Re-Examining Transfer Pricing: Sourcing of Services for Texas Franchise Tax Purposes
Transfer pricing—the tax consequences arising from transactions between such commonly controlled entities—is indeed a vast and complex area of tax law. Most taxpayers typically consider this area limited to such transactions for properly determining a taxpayer’s income tax liability. However, the application of transfer pricing can arise in some unlikely domains. Texas, a state imposing a franchise tax on an entity’s margin rather than net income, is one example.
Under a regulation recently promulgated by the Texas Comptroller, receipts from providing a service are apportioned to the location where the service is performed. The regulation further provides that if there is a receipts-producing, end-product act, the location of other acts will not be considered even if those acts are essential to the performance of the receipts-producing act. This also is consistent with the Texas Court of Appeals decision in Hegar v. Sirius XM Radio, Inc. where the court held that producing programming content for satellite radio stations was a nonreceipt-producing act, albeit an essential one.
Nonetheless, as the regulation clarifies, if the service is performed in Texas and another state for a single charge, a fair value analysis is required, and the regulation provides guidance on determining fair value. The guidance provides a few examples that illustrate that for certain types of services, the fair value analysis will apply and receipts will be sourced proportionately based on where the services are performed. In determining fair value, the relative value of each service provided on a standalone basis may be considered. Units of the service, such as hours worked, also may be considered. The actual cost of performing a service does not necessarily represent its value. If costs are considered, they should be limited to costs directly related to the service and not overhead costs.
A transfer pricing study could prove to be tremendously beneficial in determining the fair value of the service provided in Texas, as transfer pricing abides by the arm’s-length standard. For example, a taxpayer provides shipping and logistics services to customers in Texas and receives $1 million of gross receipts from such services. The taxpayer incurs costs of $300,000 in Texas (warehousing) and costs of $100,000 in Missouri (logistics planning by technical professionals). Assume the taxpayer has $1 million of gross receipts sourced to Texas, $3 million of gross receipts sourced everywhere, and a margin of $600,000. The taxable margin in Texas would be $200,000.
Sales Factor ($1,000,000/$3,000,000) × $600,000 Margin = $200,000 Taxable Margin
However, assume the hypothetical markup on the service, i.e., if the taxpayer were to obtain the warehousing or logistics services for its business from a third party, for the functions linked to those costs is $200,000 and $400,000, respectively. After the adjustment, the taxpayer may only have $500,000 of gross receipts sourced to Texas. The taxable margin would then become $100,000.
Sales Factor ($500,000/$3,000,000) × $600,000 Margin = $100,000 Taxable Margin
Therefore, the taxpayer’s Texas tax liability has been effectively reduced by 50 percent.
For additional guidance on the Texas regulation or a fair value analysis, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.