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State & Local Tax Alert Breaking state and local tax developments from Grant Thornton LLP ________________________________________________________

Release date June 2, 2016

Texas Comptroller Rules on Electricity Transmission and Distribution Cost Inclusion in COGS Deduction

States

On March 3, 2016, the Texas Comptroller of Public Accounts issued a letter ruling addressing the inclusion of certain costs incurred by different types of utility providers in the Revised Texas Franchise Tax (RTFT) cost of goods sold (COGS) deduction.1 Specifically, the ruling addresses the treatment of electricity transmission and distribution (T&D) costs, franchise fees, property taxes and insurance costs related to T&D assets and operations.

Issue/Topic

Deregulation of Texas Electric Utility Market

Beginning on September 1, 1999, the Texas electricity market was partially deregulated.2 With the advent of deregulation, some of the formerly rate-regulated and integrated electric utilities (IEUs) in Texas were separated into non-regulated power generation companies (PGCs) and retail electricity providers (REPs) and regulated transmission and distribution utilities (TDUs). The REPs purchase electricity from the PGCs and resell the electricity to consumers. The TDUs transmit and distribute the electricity under a complex regulatory scheme established as part of the deregulated market. Electricity and Texas COGS Deduction

In computing their Texas franchise tax base, taxpayers may generally include a deduction based on the maximum of four amounts: (1) (2) (3) (4)

30 percent of total revenue; $1 million; COGS; or Compensation.3

The COGS deduction is allowed only to taxpayers who acquire or produce “goods,” which are defined as real or tangible personal property sold in the ordinary course of business.4 The costs to acquire or produce a service or intangible property are excluded from the COGS deduction.5 Further, a taxable entity may only include costs related to

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Letter Ruling No. 201603710L, Texas Comptroller of Public Accounts, March 3, 2016. S.B. 7, Laws 1999. 3 TEX. TAX CODE ANN. § 171.101. 4 TEX. TAX CODE ANN. § 171.1012(a). 5 TEX. TAX CODE ANN. § 171.1012(a)(3)(B). 2

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Texas

Revised Texas Franchise Tax

Contact details John LaBorde Houston T 832.476.3605 E [emailprotected] Pat McCown Dallas T 214.561.2350 E [emailprotected] Terry Gaul Houston T 832.476.5088 E [emailprotected] Rick Herrmann Houston T 832.476.3713 E [emailprotected] David Somerville Houston T 832.476.3601 E [emailprotected] Jamie C. Yesnowitz Washington, DC T 202.521.1504 E [emailprotected] Chuck Jones Chicago T 312.602.8517 E [emailprotected] Lori Stolly Cincinnati T 513.345.4540 E [emailprotected] Priya D. Nair Washington, DC T 202.521.1546 E [emailprotected] www.GrantThornton.com/SALT

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goods the entity owns. The determination of ownership is based upon all facts and circ*mstances, including the various benefits and burdens of ownership vested with the taxable entity.6 By statute, the Texas COGS law under the RTFT is closely aligned to federal income tax authorities.7 A taxable entity’s COGS is determined “in accordance with the methods used on the federal income tax return on which the report under this chapter is based.”8 Internal Revenue Code (IRC) Sections 263A (Uniform Capitalization of Costs), 460 (Long-Term Contracts) and 471 (Inventories) are specifically referenced by statute.9 Also, the Texas COGS law10 and rule11 parallel significantly the language of Treas. Reg. Sec. 1.263A-1, Uniform Capitalization of Costs. In determining that electricity constitutes tangible personal property, the Comptroller’s position in this ruling is the same as that of the Internal Revenue Service.12 Specifically, Texas statutes allow as a COGS “the cost of producing or acquiring electricity sold.”13 The Texas COGS deduction also includes handling costs attributable to acquisition and production, including costs attributable to processing, assembling, repackaging, and inbound transportation costs,14 and postproduction direct costs allocable to the property, including storage and handling costs.15 The Texas COGS deduction excludes selling costs and distribution costs, including outbound transportation costs.16 The distinction between deductible handling costs and excluded distribution/outbound transportation costs presents a challenge for affected taxpayers, tax practitioners and the Comptroller’s office personnel administering the RTFT.17

