For Texas franchise tax, are sales of commodity futures contracts reported gross or net, and how are the receipts apportioned - by the exchange or the buyer's domicile?

Plain-English summary

An auditor asked Tax Policy how a grain manufacturer/processor that also trades commodity futures and options on out-of-state exchanges should report and apportion its futures-contract sales for the (pre-2008) Texas franchise tax. The taxpayer argued that a futures contract is an intangible reportable at gross, and that because trades run through the exchange's Clearing House (not another member) and no exchange is in Texas, no receipts should be apportioned to Texas. The Comptroller rejected both premises.

• "Intangible" does not decide gross vs net. The intangible characterization dictates how the receipts are apportioned, but does not determine the computation of gross receipts.
• Gross if inventory; net gain if investment. If the taxpayer maintains a running inventory of futures contracts and sells them in the ordinary course of business, the total sales price is gross receipts. If the futures are not held as inventory for sale in the ordinary course, they are an investment, and gross receipts include only the net gain on the sale (Secs. 171.105(b) and 171.1051(b); Rules 3.549(b)(3)/3.557(b)(6) and 3.549(e)(3)/3.557(e)(3)).
• A fact question for the audit. The facts did not say which applied; the taxpayer's net-gain federal reporting indicates investment treatment, but the auditor must make that determination.
• Apportioned to the buyer's legal domicile, not the exchange. Futures-contract sales are intangibles apportioned to the legal domicile of the purchaser under the location-of-payor rule - regardless of whether the futures are inventory (gross proceeds) or an investment (net gain). The location of the exchange does not control.
• The 6.5% shortcut is narrow. The 6.5% factor (Rules 3.549(e)(39)/3.557(e)(35)) is limited to securities sold through a stock exchange when the buyer cannot be identified; it does not automatically extend to futures. If the futures buyers cannot be identified, the taxpayer should use the most accurate representation it can derive from its records of sales to purchasers legally domiciled in Texas.

Currency note: This applies the pre-2008 franchise tax's gross-receipts and apportionment rules, replaced by the current margin tax (House Bills 3 and 3928) effective January 1, 2008. Treat as historical.

What this means for you

Businesses that trade commodity futures or options

Whether you report the full sales price or only the net gain turns on a single fact: are the contracts inventory you trade in the ordinary course, or investments? How you report the gain federally is evidence but not conclusive. And do not assume out-of-state exchanges keep the receipts out of Texas - the sourcing looks to where your buyer is legally domiciled, not where the exchange sits.

Auditors and tax professionals

Resolve the inventory-vs-investment question first (it sets gross vs net), then apply the location-of-payor rule to source the receipts to each purchaser's legal domicile. Reserve the 6.5% factor for its actual trigger - securities sold through an exchange with unidentifiable buyers - and, where futures buyers are unidentifiable, build the Texas percentage from the best available records rather than defaulting to 6.5%.

Common questions

Q: Are commodity futures sales reported gross or net for the Texas franchise tax?
A: Gross (total sales price) if held as inventory sold in the ordinary course; net gain only if held as an investment (Secs. 171.105(b), 171.1051(b)).

Q: Does trading through an out-of-state exchange keep the receipts out of Texas?
A: No. Futures are intangibles sourced to the buyer's legal domicile under the location-of-payor rule, not the exchange's location.

Q: Does the 6.5% securities factor apply to futures?
A: Only within its narrow scope - securities sold through a stock exchange when the buyer cannot be identified. Otherwise, estimate the Texas share from the taxpayer's records.

