How is income a pharmaceutical parent recognizes under the IRC Section 936 Profit Split Method sourced for the Texas franchise tax earned-surplus gross receipts factor?

Plain-English summary

A domestic pharmaceutical parent (P Co) owned a subsidiary (S Co) that made a valid IRC Section 936 election (a possessions corporation, operating in Puerto Rico). P Co recognized income under the Profit Split Method (PSM) of IRC Section 936(h)(5)(C)(ii): P Co and S Co combine the product's sales and expenses, and each is allocated 50% of the combined income. Section 936 also requires P Co to charge S Co a minimum amount tied to P Co's research and development (R&D) expenses, recognized as income to P Co. P Co asked how this PSM income is treated for the earned-surplus gross receipts factor. The Comptroller split the answer into intangible-use receipts and service receipts.

The split-profit share = receipts from use of an intangible

• Section 936(h) addresses income from intangibles - patents, copyrights, trademarks, licenses - and the Texas definition (Rule 3.557(e)(3)(B)) matches. The Comptroller presumed S Co merely uses the intangible (did not purchase it from P Co).
• Gross receipts are all revenues reportable on the federal return without deducting costs (Tax Code Section 171.1121(a)), so P Co's income attributed to S Co's use of the intangible is a gross receipt.
• Sourcing: receipts from the use of intangible rights are apportioned to Texas to the extent the intangible is used in Texas (Rule 3.557(e)(25)). Because the intangible is used only in Puerto Rico, the receipts are not Texas gross receipts - but they are gross receipts everywhere for P Co.

The R&D charge = receipts from services

• P Co's charges to S Co for P Co's research work are receipts from services. Under Tax Code Section 171.1032(a)(2) (and Rule 3.557(e)(19)), service receipts are Texas receipts to the extent the services are performed in Texas. So if P Co performs research activities in Texas, those receipts are Texas receipts.

Applied to the example

In the taxpayer's example, the $25 split-profit amount was gross receipts from the use of an intangible, and the $14.4 amount was gross receipts from services. Each is then apportioned under the rules above to build P Co's apportionment factor.

Currency note: This applies the pre-2008 franchise tax's 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

Multinationals using possessions corporations / PSM structures

The two economic pieces of a PSM arrangement did not source the same way. The profit-split share tracked where the underlying intangible was used (here, all outside Texas), landing in the "everywhere" denominator but not the Texas numerator. The R&D charge tracked where the parent actually performed the research - which could be a Texas receipt if the labs were in Texas.

Accountants and tax professionals

Decompose PSM income before apportioning: treat the profit-split share as intangible-use receipts (Rule 3.557(e)(25), sourced to where the intangible is used) and the mandatory R&D charge as service receipts (Section 171.1032(a)(2), sourced to where the research is performed). Both are gross receipts everywhere under Section 171.1121(a); only the Texas-use / Texas-performance portions enter the Texas numerator.

Common questions

Q: Is the parent's PSM profit-split share a Texas receipt?
A: Only to the extent the underlying intangible is used in Texas. Here it was used only in Puerto Rico, so it was gross receipts everywhere but not Texas receipts.

Q: How is the required R&D charge sourced?
A: As service receipts - Texas receipts to the extent the research is performed in Texas (Section 171.1032(a)(2); Rule 3.557(e)(19)).

Q: Are these amounts gross receipts at all?
A: Yes. Both are gross receipts everywhere because they are revenues reportable on the federal return (Section 171.1121(a)); the question is how much is apportioned to Texas.

Citations and references

Statutes and rules:

• Tex. Tax Code Sec. 171.1121(a) (gross receipts = all revenues reportable on the federal return without deducting costs)
• Tex. Tax Code Sec. 171.1032(a)(2) (receipts from services performed in Texas are Texas receipts)
• 34 Tex. Admin. Code Sec. 3.557(e)(25) (receipts from use of intangible rights apportioned to Texas to the extent used in Texas)
• 34 Tex. Admin. Code Sec. 3.557(e)(3)(B) (definition of intangibles: patents, copyrights, trademarks, licenses)
• 34 Tex. Admin. Code Sec. 3.557(e)(19) (service receipts sourcing)
• IRC Sec. 936(h)(5)(C)(ii) (Profit Split Method for possessions-corporation intangible income)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200305906L

Original ruling text

May 8, 2003

Dear **:

Thank you for your letter requesting a ruling regarding the franchise tax
treatment of income recognized under the Profit Split Method (PSM) of Internal
Revenue Code (IRC) Section 936(h)(5)(C)(ii). I apologize for the delay in
responding to you.