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TEX. TAX CODE ANN. § 171.1012(j). The RTFT generally adopts the Internal Revenue Code (IRC) in effect for tax years beginning on January 1, 2007 and any regulations adopted pursuant to the IRC applicable to that period. TEX. TAX CODE ANN. § 171.0001(9). 8 TEX. TAX CODE ANN. § 171.1012(h). 9 TEX. TAX CODE ANN. § 171.1012(g). 10 TEX. TAX CODE ANN. § 171.1012. 11 34 TEX. ADMIN. CODE § 3.588. 12 Generally, electricity is considered to be tangible personal property rather than a service or intangible property for both federal income tax and Texas COGS purposes. Technical Advice Memorandum, IRS Letter Ruling 200543050, Jun. 29, 2005. 13 TEX. TAX CODE ANN. § 171.1012(c)(12) (emphasis added). 14 TEX. TAX CODE ANN. § 171.1012(c)(4); compare with IRS TREAS. REG. § 1.263A-1(e)(3)(ii)(G). 15 TEX. TAX CODE ANN. § 171.1012(d)(5). 16 TEX. TAX CODE ANN. § 171.1012(e)(3); compare with IRS TREAS. REG. § 1.263A-1(e)(3)(iii)(A). 17 Note that the terms “handling costs,” “selling costs” and “distribution costs” are undefined by Texas statutes and regulations. Also, a significant difference between federal income tax law and the Texas COGS deduction is that the Texas COGS deduction for indirect or administrative service costs, including mixed services costs, is limited to 4 percent of the total of such costs. TEX. TAX CODE ANN. § 171.1012(f). Because the ruling highlighted in this Alert neither discusses nor mentions this category of costs, the subject is outside the immediate scope of this analysis. 7

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Ruling Establishes Tax Treatment of Electricity T&D

T&D Costs The Comptroller determined that because IEUs and REPs own the electricity that they handle and sell, their T&D costs incurred through the final step down of voltage required to make the electricity usable to each customer may be included in the COGS deduction as costs of handling the goods. However, T&D costs incurred after the point of final step down are excludible from the COGS deduction as distribution or outbound freight deductions. Also, because a TDU provides electricity transmission and distribution services and does not own the electricity handled, its T&D costs may not be included in the COGS deduction. Franchise Fees The Comptroller concluded that an IEU may include in the COGS deduction franchise fees related to transmission assets (utilized through the point of step down of voltage). Generally, REPs do not incur franchise fees, and TDUs are not allowed a COGS deduction for these costs.18 Property Taxes Similarly, the Comptroller ruled that IEUs may include real and personal property taxes related to T&D assets in the COGS deduction, REPs do not own T&D assets upon which to incur property taxes and TDUs are generally not allowed a COGS deduction for these costs. Insurance Costs Finally, the Comptroller held that insurance costs are included in the COGS deduction for the cost of insurance on a plant or a facility, machinery, equipment, or materials directly used in the production of the goods.19 Specifically, the ruling provides that “because processing is a production activity, integrated electric utilities may include the cost of insurance related to transmission assets in their COGS deduction.” REPs do not own T&D assets on which to incur insurance costs and TDUs generally are not allowed a COGS deduction for these costs.

18 Note that franchise fees are generally imposed on a utility (i.e., an IEU or a TDU for this purpose) as a percentage (e.g., 5 percent) of gross receipts by a city or county for the use of public streets and rights-of-way for the transmission and distribution lines. 19 TEX. TAX CODE ANN. § 171.1012(d)(6).