Citations and references

Statutes and rules:

• Texas Tax Code Sec. 171.105(b) - gross receipts from the sale of an investment/capital asset include only the net gain (taxable capital)
• Texas Tax Code Sec. 171.1051(b) - same, for earned surplus
• 34 Tex. Admin. Code Secs. 3.549(b)(3), 3.557(b)(6) - investment vs inventory
• 34 Tex. Admin. Code Secs. 3.549(e)(3), 3.557(e)(3) - net gain on the sale of an investment
• 34 Tex. Admin. Code Secs. 3.549(e)(39), 3.557(e)(35) - 6.5% factor for securities sold through an exchange when the buyer cannot be identified

Related STAR documents (described in prose, not linked):

• STAR document 8004T0186D01 - inventory-held futures reported at total sales price; intangibles apportioned to the purchaser's legal domicile
• STAR document 9508902L - further guidelines on the sale of futures contracts held as an investment

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200210509L

Original ruling text

October 15, 2002

Subject: Sales of Commodity Futures Contracts

Question: Taxpayer is a manufacturer and processor of grains and other
agricultural products. Taxpayer also trades in commodities, futures, and
options contracts on several regulated exchanges throughout the United States
(CITY TRADE COMPANY, etc.). None of these exchanges are located in Texas.
Taxpayer reports the net gain from sales of commodity futures contracts for
federal income tax purposes. Gross receipts are calculated by subtracting from
the proceeds (from sales of future contracts) the cost of sales of futures
contracts. The gain is a part of total purchases under the cost of goods sold
reported on Page 1, line 2 of the 1120 Federal Tax Return.

Taxpayer contends that a sale of a commodity futures contract through a
commodity exchange is a sale of an intangible and should be reported at gross;
and that because commodity transactions through the exchanges listed above
occur between a member and the Clearing House and NOT with another member of
the exchange, no receipts should be apportioned to Texas, since none of the
exchanges utilized are located in Texas.

My questions are as follows:

1. Gross versus Net Reporting. Is a sale of a futures contract the sale of an
   investment in which the taxpayer should report net receipts, or is it the sale
   of an intangible in which the taxpayer should report gross receipts?

2. If this is considered the sale of an investment and the buyer cannot be
   identified, can Texas receipts be estimated to be 6.5%? Is it appropriate to
   liken the sale of a futures contract to the sale of securities and apply this
   section of the rule? Does another rule provision apply?

Answer: Your question presupposes that if the transaction is considered to be
the sale of an intangible, then the gross proceeds from the sale should be
considered gross receipts. You need to be aware that the characterization of
the items as intangibles does not determine the gross vs. net treatment. The
intangible characterization dictates the apportionment of the gross receipts in
question, but does not impact the computation of the gross receipts.

If Taxpayer maintains a running inventory of futures contracts and sells these
futures contracts in the ordinary course of its business, then the total sales
price of the futures contracts should be reported as gross receipts. See STAR
document 8004T0186D01. If Taxpayer does not hold these futures contracts as
inventory for sale in the ordinary course of its business, the futures
contracts would be considered an investment. See Rules 3.549(b)(3) and
3.557(b) (6). The gross receipts from the sale of an investment include only
the net gain from the sale. See Tax Code Sections 171.105(b) and 171.1051(b);
Rules 3.549(e) (3) and 3.557(e)(3); STAR document 9508902L for further
guidelines about the sale of futures contracts held as an investment.

The facts presented do not state whether these futures contracts are carried as
inventory or are held as an investment. Taxpayer's reporting of the sales as a
net gain for federal income tax purposes would indicate that the items are held
as an investment. In your audit, you will need to make this fact determination
and apply the above guidelines.

Once the gross receipts are determined, they must be apportioned. You ask if
future contracts can be treated similarly to the sale of securities and thereby
subject to the 6.5% factor used in Rules 3.549(e)(39) and 3.557(e)(35). As a
general rule, the 6.5% factor is limited to the circumstances noted -- when
securities are sold through a stock exchange and the buyer cannot be
identified. The sales of futures contracts are considered to be intangibles,
and the receipts from those sales are apportioned to the legal domicile of the
purchaser. See STAR document 8004T0186D01. The location of payor rule will
apply for apportionment purposes, regardless of whether the futures contracts
are inventory (using gross proceeds) or an investment (using the net gain).
The legal domicile of the purchasers of the futures contracts is controlling,
and not the location of the exchange.

If the buyers cannot be identified, then you should use the most accurate
representation of the percentage that you can ascertain from Taxpayer's records
of its sales to purchasers legally domiciled in Texas.

ASK POLI - 200210509T