You have indicated that your client, P Co, is a domestic pharmaceutical
company. P Co is the sole shareholder of a subsidiary, S Co. S Co is a
domestic company that has made a valid election under IRC Section 936. P Co
recognizes income for federal income tax purposes under the Profit Split Method
(PSM) elaborated in IRC Section 936(h)(5)(C)(ii).

You have also indicated that under the PSM structure, P Co and S Co combine the
sales and expenses related to S Co's product/service as a single effort. Half
of the income related to the single product area is attributed to P Co, and the
remaining 50% of the combined income is allocated to S Co. Under IRC Section
936, S Co. is not included in P Co's federal income tax return.

Additionally under IRC Section 936, P Co must charge to S Co a minimum amount
related to P Co's research and development expenses (R & D). The charge is
recognized as income to P Co. The minimum amount to charge equals the total R
& D expenses for the product area multiplied by 120% of the ratio of the
group's sales of S Co products divided by the group's sales within the product
area.

You requested that our agency address the specific treatment of income
recognized under the PSM as it pertains to the computation of P Co's gross
receipts for earned surplus apportionment purposes.

RESPONSE

IRC Section 936(h) addresses the tax treatment of income from intangibles.
Intangibles in this context include, but are not limited to, patents,
copyrights, trademarks, and licenses. According to Franchise Tax Rule
3.557(e)(3)(B), intangibles for Texas franchise tax purposes also include
patents, copyrights, trademarks, and licenses. While it is unclear the exact
type of intangible S Co is using in this situation, I will presume it is one of
those enumerated in the definition of intangibles given for both the IRC
Section 936(h) and Texas franchise tax. I will also presume that S Co merely
uses the intangible and has not purchased it from P Co.

IRC Section 936(h) was enacted to prevent companies from circumventing taxation
altogether. A company classified under this section has the option to be taxed
one of two ways, the PSM or the cost sharing method. S Co elects the PSM.
Consequently, P Co derives income in this situation based upon S Co's use of
intangibles developed by P Co.

Tax Code Section 171.1121(a) defines "gross receipts" as all revenues that are
reportable by the corporation on its federal income tax return without
deduction for costs. Because P Co recognizes the royalty income attributed to
S Co's use of intangible property, that income reported on its federal income
tax return would be considered gross receipts for earned surplus apportionment
purposes.

In sourcing these receipts, Rule 3.557(e)(25) provides that gross receipts from
the use of intangible rights are apportioned to Texas to the extent the
intangible is used in Texas. Any income that P Co recognizes under the PSM is
a result of P Co's underlying intangible that S Co uses in the production of
the product. As such, the income would be considered receipts to P Co from S
Co's use of the intangibles.

Because the intangible is only used in Puerto Rico by S Co, the gross receipts
are not Texas gross receipts. However, these receipts will be considered gross
receipts everywhere for P Co.

P Co's charges to S Co for P Co's research work are receipts from services.
Tax Code Section 171.1032(a)(2) provides that receipts from services performed
in Texas are apportioned as Texas receipts. Therefore, if P Co performs any of
the research activities in Texas, the receipts attributed to those services
would be Texas receipts. Also, see Rule 3.557(e)(19).

In the example you provided (Attachment I), P Co's $25 split profit amount
would be considered gross receipts from use of an intangible. The $14.4 amount
would be considered gross receipts from services. The apportionment guidelines
outlined above would then be applied to determine P Co's apportionment factor.

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 3.4496.

Sincerely,

Jerry Bobbitt
Tax Policy Division