Can a bank deduct interest earned on federal funds from its earned surplus (or taxable capital) for Texas franchise tax under Sec. 171.106(h)?

Plain-English summary

A bank asked the Comptroller to interpret Tax Code Sec. 171.106(h) because consulting firms were telling financial institutions they could deduct interest earned on federal funds (under a "correspondent bank" relationship) from federal taxable income when figuring taxable earned surplus for the franchise tax.

• What Sec. 171.106(h) actually does. It directs a banking corporation to exclude from the numerator of its apportionment factor the interest earned on federal funds and on securities sold under a repurchase agreement that are held in Texas in a correspondent bank domiciled in Texas ("correspondent" as defined in 12 C.F.R. Sec. 206.2(c)). In other words, it changes how much of the bank's income is sourced to Texas - an apportionment rule.
• What it does not do. Nothing in the section allows a reduction of either tax base component - not taxable capital, and not earned surplus. So the consulting firms' advice to strip this interest out of the earned-surplus base was wrong.
• The cited ruling. The firms also pointed to letter ruling 200103126L. That ruling says only that this interest will not be part of the bank's Texas gross receipts beginning January 1, 2002 - again a sourcing/apportionment point, not a deduction from the tax base.

Currency note: This letter describes the pre-2008 franchise tax (taxable capital and earned surplus), replaced by the current margin tax effective January 1, 2008 (House Bills 3 and 3928). Treat it as historical.

What this means for you

Banks and their advisors (pre-2008 franchise-tax reports)

Excluding correspondent federal-fund and repo interest from your Texas apportionment numerator was correct under Sec. 171.106(h); using that same interest to shrink your earned-surplus or taxable-capital base was not. The provision moves receipts out of the Texas fraction; it does not carve income out of the base being apportioned.

Anyone relying on a favorable letter ruling

The Comptroller here narrowed how far ruling 200103126L reached: it addressed gross receipts (apportionment) only. A ruling that a receipt is not Texas gross receipts does not also mean the underlying income is deducted from the tax base.

Common questions

Q: Does Sec. 171.106(h) let a bank deduct federal-funds interest from earned surplus?
A: No. It only removes that interest from the numerator of the bank's apportionment factor; it does not reduce taxable capital or earned surplus.

Q: What did ruling 200103126L actually hold?
A: Only that the interest is not part of the bank's Texas gross receipts beginning January 1, 2002 - an apportionment result, not a base deduction.

Q: What is a "correspondent" for this rule?
A: The term has the meaning assigned by 12 C.F.R. Sec. 206.2(c).

Citations and references

Statutes and regulations:

• Texas Tax Code Sec. 171.106(h) - a banking corporation excludes interest on federal funds and on repurchase-agreement securities held in an in-state correspondent bank from the numerator of its apportionment factor
• 12 C.F.R. Sec. 206.2(c) - definition of "correspondent"

Related letter ruling:

• 200103126L - the interest is not part of the bank's Texas gross receipts beginning January 1, 2002 (apportionment only)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200206203L

Original ruling text

June 21, 2002

To: *****

Dear Mr. **:

Thank you for your email regarding Section 171.106(h) of the Texas Tax Code
(TTC).

You stated in your message that certain consulting firms are advising financial
institutions that federal fund interest earned under a "correspondent bank"
relationship by banks would be deducted from federal taxable income in the
determination of taxable earned surplus for franchise tax purposes. They are
citing as authority for this position Section 171.106(h) and ruling 200103126L.

You asked for an interpretation of Sec. 171-106(h).

This section of the code specifically states that "a banking corporation shall
exclude from the numerator of the bank's apportionment factor interest earned
on federal funds and interest earned on securities sold under an agreement to
repurchase that are held in this state in a correspondent bank that is
domiciled in this state. In this subsection, "correspondent" has the meaning
assigned by 12 C.F.R. Section 206.2(c)."

There is nothing in this section of the code that allows for a reduction of
either tax base component (taxable capital or earned surplus). The letter
ruling that you referenced says only that this interest will not be part of
gross receipts in Texas beginning January 1, 2002.

If you have any questions about this or any other franchise tax matter, please
call me at 1-800-531-5441, extension 34612. My direct number is (512)
463-4612. You may write me at Tax Policy Division, Comptroller of Public
Accounts, Austin, Texas 78774 or via email to .

Sincerely,

Janet Spies
Tax Policy Division