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Commentary and Observations

This ruling, sent from the Comptroller’s Tax Policy Division to the Audit Division, establishes in writing the Comptroller’s policy for determining the COGS deduction for entities engaged in electricity transmission and distribution in a manner which should be binding upon its auditors. However, the decision includes minimal analytical discussion and seems to lack authoritative references. For example, the ruling does not reference the IRC or related regulations, or Texas’ adoption of those authorities. There are no references to the federal Uniform Capitalization of Costs (UNICAP; IRC Sec. 263A) system of cost classification adopted, at least in significant part, by the Texas legislature, despite Treas. Reg. Sec. 1.263A-1 being specifically referenced in the Comptroller’s COGS rule.20 Directly on point, the Internal Revenue Service (IRS) has determined in a Technical Advice Memorandum that electricity transmission and distribution costs are handling costs subject to UNICAP provisions “until the electricity passes through the last transformer in the distribution system and onto the drop line that is connected to its customers’ meters.”21 This IRS guidance provides a detailed analysis of the operation of electricity T&D systems and the application of the provisions of Treas. Reg. Sec. 1.263A-3 in arriving at its conclusion, including distinguishing electricity handling costs from distribution/transportation costs. The Comptroller’s ruling neither references this IRS determination nor bridges the resulting theoretical and practical chasms.22 In denying the COGS deduction to TDUs for T&D costs, the Comptroller states that “[i]n deregulated markets TDUs do not own the electricity.” No further analysis or reasoning is provided to explain this conclusion. As Texas franchise tax law provides that the determination of ownership is based upon a facts and circ*mstances/benefits and burdens of ownership test,23 authoritative and analytical support for the Comptroller’s position appear lacking. Also, the guidance provided with respect to franchise fees incurred by IEUs is problematic in that the fees are generally contracted for as a percentage of gross receipts, but the ruling allows a COGS deduction for “franchise fees related to transmission assets.”24 This logic makes more sense when applied to property taxes which are imposed on T&D assets (although somewhat indirectly) via the income (unit) approach. Finally, the ruling is somewhat tortuous in the treatment of insurance costs as “processing.” Despite the statement in the ruling (“processing is a production activity”), the term “processing” is not one of the several activities included in the definition of

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34 TEX. ADMIN. CODE § 3.588(d)(1); TREAS. REG. § 1.460-5, Cost Allocation Rules (applicable, inter alia, to construction contracts), is also referenced. 21 Technical Advice Memorandum, IRS Letter Ruling 200543050, Jun. 29, 2005. 22 The IRS UNICAP regulation on the treatment of handling costs neither lends itself well to costs related to electricity, nor to the treatment of T&D costs in particular. Instead, the regulation predominantly addresses handling costs with respect to retailers and wholesalers of goods. TREAS. REG. § 1.263A-3, Rules Relating to Property Acquired for Resale. 23 TEX. TAX CODE ANN. § 171.1012(j). 24 As a result, it could prove quite difficult for a taxpayer to determine the appropriate amount of franchise fees includable in the COGS deduction.

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“production.”25 “Processing” is, however, included in the description of costs included within “handling.”26 In that “handling” is not equated to “production” in the Texas franchise tax law, the Comptroller may be attempting to place artificial restrictions on the COGS deduction with this decision.27 Specifically, the Comptroller’s construct implies that only producers, and not retailers or wholesalers, are entitled to deduct handling costs; a position that the Comptroller appeared to have abandoned with the 2013 adoption of amendments to the COGS rule.28 At that time, a number of practitioners considered those 2013 amendments and subsequent developments (e.g., COGS for printers and R&D costs as COGS for retailers and wholesalers) to be a defining moment for the Comptroller. In summary, several aspects of this ruling and its reasoning are troublesome and likely to be challenged by affected taxpayers. If the logic of the ruling is extended to a broader class of taxpayers (other utilities such as natural gas, water and telecommunications are the most likely candidates), protracted controversies should be expected.

________________________________________________________ The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circ*mstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circ*mstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circ*mstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed.

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TEX. TAX CODE ANN. § 171.1012(a)(2). TEX. TAX CODE ANN. § 171.1012(c)(4). 27 Note that the IRS has concluded that “handling costs, including assembly and processing, are not production costs.” Technical Advice Memorandum, IRS Letter Ruling 200543050, Jun. 29, 2005. 28 34 TEX. ADMIN. CODE § 3.588; Texas Register, Vol. 38, No. 22, 3415 et seq., May 31, 2013. 26