Over strenuous objections of business taxpayer organizations, the Texas Supreme Court has denied review of a pair of Austin Court of Appeals’ decisions upholding the Comptroller’s interpretation a 2007 statute dealing with the treatment of proceeds from the sale of certain loans or securities for purposes of calculating a taxpayer’s gross receipts.

CITGO Petroleum Corporation v. Hegar (No. 21-0997) and Conagra Brands, Inc. v. Hegar (No. 22-0790) involve the interpretation of § 171.106(f), Tax Code. This subsection provides that “[n]otwithstanding section 171.1055 [exclusion of certain receipts from margin apportionment], if a loan or security is treated as inventory of the seller for federal income tax purposes, the gross proceeds of the sale of that loan or security are considered gross receipts.” In CITGO, the company sought a refund of franchise taxes based on the Comptroller’s decision to exclude from its gross receipts certain proceeds of the sale of securities that were included in the company’s inventory reported for federal tax purposes pursuant to IRC § 475. In Conagra, the taxpayer argued that its use of commodity hedges (i.e., corn futures) such as the securities at issue to manage its inventory of raw materials constituted the functional equivalent of that inventory, not capital-assets [citing in support Corn Products Refining Co. v. Commissioner of Internal Revenue, 350 U.S. 46 (1955)]. In both cases, the court of appeals upheld the Comptroller’s position that the securities at issue were not treated as inventory of the seller for federal income tax purposes, but simply as sales “in the ordinary course of business.”

As argued, ultimately to no avail, by amicus Texas Taxpayers and Research Association in CITGO:

There is no dispute that the proceeds of the sale of the securities in question are “treated as” inventory for federal income tax purposes pursuant to IRC § 475. That fact should end the inquiry. The court of appeals, however, became entangled in an extra-statutory analysis of § 475 that creates a false distinction between how “the net gains and losses are ultimately recognized as ordinary income” and “how the securities are handled as part of the seller’s business.” The court then erected a “business-purpose” test for interpreting § 171.106(f) that has no statutory basis whatsoever. Chapter 171 uses the term “ordinary course of business” three times but not in § 171.106(f). Presumably, if the Legislature had intended to qualify “inventory of the seller” in the manner proposed by the court of appeals, it would simply have drafted the statute to say “if a loan or security is held for sale to customers in the ordinary course of business, the gross proceeds of the sale of that loan or security are considered gross receipts.” The court of appeals puts words in the statute that do not exist.

            To make matters worse, putting these words in the statute dramatically changes the meaning of the statute, which merely says that under certain circumstances, non-inventory securities may be treated as if they are held in inventory provided that federal tax law treats them that way. No one disputes that the Legislature may—for very good policy reasons—draft a statute that makes one thing into another thing for a specified purpose. The court of appeals, however, impinges on the Legislature’s prerogative by ruling that only securities actually held in inventory for federal tax purposes may be treated as if they are held in inventory. This interpretation disregards well-settled rules of statutory construction and renders § 171.106(f) entirely meaningless.

Instead of focusing on nonexistent language, the court of appeals should have concentrated its analysis on the words that do exist: “treated as inventory of the seller for federal income tax purposes” (emphasis added). The emphasized phrase is used 13 other times in Chapter 171. In each case, the use of the term is plain and consistent: “treated as” means that different items are to be regarded as the same for some specific purpose. There is a good reason for using the phrase “treated as” to provide certain state tax treatment regardless of how that item is taxes under federal law. Under federal law, businesses are subject to different tax treatment depending on their form of organization. Corporations are generally taxed directly in their own right under the corporate income tax, while many other non-corporate forms of business, such as limited partnerships or limited liability companies, are treated as pass-through entities whereby their owners shoulder the direct tax burden. Either way, federal tax law captures and taxes business income regardless of their organizational form.

As this Court well knows, Texas has no personal or corporate income tax. For years leading up to 2006, lawmakers lamented that large amounts of business income in the state, generated by limited partnerships and other pass-through entities, escaped taxation while (in some cases) enjoying both liability protection and the benefits of public services. In 2006 the Legislature restructured the franchise tax and extended its reach to a number of business entities treated as pass-through entities for federal tax purposes. Consequently, limited partnerships, business associations, joint ventures, and other entities now had to pay a direct tax on the entity (since Texas had no personal income tax to capture income passed through to the owners). This significant deviation from the treatment of pass-through entities under the Internal Revenue Code necessitated the use of the phrase “treated as” in so many sections of Chapter 171 to ensure that all liability-protected business entities, regardless of organizational form, were taxed uniformly. For example, even if your limited partnership is “treated as” a pass-through entity for federal tax purposes, it must pay franchise tax just like any other liability-limited entity doing business in Texas.

In this case, federal tax law “treats” proceeds from the sale of certain securities not included in the taxpayer’s inventory “as” if they were. It does not matter what the taxpayer’s “ordinary course of business” may be or “whether [the securities] were held for other purposes.” Chapter 171 goes both ways: sometimes it “treats” business income or expenses differently than federal, and sometimes—as in § 171.106(f)—it treats them the same. In each case, the Legislature made a policy decision and put the appropriate words in the statute. It is not up to the courts to add or detract because they think the Legislature “meant” something else.

It remains to be seen whether taxpayer organizations will seek a legislative clarification during the next session to reverse what we believe to be the court of appeals’ erroneous construction of § 171.106(f).

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