For the Texas franchise tax taxable-capital component, can a corporation net unrealized losses against unrealized gains, or must both be included in surplus?

Plain-English summary

This is an internal Tax Policy memorandum to Audit about a corporation with energy trading contracts that, under GAAP, recognized both an asset (unrealized gains) and a separate liability (unrealized losses). The question: can the corporation net the unrealized losses against the unrealized gains when computing surplus for the (pre-2008) franchise tax? The answer is no.

• Assets follow GAAP. Under Tax Code Section 171.109(b), a corporation computes surplus, assets, and debts under GAAP unless the statute says otherwise. Because GAAP recognizes the unrealized gains as an asset, they are an asset in the surplus computation, and the statute provides no exception for this unrealized gain.
• A liability offsets assets only if it is "debt." A liability account must meet the debt requirements of Section 171.109(a)(3) to offset assets in computing net assets for surplus. If it does not meet the debt criteria, there is no offset.
• Unrealized losses are surplus. The unrealized losses do not meet the statutory debt test, and Section 171.109(a)(1) specifically provides that unrealized losses are included in surplus (with exceptions only for depreciation/depletion/amortization accounts and allowances for uncollectible accounts). So there is no basis to offset the unrealized-loss liability against the recognized asset.
• The asymmetry is intentional. As the memo puts it, unrealized gains and unrealized losses are both included in surplus; unrealized losses may not be excluded, whereas realized losses are excluded from surplus.

The memo notes this treatment was affirmed in Comptroller's Decision Nos. 29,988 (1994), 31,153 (1994), and 33,227 (1999), discusses older litigation (Sun Refining and Marketing, Sun Oil, Sage Energy, Harken Oil and Gas) that prompted 1987 and 1989 legislative amendments to Section 171.109, and explains that the foreign currency provisions of Rule 3.551 are consistent with the statute (the taxpayer was misreading Rule 3.551(e)(3)-(4)).

Currency note: This applies the pre-2008 taxable-capital/surplus rules, replaced by the current margin tax (House Bills 3 and 3928) effective January 1, 2008. Treat as historical.

What this means for you

Companies with mark-to-market or trading positions

Booking offsetting unrealized gains and losses on your financials did not let you net them for Texas taxable capital. The gain side counted as a surplus asset, while the loss side was pulled into surplus and could not offset the gain unless it independently qualified as debt (certain in amount and time). The result could be a larger surplus than your net GAAP position suggested.

Accountants and tax professionals

Treat unrealized gains as surplus assets and test any offsetting liability against the Section 171.109(a)(3) debt criteria before netting. Remember the statutory rule that unrealized losses are in surplus (Section 171.109(a)(1)) while realized losses are excluded - the realized/unrealized line, not GAAP netting, controls.

Common questions

Q: Can I net unrealized losses against unrealized gains for taxable capital?
A: No. The gains are surplus assets, and the unrealized losses cannot offset them unless they meet the statutory debt test - which they generally do not.

Q: Are unrealized losses included in surplus?
A: Yes, under Section 171.109(a)(1), with exceptions only for depreciation/depletion/amortization accounts and allowances for uncollectible accounts.

Q: What is the difference between realized and unrealized losses here?
A: Realized losses are excluded from surplus; unrealized losses are included in surplus and cannot be netted.

Citations and references

Statutes, rules, and decisions:

• Tex. Tax Code Sec. 171.109(b) (surplus, assets, and debts computed under GAAP unless the statute provides otherwise)
• Tex. Tax Code Sec. 171.109(a)(3) (debt requirements a liability must meet to offset assets)
• Tex. Tax Code Sec. 171.109(a)(1) (unrealized losses included in surplus; exceptions for depreciation/depletion/amortization and uncollectible-account allowances)
• 34 Tex. Admin. Code Sec. 3.551 (foreign currency treatment, consistent with Sec. 171.109)
• Comptroller's Decision Nos. 29,988 (1994); 31,153 (1994); 33,227 (1999); 35,519

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200306958L

Original ruling text

DATE: June 19, 2003

TO: Bobby Lebkowsky, ** Audit

FROM: Jerry Bobbitt, Tax Policy

RE: Unrealized Losses and Gains

Based on the information provided, I understand that under GAAP, an asset
(based on unrealized gains on energy trading contracts) and a separate
liability account (based on unrealized losses on energy trading contracts) must
be recognized.

Texas Tax Code Sec. 171.109(b) requires that a corporation compute its surplus,
assets, and debts according to GAAP, unless the statute provides otherwise.
Thus, if GAAP requires an account to be recognized as an asset, it must be
considered an asset in the computation of surplus, unless otherwise provided
for in the statute. With respect to the unrealized gain in question, the
statute does not provide for such an exception.

A liability account must meet the Sec. 171.109(a)(3) debt requirements in order
to offset any assets in the computation of a corporation's net assets for
purposes of determining surplus. If a liability account does not meet the debt
criteria, there is no offset of the assets.

The unrealized losses at issue do not meet the statutory debt test.
Furthermore, Sec. 171.109(a)(1) specifies that unrealized losses are included
in surplus. The provision provides exceptions only for
depreciation/depletion/amortization accounts and allowances for uncollectible
accounts.

In accordance with the above statutory provisions, there is no basis to offset
the liability in question against the GAAP asset that is recognized. As you
noted, this treatment has been affirmed in a number of administrative hearings.
See Comptroller's Decision Nos.
29,988 (1994), 31,153 (1994), and 33,227 (1999).

In HD 29,988, the taxpayer argued that such treatment was inconsistent. In
response to this contention, the ALJ noted that the franchise tax statute is
controlling with respect to the determination of surplus. He pointed out that
the Tax Code defines assets and debt by reference to different standards.

The taxpayer cites the Sun Refining and Marketing, Inc. case as support for its
position. Because of this case and several other cases (e.g., Sun Oil Co.,
Sage Energy Co.), the legislature in 1987 and 1989 made a number of amendments
to the Tax Code, including the Sec. 171.109 provisions referenced above.

The Harken Oil and Gas, Inc. decision involved the treatment of pre-acquisition
earnings. This issue was also in dispute in Sun Refining and Marketing, Inc.
and was subsequently addressed by the legislature. In Harken, the court itself
said that the subsequent legislation had the effect of overruling the earlier
decision. Also, see HD 35,519.

The foreign currency provisions in Rule 3.551 cited by the taxpayer are
consistent with the Sec. 171.109 provisions. The taxpayer is not correctly
interpreting Rule 3.551(e)(3). Like what you are proposing, the unrealized
gains and unrealized losses are included in surplus. The unrealized losses are
not allowed to be excluded from surplus, whereas realized losses are excluded
from surplus. Based on my understanding, the unrealized gain from foreign
currency translations addressed in Rule 3.551(e)(4) represents an account that
is not recognized as an asset under GAAP.

Please let me know if you have any questions.