The Texas Comptroller of Public Accounts held its annual briefing in Austin on September 26 and provided taxpayers with updates regarding the administration of research and development credits, pending litigation, rule updates and related topics. The meeting – which was the first all in-person briefing since the beginning of the pandemic – struck an optimistic tone regarding the strength of the Texas economy and the Comptroller’s efforts to recover from its recent staffing shortages.

A Texas-sized R&D Backlog

The Texas Comptroller has struggled to administer the R&D credit over the past few years, resulting in a significant backlog of R&D audits and appeals. Texas’ R&D credit was a topic of intense interest for this year’s annual meeting and was covered in many of this year’s presentations. 

Brett Hare, the director of the Comptroller’s Direct Tax Section, said that the agency is making progress on its large backlog of R&D cases. Tax Hearings Attorney Supervisor Sarah Berry similarly said that her team was starting to move forward with pending R&D-related hearings and would consider taxpayer settlement requests for R&D issues.

Audit Director Emma Fuentes said that the audit division has shifted its approach to reviewing R&D credits. R&D credits are no longer being sent solely to the Tax Policy Division, which had been overwhelmed by the volume of requests. Now, a team from the Comptroller’s headquarters assists auditors to review R&D credit documentation. Fuentes also said that the Comptroller’s office understands that taxpayers typically cannot provide perfect documentation to substantiate R&D claims. Therefore, the Comptroller expanded the types of documentation that it will consider such as contemporaneous emails from personnel demonstrating that testing activity occurred.

Nick Souza of the Comptroller’s Policy Division said that the agency continues to focus on the Four-Part Test to determine whether a project has conducted qualifying research activities. The Four-Part Test is the test described in IRC, §41(d) (“Qualified research defined”) that determines whether research activities are qualified research. The four parts of the test are the Section 174 Test, the Discovering Technological Information Test, the Business Component Test, and the Process of Experimentation Test.

Souza added that taxpayers should continue to submit information used to qualify for the federal R&D credit, but that such documentation is not always conclusive for Texas purposes because the IRS does not always analyze the Four-Part Test, and the Texas-specific R&D expenses may not be apparent.

Virtual Currency, Cloud Computing, Data Processing and other Indirect Tax Developments

The Comptroller’s Indirect Tax Division highlighted two recent memorandums concerning virtual currency and credit card reporting services:

1. No. 202309029L, the Comptroller clarifies that it considers electronic video games and associated virtual currency, virtual goods, and other content to be taxable amusement services. Meanwhile, membership fees, subscription fees, or similar charges, by whatever name called, for access to an electronic game or associated content are charges for membership or access to special privileges.
2. In Memo No. 202302004L, the Comptroller determined that services to assign credit ratings to legal entities are taxable as credit reporting services.

Two legislative changes that the Indirect Tax team is helping administer are H.B. 1515, which modifies the residency requirement for qualified Enterprise Zone employees to permit remote work, and S.B. 1122, which deals with the taxability of designated doctor exams related to workers’ compensation claims.

The Indirect Tax Analyst Melissa Schulz said that her team is working on updates to Comptroller Rule 3.330, to provide examples of data processing services. Schultz also added that the team is discussing topics such as resale exemptions for cloud computing, out-of-state software licenses, and what emerging technologies may constitute taxable data processing.

Franchise Tax apportionment, reporting, and other Direct Tax Updates

The Comptroller finalized amendments to its franchise tax apportionment rule, discarding the now-repudiated “receipt-producing, end-product act” test. The Comptroller proposed these amendments in response to the Texas supreme court’s unanimous decision in Sirius XM Radio, Inc. v. Hegar. Eversheds Sutherland’s SALT Team represented Sirius XM in this litigation.

Comptroller’s rule replaces the term used by the Texas supreme court—“equipment”—with the more general term “property” in apparent recognition that the location of property that is not equipment may be relevant as well.

The Direct Tax team discussed the implementation of S.B. 3, which increases the threshold before small businesses are required to pay and file franchise taxes. The Tax Policy division also issued a memo to the Audit division on the impact of Hegar v. Health Care Services Corp. to stop-loss insurance. Based on the decision in Health Care Services Corp., insurers can allocate premiums received for stop-loss policies purchased by employers to finance self-funded employee health care benefits when calculating gross premiums subject to premium and maintenance tax if the insurer follows a reasonable allocation methodology that is supported by sufficient evidence.

