How are receipts from Texas oil and gas production payments treated as mortgage loans under IRC Section 636 apportioned for the earned-surplus and taxable-capital components of the Texas franchise tax?

Plain-English summary

Two foreign corporations planned to form a limited partnership (LP) outside Texas that would acquire oil and gas production payments carved out of real property located in Texas. The payments entitle the LP to an exact amount of future oil and gas production. Importantly, the payments would be treated as mortgage loans under IRC Section 636 for federal tax purposes, but as interests in the burdened oil and gas real property under GAAP and Texas real property law. The taxpayer asked how the receipts are apportioned for each component of the (pre-2008) franchise tax. The answer differs by component because each component follows a different accounting baseline.

Earned surplus - follows federal treatment (mortgage loan)

• A corporation uses the same accounting methods to apportion taxable earned surplus as it uses in computing reportable federal taxable income (Tax Code Section 171.1121(b)).
• Because the payments are classified as mortgage loans for federal purposes, the principal of the loans received or repaid is not a gross receipt (Rule 3.557(e)(22)).
• The interest on the mortgage loans is apportioned to the state of incorporation of the payor (Rule 3.557(e)(13)(C)).

Taxable capital - follows GAAP (real property interest)

• For taxable capital, a corporation computes gross receipts in accordance with GAAP (Tax Code Section 171.112(b)).
• If GAAP requires the payments to be treated as income from an interest in real property, the gross receipts are apportioned as such - to the location of the property (Rule 3.549(e)(32)).

So the very same production payments source their receipts out of state (to the payor's state of incorporation) for earned surplus, but to Texas (property location) for taxable capital - a direct consequence of the federal-vs-GAAP characterization difference.

Currency note: This applies the pre-2008 franchise tax's dual taxable-capital/earned-surplus apportionment, replaced by the current margin tax (House Bills 3 and 3928) effective January 1, 2008, which sources receipts under its own rules. Treat as historical.

What this means for you

Oil and gas investors using production payments

The federal Section 636 "mortgage loan" characterization did not carry over to the taxable-capital side. For earned surplus, only the interest counted (sourced to the payor's state), and principal was ignored; for taxable capital, GAAP's real-property characterization pulled the receipts to Texas where the wells sit. The same instrument produced opposite sourcing results.

Accountants and tax professionals

Apportion each component on its own baseline: earned surplus tracks the federal accounting method (here, mortgage-loan treatment - principal excluded, interest to payor's state of incorporation), while taxable capital tracks GAAP (here, real-property income sourced to property location). Do not assume a single characterization governs both components.

Common questions

Q: Are the production-payment receipts sourced to Texas?
A: It depends on the component. For taxable capital, yes - as real property receipts sourced to the property's Texas location. For earned surplus, the interest is sourced to the payor's state of incorporation.

Q: Is the loan principal a gross receipt for earned surplus?
A: No. Loan principal received or repaid is not a gross receipt under Rule 3.557(e)(22).

Q: Why do the two components reach different answers?
A: Earned surplus follows the federal accounting method (mortgage loan under IRC Section 636), while taxable capital follows GAAP (an interest in real property).

Citations and references

Statutes and rules:

• Tex. Tax Code Sec. 171.1121(b) (earned surplus uses the same accounting methods as reportable federal taxable income)
• Tex. Tax Code Sec. 171.112(b) (taxable capital gross receipts computed under GAAP)
• 34 Tex. Admin. Code Sec. 3.557(e)(22) (loan principal received or repaid is not a gross receipt)
• 34 Tex. Admin. Code Sec. 3.557(e)(13)(C) (interest on mortgage loans apportioned to payor's state of incorporation)
• 34 Tex. Admin. Code Sec. 3.549(e)(32) (receipts from real property apportioned to the property's location)
• IRC Sec. 636 (production payments treated as mortgage loans)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200309930L

Original ruling text

September 5, 2003

Dear **:

This letter is in response to your ruling request regarding the Texas franchise
tax consequences of a proposed transaction.

You have indicated two foreign corporations will form a limited partnership
(LP) outside of Texas. LP will acquire oil and gas production payments
(Payments) from a foreign corporation that are carved out of real property
located in Texas. The Payments will entitle LP to an exact amount of actual
future oil and gas production from the properties.

You have also indicated that the Payments will be considered mortgage loans
under Section 636 of the Internal Revenue Code. For generally accepted
accounting principles (GAAP) and Texas real property law purposes, the Payments
will be treated as interests in the burdened oil and gas real property
entitling LP to the income from oil and gas production attributable to the
Payments.

You asked the following questions with regard to the proposed transaction:

1. How will the gross receipts attributable to the Payments be apportioned for
   the earned surplus component of the Texas franchise tax?

Response: Except as otherwise provided, a corporation shall use the same
accounting methods to apportion taxable earned surplus as used in computing
reportable federal taxable income. See Texas Tax Code Sec. 171.1121(b). Since
the corporation will compute reportable federal taxable income with the
Payments classified as mortgage loans, then the same method will be used to
compute Texas franchise tax. Accordingly, the principal of the loans received
or repaid will not be considered a gross receipt. See Comptroller's Rule Sec.
3.557(e)(22). However, the interest on the mortgage loans will be apportioned
to the state of incorporation of the payor. See Rule Sec. 3.557(e)(13)(C).

2. How will the gross receipts attributable to the Payments be apportioned for
   the taxable capital component of the Texas franchise tax?

Response: Except as otherwise provided, a corporation must compute gross
receipts for taxable capital purposes in accordance with GAAP. See Tax Code
Sec. 171.112(b). If GAAP requires the Payments to be treated as income from
an interest in real property, then the gross receipts for taxable capital will
be apportioned as such. Receipts from the sale, lease, or sublease of real
property are apportioned to the location of the property. See Rule Sec.
3.549(e)(32).

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

If you have any questions or need additional information, please call me at
1-800-531-5441, extension 3-4629.

Sincerely,

Lowell Olsen Dunn
Tax Policy Division