Can a direct payment permit holder switch to a new inventory accounting system by depleting old tax-paid parts first (FIFO) before reporting tax on new usage?

Plain-English summary

A brewery holding a Texas direct payment permit had historically maintained an inventory of small equipment and spare parts, paying or accruing sales/use tax at the time of purchase based on its best estimate of how each part would eventually be used (since exempt vs. taxable use couldn't be known until the part was actually put into service). New inventory-tracking software let the brewery instead determine the actual use of each part accurately at the moment it's withdrawn from inventory — a more precise approach. To transition to this new system, the brewery proposed: deplete all its existing, previously tax-paid inventory first on a First-In-First-Out (FIFO) basis, and only start reporting tax on a usage basis (as parts come out of inventory) once that old tax-paid inventory ran out — reasoning that distinguishing which commingled parts had already been taxed, and when they were purchased, was essentially impossible.

The Comptroller rejected this specific FIFO depletion/deferral plan. Instead, per Rule 3.288 (direct payment procedures), the correct treatment depends on what the brewery knew at the time of purchase:

• If, at the time of purchase, it's not known whether items bought tax-free under the direct payment permit will be used in Texas, the brewery may elect to report use tax either when the items are first stored in Texas, or when first removed from inventory for use in Texas — but must apply whichever method it picks consistently.
• If, at the time of purchase, it is known the items will be used in Texas (which was the case here, since the parts were only ever used at this one Texas brewery), use tax must be reported when the items are first stored, used, or otherwise consumed — not deferred until some later withdrawal-from-inventory event tied to depleting an old tax-paid balance.

What this means for you

Direct payment permit holders with mixed exempt/taxable inventory

You can't simply propose to "run down" your existing tax-paid inventory first and defer new tax reporting until it's exhausted. Rule 3.288 gives you two specific, narrower options depending on whether you know at purchase time that the item will be used in Texas — and if you do know, tax is due when the item is first stored, used, or consumed, not whenever it happens to be withdrawn under a FIFO assumption.

Accountants and tax professionals administering direct payment permits

When advising a direct-pay client on a new inventory-tracking system, check whether the client can honestly say it doesn't know at purchase time whether an item will be used in Texas — only then does the "report when stored OR report when withdrawn" election under Rule 3.288 apply, and it must be applied consistently, not as a one-time FIFO transition mechanism.

Common questions

Q: Can a direct payment permit holder switch to a "report tax at withdrawal" system for all its old inventory at once?
A: Not through the FIFO depletion plan described in this letter — the Comptroller found that method unacceptable and pointed to Rule 3.288's specific timing rules instead.

Q: When must a direct-pay permit holder report use tax if it already knows the item will be used in Texas?
A: Per this letter, when the item is first stored, used, or otherwise consumed — not deferred to a later inventory withdrawal.

Q: Is there any situation where reporting at withdrawal from inventory is allowed?
A: Yes — per this letter, if it's genuinely not known at purchase time whether the item will be used in Texas, the permit holder may elect to report at first storage in Texas or at first removal from inventory for Texas use, applied consistently.

Citations and references

Statutes and rules:

• 34 Tex. Admin. Code Rule 3.288 (Direct Payment Procedures, Qualifications and Requirements)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9806695L

Original ruling text

June 18, 1998

Dear Mr. **:

This is in response to your request for a ruling regarding COMPANY A's
contemplation of a change in the method to determine the tax uniqueness of
certain items it uses at its ** brewery. This change is intended to
enhance COMPANY A's sales/use tax compliance. You are requesting that the
Comptroller approve this plan. I have restated the facts you presented below,
followed by my response:

COMPANY A has operated a brewery in Texas for many years. During this time,
COMPANY A maintained an inventory of small equipment and equipment spare parts
at the brewery on which sales/use tax was either paid to the vendor or accrued
and reported directly to Texas at the time of purchase. For financial purposes
the parts are expensed when purchased but inventory records are maintained to
monitor usage and ensure an adequate supply is maintained so manufacturing
operations are not disrupted. For income tax purposes the parts are not
expensed until issued from inventory and actually put into use.

At the time of purchase it is not known where or how specific items will be
used. Therefore, an accurate tax determination cannot be made at that time,
since the same item may be used in either an exempt or taxable manner. As a
result, payment of sales/use tax has been based on COMPANY A's best estimate at
the time of purchase regarding how and where the property will eventually be
used. This process has become increasingly difficult and cumbersome. The new
software allows COMPANY A to accurately identify relevant information, such as
where and how the item will be used at the time of withdrawal from inventory.
COMPANY A believes better tax decisions can now be made using our inventory
withdrawal system

Because of this situation and the implementation of a new software system,
COMPANY A has a direct payment permit from Texas for the purpose of reporting
tax when all relevant facts are known. All relevant facts will be known at the
time of issuance from inventory rather than at the time of purchase. This new
procedure will facilitate more accurate sales/use tax reporting based on the
actual use of the property rather than the purchaser's best estimate.

The following procedure will facilitate the transition from the current tax
paid inventory to an inventory on which tax will be reported upon distribution
for use.

1. Existing inventory, previously taxed, will be deemed distributed on a "First
   in - First Out" (FIFO) basis. This procedure will result in the distribution of
   the dollar value of all tax paid inventory before reporting sales/use tax on a
   usage basis that will begin under the direct payment authority.

2. Once the tax paid inventory is depleted, all distributions from inventory
   will be analyzed based on whether the property qualifies for an exemption. If
   the parts are used in a taxable manner, the sales/use tax on the property will
   be reported directly to Texas.

You believe the above transition plan is reasonable since it would be extremely
difficult to distinguish between inventory parts that have been taxed and parts
that were treated as exempt when purchased under direct pay authority. In
addition, it is difficult to determine the actual purchase date of the parts
once the inventory is commingled. In other words, specific identification of
existing parts as to purchase date or whether they were taxed when purchased is
virtually impossible. The new software system will now allow COMPANY A to more
accurately track distributions from this inventory.

Accordingly, you are requesting confirmation from the Comptroller that the
transition plan described herein meets with the Comptroller's approval. COMPANY
A is requesting approval to distribute existing, previously tax inventory, on a
FIFO basis until the dollar value has been depleted.

Response: Your proposed method for converting a tax paid inventory of parts to
a tax-free inventory by depleting the tax-paid purchases on a FIFO method, and
not accruing tax on future parts until the part is removed from inventory, is
not acceptable.

If your storage facilities will contain taxable items purchased tax free under
a direct payment exemption certificate and at the time of storage it is not
known whether the items will be used in Texas, then you may elect to report the
use taxes either when the taxable items are first stored in Texas or are first
removed from inventory for use in Texas, as long as they are reported in a
consistent manner. If at the time of purchase you know that the taxable items
will be used in Texas, the use taxes must be reported when the items are first
stored, used, or otherwise consumed. As I understand it, your company will only
use these parts in your ** brewery; therefore, you are required to
report tax-free purchases during the return month in which the taxable items
are first stored, or first used if not stored prior to use.

Please refer to the enclosed Rule 3.288 for direct payment procedures,
qualifications and requirements.

This opinion is based on the facts presented. Other facts though similar may
provide a different result.

I hope this information answers your questions. If you need additional
information, please call me toll-free at 1-800-531-5441, extension 3-4502. The
direct line is 512/463-4502. You may also write to Tax Policy Division,
Comptroller of Public Accounts. You may also e-mail our tax help section at:

Sincerely,

Gilbert Zamora
Tax Policy Division