How are the payments an oil-and-gas producer receives under commodity swap agreements treated for Texas franchise-tax apportionment?

Plain-English summary

An oil-and-gas producer used commodity swap agreements to hedge price risk and asked how the payments it receives are treated for pre-2008 franchise-tax apportionment (gross receipts). The swaps are not netted - each party pays the full amount due, so in the example the producer receives $150 and separately pays $100.

• The gross-receipts definitions. For taxable capital, gross receipts are all revenues recognized annually under GAAP (Tax Code Sec. 171.112(a)); for earned surplus, all revenues reportable on the federal return (Sec. 171.1121(a)). Neither allows a deduction for costs.
• Revenue recognition controls. A receipt counts only if the revenue-recognition test is met. Because the producer records the money as sales (Swaps/Annuities-Sales), the $150 is treated as recognized revenue.
• The net-only exception does not apply. Only the net gain from sales of capital assets and investments is included in gross receipts (Sec. 171.105(b), 171.1051(b)). The taxpayer represents the swaps are not sales of capital assets or investments, so that net-only rule does not apply.
• Bottom line. The full $150 received - not the $150 minus the $100 paid - is reported as gross receipts for both taxable capital and earned surplus apportionment, provided it is recognized as revenue under GAAP and for federal purposes and is not a capital-asset/investment sale.

Currency note: This describes the pre-2008 franchise tax (replaced by the margin tax effective January 1, 2008 under House Bills 3 and 3928). The margin tax computes receipts and apportionment differently; confirm present law.

What this means for you

Companies using derivatives or swaps (pre-2008)

Whether a swap payment was "gross" or "net" for franchise apportionment turned on two things: was the amount recognized as revenue under your accounting, and was it a sale of a capital asset or investment? If it was ordinary revenue and not a capital-asset sale, the gross amount received went into the apportionment factor - the offsetting payment did not reduce it.

Tax professionals

The letter applies the general gross-receipts definitions (Sec. 171.112(a) / 171.1121(a)) and the capital-asset net-gain carve-out (Sec. 171.105(b) / 171.1051(b)) to a non-netted commodity swap. The characterization is fact-driven: it rests on the taxpayer's own booking of the receipt as sales revenue and its representation that no capital asset or investment was sold. A different characterization of the instrument could change the result.

Common questions

Q: Do I report the gross swap payment or the net?
A: Per this letter, the gross amount received (for example, the full $150) is reported, so long as it is recognized as revenue and is not a sale of a capital asset or investment.

Q: Why doesn't the net-only rule apply?
A: Sec. 171.105(b) and 171.1051(b) limit gross receipts to net gain only for sales of capital assets and investments; the taxpayer represented the swaps were not such sales.

Q: What makes the payment a "receipt" at all?
A: It must meet the revenue-recognition test; here, recording the amount as sales revenue showed it was recognized as revenue.

Citations and references

Statutes:

• Texas Tax Code Sec. 171.112(a) - gross receipts for taxable capital apportionment: all revenues recognized annually under GAAP, without deduction for costs
• Texas Tax Code Sec. 171.1121(a) - gross receipts for earned surplus apportionment: all revenues reportable on the federal return, without deduction for costs
• Texas Tax Code Sec. 171.105(b) and 171.1051(b) - only the net gain from sales of capital assets and investments is included in gross receipts

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200109861L

Original ruling text

September 26, 2001

Dear **:

This is in response to your inquiry concerning swap agreements. I appreciate
your patience while we have been working on the response.

The ruling request indicates that the client company ("Taxpayer") is an oil and
gas producer. Taxpayer may enter into certain commodity swaps whereby it
would make payments to another party. The intent of a swap is to reduce the
risk of fluctuating prices in the future.

The payments equal a stipulated notional quantity of oil and gas multiplied by
the NYMEX or other index-quoted price of the quantity as of a designated date.
Taxpayer in turn would receive a payment from the other party equal to the same
notional quantity of oil and gas multiplied by a fixed price for the quantity.

The swap agreements do not provide for a netting of the above-described
payments. Each party will transfer the full payment due on any particular
settlement date. The parties will usually make the payments on the same date.

In the example you provided, the Taxpayer receives $150 and pays out $100 under
the swap agreement. The Taxpayer's accounting entries for the amount received
reflect a $150 debit to cash and a $150 credit to Swaps/Annuities-Sales. The
payment is accounted for by a debit of $100 to Swaps-Annuities-Purchases and a
$100 credit to cash.

The inquiry asks how the payments received by Taxpayer from these SWAP
agreements should be treated for franchise tax apportionment purposes.

Sec. 171.112(a) of the Tax Code defines gross receipts for taxable capital
apportionment. Under this provision "gross receipts" is defined as all
revenues that would be recognized annually under a generally accepted
accounting method of accounting. The statute further specifies that gross
receipts are computed without deduction for cost of property sold, materials
used, labor performed, or other costs incurred, unless otherwise specifically
provided for in the franchise tax law.

Sec. 171.1121(a) defines gross receipts for earned surplus apportionment. This
provision defines "gross receipts" as all revenues reportable by a corporation
on its federal tax return without deduction for the cost of property sold,
materials used, labor performed, or other costs incurred, unless otherwise
specifically provided in the franchise tax law.

Under these statutory definitions of gross receipts for taxable capital and
earned surplus, the respective revenue recognition test must be established in
order for a receipt to be established for apportionment purposes.

In the example provided in the ruling request, the $150 cash received is
recorded as Swap/Annuities-Sales. Although the actual cash received does not
necessarily meet the revenue recognition test, the representation that the $150
is recorded as sales would indicate that the $150 is recognized as revenue.

One of the exceptions noted in the above statutory provisions concerns the
gross vs. net treatment of sales of capital assets and investments. For both
taxable capital and earned surplus apportionment, only the net gain from the
sales of capital assets and investments is included in a corporation's gross
receipts. Sections 171.105(b) and 171.1051(b), Texas Tax Code.

The ruling request represents that the swap transactions do not involve the
sale of a capital asset or investment. To the extent the transactions do not
involve the sales of capital assets and investments, Sec. 171.105(b) and
171.1051(b) would not be applicable.

In summary, the $150 (from the example) would be reported as gross receipts for
taxable capital and earned surplus apportionment purposes provided the $150 is
recognized as revenue to the Taxpayer under GAAP and federal income tax
reporting, respectively. The gross amount would be reported for taxable
capital and earned surplus provided the transactions do not involve the sales
of "capital assets" or "investments" as these terms are defined under GAAP and
federal income tax authorities.

This response is based on the facts presented. If there are different or
additional facts, the response may change.

If you have any questions, please call toll-free 1-800-531-5441, extension
3-4496 or (512) 463-4496.

Sincerely,

Jerry Bobbitt
Tax Policy Division