The Texas Comptroller of Public Accounts held its annual briefing in Austin on September 29 and provided taxpayers with updates regarding audits, staffing, pending legislation and related topics. The meeting – which was the first in-person briefing since the beginning of the pandemic – highlighted several taxpayer-friendly audit changes and efficiencies being driven by the Comptroller’s ongoing staffing challenges.

Seeing green: Texas’ robust economic outlook

Once again, Texas blew past its projected revenues this past year, according to the Comptroller’s Chief Revenue Estimator, Brad Reynolds. Texas’ rosy revenue numbers were largely driven by strong sales tax collections. Reynolds noted that business-to-business sales such as building materials bore more inflation than what consumers typically experience. Comptroller Glenn Hegar also predicted that Texas will continue to outperform other states in the country in the year to come.

Staffing issues spur audit efficiencies

Comptroller Hegar noted that he hopes some of Texas’ increased tax revenue finds its way back to his agency in the form of funds for increased salaries and general staffing. Hegar also noted that the Comptroller’s office experienced significant turnover and retirements during the pandemic, leaving many job vacancies open. The Comptroller’s Director of Audit, Emma Fuentes, stated that her division started the year with only about 450 of 623 auditor positions filled. Personnel shortages were also noted by other divisions that presented at the Comptroller’s annual briefing.

Audit Director Fuentes said that her division is addressing its staffing issues by increasing the number of hiring cycles per year and finding efficiencies that will allow its auditors to serve more taxpayers, such as:

• Managed Audits: The Comptroller expanded the managed audit program to include taxpayers that have not previously undergone an audit. This program frees up auditor time because taxpayers agree to do the backfill work in return for interest and penalty waivers.
• Onsite audit kickoffs: Auditors are encouraged to request in-person meetings with taxpayers to kickoff audits. This prevents extended back-and-forth correspondence during the audit initiation phase by allowing the auditor to immediately address questions with the taxpayer.
• Bringing audits current: Audit Director Fuentes estimates that at least 1,300 work hours have been saved by bringing some of the Comptroller’s largest audits current to the most recent available tax year.
• Streaming franchise tax refunds: When processing a franchise tax refund, the Comptroller will no longer initiate audits for affiliated companies that are disregarded entities without nexus in Texas. Comptroller will request an affiliate schedule and Texas nexus questionnaire for these entities instead.
• Informal review: Audit will also informally process taxpayer questions and requests for reconsideration of audit determinations rather than forcing taxpayers to go through a formal determination process.

We’ll see you in court – Litigation update

Comptroller Tax Litigation Attorney, Bree Boyett, provided this year’s litigation update, covering several noteworthy cases such as:

• Coppell v. Hegar: This is a dispute regarding the Comptroller’s amendments to Rule 3.334 concerning local tax, which provide that computer servers, IP addresses, websites, and software applications are not places of business of the seller. A trial date is pending.
• Apple v. Hegar: This ongoing District Court case is about whether the Internet Tax Freedom Act (ITFA) preempts Texas from taxing the iCloud and iTunes Match services, or if these services are taxable as data processing.
• Prison litigation: Several for-profit prison operators have filed suits concerning whether they are entitled to make sales tax-free purchases as government agents.
• Texas Westmoreland Coal Co. v. Hegar: A lignite coal miner asserted that it could take the manufacturing exemption on lignite excavators. The issue in this case, which is pending before the Texas Supreme Court, is whether the statutory requires the inputs to the manufacturing process be tangible personal property for ultimate sale.

Focus on R&D Credits

One of the most highly-watched direct tax developments is the Comptroller’s recent back-to-back revisions of its R&D rules, which Indirect Tax Analyst Julio Mendoza-Quiroz covered during the meeting. In October 2021, the Comptroller released a comprehensive set of amendments regarding the state’s R&D credit.  These regulations, however, misstated the relevant IRC regulations and effectively prohibited the R&D credit for internal use software. After considerable taxpayer pushback, the Comptroller revised its regulations again in August 2022 to allow taxpayers to apply optional IRC regulations, thereby permitting the R&D credit for some forms of internal use software.

The Comptroller further addressed carryover issues related to the R&D credit. Under the prior R&D rule, a change in a combined group could result in the loss of the credit carryforward. The revised rule makes the tax attribute loss less likely to occur, except in situations where the relevant entity is terminated without a merger or acquisition.

Audit Director Fuentes also noted that the Comptroller currently has about 1,300 outstanding R&D audits and that the Comptroller has modified its approach to these audits. Prior to May, the audit team was directed to automatically reject R&D credits for four areas:

• Engineering and design
• Oil and gas
• Services
• Internal use software

Audit Director Fuentes noted that after reconsideration, the Comptroller will now review R&D credit claims involving internal use software and oil and gas issues. Auditors will, however, continue to initially reject R&D credits for services and engineering. The Comptroller is also reaching out to other state tax departments to determine if they have expertise to evaluate complicated R&D credit requests.

Additional updates from the direct and indirect tax teams

Other noteworthy direct tax changes included revisions to the apportionment rules to align with the outcome of recent litigation and pending oil and gas rule updates regarding marketing costs and the high-cost gas exemption.

During the indirect tax update, Analyst Mendoza-Quiroz said that the Comptroller is reviewing the various situations in which software may be subject to sales or use tax. The Comptroller is also reviewing situations whether SaaS providers may be able to purchase cloud-computing related services under the resale exemption, and whether some new e-learning platforms qualify for treatment as exempt instructional services if they also contain other types of information.

Data centers are another area of focus for the indirect tax team, which is reviewing issues such as:

• Whether the existence of a right-of-way means that properties are no longer contiguous for tax purposes
• How telework employees impact a data center’s job creation obligations
• The availability of capital investment credits to successor owners, and the audit liability of prior data center owners

The indirect tax team is also reviewing rules related to local sales taxes, qualified hotel services and amusement services.

What’s next for Texas?

There is no such thing as a dull tax year in Texas, and this coming year is sure to present unique challenges for the Comptroller and taxpayers. The 88th Texas Legislature kicks off January 10, 2022, and it remains to be seen whether the Comptroller will obtain sufficient funding to address its staffing issues. 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.