of 15 hearings attorneys and two supervisors. Tax Litigation Attorney Bree Boyett said that the Comptroller is willing to consider settlement offers from taxpayers interested in having a more expedient resolution to their cases and that approximately two thirds of cases are settled. 

Texas Tax Policy and Guidance

Tax Policy Director Jenny Burleson said that her division is issuing fewer private letter ruling (“PLR”) requests in favor of publishing more regulations in a timely manner. If a taxpayer really wants a PLR and is willing to wait, they should reach out to the tax policy division directly.

Direct Tax Team Lead Julian Daniels (J.D.) highlighted recent franchise tax developments, including the increase of the no tax due (NTD) threshold from annualized total revenue of $1 million to $2.47 million. See Tex. Tax Code § 171.002(d). The tax policy team also released two recent audit memos on benefits for the compensation subtraction (202310005M) and determining the statute of limitation when a taxpayer requests an extension for the report period (202408001M).

Indirect Tax Team Lead Julio Mendoza-Quiro also covered a myriad of guidance released by the Comptroller since the last annual briefing. Highlights include:

Rule changes:

• Proposed Rule 3.330 (Data Processing Services), was published in the Texas Register on September 13, 2024 with significant revisions to the current rule, including the expansion of “data processing” to specified online services and revocation of the “essence of the transaction” test for data processing transactions in favor of an “ancillary” test. This proposed rule was also the subject of a recent op-ed by Comptroller Hegar. Eversheds Sutherland is closely monitoring Proposed Rule 3.330, with separate alerts forthcoming. The public comment period for this rule closes October 13, 2024.

• Rule 3.334 (Local Sales and Use Taxes), was adopted and effective July 4, 2024 and is subject of a trial set for October 14, 2024. Some municipalities with processing facilities object to the sourcing provisions in the rule which prevent them from assessing local sales taxes on orders.

Memorandums:

• Memo 202312010M (Taxability of flowback and water transfer services), offers guidance on the taxability of flowback and water transfer services provided at an oil or gas well site to support hydraulic fracturing operations.

• Memo 202407003M (Chemical Plant and Petrochemical Refinery Utility Studies and Turnarounds), covers guidance regarding the requirements for utility studies and issues related to plant turnarounds for chemical plants and petrochemical refineries.

• Memo 202406004M (Sales price and credit card processing fees) – holds that separately stated credit card processing fees are taxable as part of the total sales price of a taxable item.

Private Letter Rulings:

• 202402021L – Stating that tax applies to lump-sum monthly rental charge covering the rental of equipment, software, leasehold improvements, and training services.

• 202402023L – Holding that a taxpayer’s website analytics products and services are not information services, but rather taxable as data processing or as the sale or license of software. (See also 202402020L addressing the taxability of website design, marketing and consulting services).

• 202407022L – Determining that materials incorporated into the construction of railroad tracks or roadbeds (“riprap”) are essential to the operation of locomotives and trains and are exempt from sales and use tax. This includes items such as sub-ballast, riprap, and steel and precast culverts.

Noteworthy Cases

Cases highlighted during this year’s annual briefing include:

• Hibernia Energy LLC v. Hegar – The Supreme Court of Texas declined to review this case in which the state argued that a taxpayer’s gains the sale of oil and gas property, which it did not include on line 11 of schedule K of its federal partnership tax returns were reportable as income. This case is significant because it is the first to address how flow-through status for federal purposes is converted to taxable entity status for Texas franchise tax. 

• Anadarko Petroleom Corp v. Hegar – A dispute regarding whether a $4 billion payment related to the Deepwater Horizon oil spill is a cost of goods sold for franchise tax purposes.

• NuStar Energy LP v. Hegar – A case where the Comptroller’s position is that a taxpayer’s bunker fuel sales are sourced to Texas despite the fuel being purchased by out-of-state customers and a federal ban on the use of this fuel within 200 miles of the U.S. coast.

• RJR Vapor v. Hegar – A dispute about whether a taxpayer’s pouches (VELO) containing nicotine isolate were taxable as a tobacco product.

• Geo Group Inc. v. Hegar – A case concerning whether a for-profit prison company is an instrumentality of the state such that it is entitled to the government sales and use tax exemption.

Finally, Comptroller staff noted that future tax cases will be heard by Texas’ new Fifteenth Court of Appeals. The court has exclusive statewide civil intermediate appellate jurisdiction over appeals involving the State and its officers and challenges to the constitutionality of a state statute, such as a tax law. The court also has exclusive jurisdiction over appeals from the Texas Business Courts, involving cases dealing with business disputes valued at more than $10 million.

A Steady Economic Outlook

In his opening remarks, Comptroller Glenn Hegar noted that the state continues to have healthy cash reserves and rainy-day funds compared to peer states. Revenue Estimating Division Director Tetyana Melnyk reported that the economic growth for Texas is stable with slightly higher growth rates expected for 2024 and slightly lower than average growth rates expected for 2025. Inflation also helped Texas revenues by contributing approximately 18 billion in additional sales tax collections over the past three years. Texas’ sales tax inflation boost offset the impact of sales tax declines associated with the depletion of excess pandemic-related household savings, which appear to have been completely exhausted around March of 2024. Where any of Texas’ surpluses will make lawmakers amenable to taxpayer-friendly changes in the next legislative session remains to be seen and will be covered in next year’s Texas Comptroller Annual Briefing.

Coverage of Previous Briefings:

• Highlights from the Texas Comptroller’s 2023 Annual Briefing
• Highlights from the Texas Comptroller’s 2022 Annual Briefing
• Highlights from the Texas Comptroller’s 2021 Annual Briefing