Audit Sampling Gone Wrong

The Comptroller’s audit team discussed an initiative to change how audit samples are developed. Audit Director Emma Fuentes said that her team has noticed instances where a taxpayer’s audit sample complies with the Comptroller’s standards, but is nevertheless so large that it becomes inefficient. The example provided was an audit sample of 6,000 items that took approximately 1,500 hours to review. Methods to reduce sample sizes include merging sample categories, eliminating immaterial sample categories, and increasing the variances between dollar stratums up to eight percent.

Refund Claims for Nonpermitted Taxpayers

Nonpermitted taxpayers are required to fill out a Form 00-985, “Assignment of Right to Refund” in order to file refund claims. The Audit Director Fuentes said that her staff has noticed a widespread issue of taxpayers losing their refund claims due to statute of limitations because the form is not being sufficiently completed, specifically the requirement to itemize the transactions that form the basis for the refund claim. Audit staff are now conducting more thorough reviews of the Assignment of Rights forms as they come in, but Fuentes implores service providers to be more thorough when submitting the forms.

Ongoing Audit Staffing Problems

The Comptroller’s audit division remains understaffed. Director Fuentes said that the audit division is averaging staffing levels around 460 auditors down from a pre-pandemic average of 570. Interest waivers may be available for taxpayers who experience audit-related delays.

Tax Hearings Bypass Process

Victor Simonds, Senior Counsel of Tax Compliance, highlighted the progress of the Comptroller’s relatively-new hearings bypass process. Simonds noted that although the process allows taxpayers to quickly access District Court, taxpayers should not ask auditors to summarily deny claims to expedite the process. Mr. Simonds said that it was important to develop a complete record for District Court and that the hearings bypass process has been successful at fully or partially resolving many claims.

See you in court… This Year’s Texas Tax Litigation Update

Bree Boyett from the Comptroller’s Tax Litigation Team provided an overview of recent significant tax cases, including:

• Apple, Inc. v. Hegar: An Internet Tax Freedom Act challenge to the imposition of sales tax on iCloud and iTunes matching services as data processing services.

• Hibernia Energy LLC v. Comptroller: A case concerning how flow-through status for federal tax purposes is converted to taxable entity status for the Texas franchise tax.

• Anadarko Petroleum Corporation v. Hegar: A COGS case regarding whether a $4 billion payment related to the Deepwater Horizon oil spill could be deducted as a cost of goods sold under an “origin of the claim” theory. 

• American Airlines v. Hegar: A franchise tax controversy in which an airline claims that Texas’ imposition of franchise tax on baggage and passenger fees is prohibited by the Anti-Head Tax Act.

• Sidetracked Bar LLC v. Hegar: A case holding that an electronic sweepstakes using magnetic card strips was taxable as an amusement service.

• Boaz Energy II Operating LLC. V. Hegar: A sales tax case concerning whether tangible personal property purchased in connection with the operation of secondary recovery injection wells is exempt as property specifically installed to reuse and recycle wastewater streams generated within the manufacturing, processing, fabrication, or repair operation. Similarly, XRI Holdings, LLC v. Hegar is a case about whether water used for fracking qualifies for a sales tax exemption for wastewater treatment.

• Avalon Exploration and Production LLC v. Hegar: A case regarding whether oil soluble chemicals are exempt from sales tax because they become a component of property sold for resale.

What’s Next for Texas

The Texas economy continues to outpace expectations according to the Comptroller’s Chief Revenue Estimator, Brad Reynolds.

Reynolds said that the forthcoming revised revenue estimate abandons predictions of a recession, and that there are no strong indications that Texas will experience a recession next year. Notable areas of increased Texas tax collections include hotel occupancy, insurance and franchise taxes. Reynolds also noted that state coffers received a boost for increased apportionment from service providers that relocated their corporate headquarters to the state.

The presentations throughout this year’s briefing struck an equally optimistic tone for the agency’s continuous efforts to improve its staffing, resolve the backlog of R&D cases, and push to clarify existing guidance. Taxpayers will continue to navigate the Comptroller’s evolving rules and audit process, as well as litigate some highly interesting cases in court. Eversheds Sutherland’s tax team will keep monitoring Texas developments and provide insights on what Texas taxpayers can expect in the Lone Star State.