How does a Texas bank treat gains, losses, interest, and dividends from federal government obligations it buys and sells for its own account?

Plain-English summary

A Texas banking corporation — incorporated and commercially domiciled in Texas, with all of its business conducted in the state — proposed to buy and sell U.S. government obligations (such as treasury bills and treasury notes) for its own account. Doing so would produce interest income and gains or losses on disposition. The bank asked the Comptroller how to treat those amounts for the (pre-2008) franchise tax.

The Comptroller advised:

1. The obligations are investment securities, not inventory. Because the bank buys and sells them for its own account and would not treat them as inventory under GAAP (taxable capital) or for federal income tax (earned surplus), they are treated as investments.
2. Only net gains or losses enter gross receipts. For investment securities, only the net gain or loss on a sale is included in the gross-receipts calculation (Rules 3.549(e)(3) and 3.557(e)(3)).
3. Sourcing is by the payor's location — with an exchange fallback. The net gain or loss is sourced to the location of the payor. If the securities are sold through a stock exchange where the buyer cannot be identified, 6.5% of the receipts are Texas receipts (Rules 3.549(e)(39) and 3.557(e)(35)).
4. Interest and dividends are Texas receipts here. Because the bank is commercially domiciled in Texas, interest and dividends it receives are gross receipts from business done in Texas (§ 171.1031).
5. But federal-obligation interest and dividends are excluded from earned surplus. If the interest and dividends come from federal obligations as defined in Rule 3.555(k), they are excluded from both the Texas and everywhere receipts and from the earned-surplus base itself.

Important currency note: This 1996 letter applies the franchise tax before the 2008 margin-tax overhaul. STAR also marks it partially superseded on 01/26/2021 on how net gains and losses are computed: following a 2016 Texas Supreme Court decision on § 171.105, Rule 3.591(e)(2) now requires net gains and losses to be figured sale-by-sale, with only net gains used in the apportionment factor for returns due on or after 01/01/2021 (STAR 201604972C). Treat the netting mechanics here as outdated and confirm current law.

What this means for you

Texas banks and financial institutions

If you hold U.S. government obligations as investments (not as dealer inventory), only the net gain or loss — not gross proceeds — flows into your gross receipts, and interest and dividends from those federal obligations stay out of the earned-surplus base. But the netting method changed in 2021, so re-check how you compute net gains and losses.

Accountants and tax professionals

Watch the investment-versus-inventory line: it determines whether you report net gains or gross proceeds. Commercial domicile in Texas is what makes interest and dividends Texas receipts under § 171.1031. All of this predates the margin tax and the 2021 netting change — use it for the framework, not the current mechanics.

Common questions

Q: Does the bank report the full sale price of the obligations as gross receipts?
A: No. Because the obligations are investment securities, only the net gain or loss is included in gross receipts.

Q: How is the gain or loss sourced to Texas?
A: By the location of the payor. If sold on an exchange where the buyer cannot be identified, 6.5% of the receipts are treated as Texas receipts.

Q: Is interest from the federal obligations taxed?
A: It is a Texas receipt because the bank is commercially domiciled in Texas, but interest and dividends from federal obligations (as defined in Rule 3.555(k)) are excluded from the earned-surplus component.

Citations and references

Statutes and rules:

• Tex. Tax Code § 171.001(b)(1) (definition of banking corporation)
• Tex. Tax Code § 171.1031 (interest and dividends of a commercially domiciled banking corporation are Texas receipts)
• Franchise Tax Rules 3.549(e)(3) and 3.557(e)(3) (only net gains/losses on investment securities in gross receipts)
• Franchise Tax Rules 3.549(e)(39) and 3.557(e)(35) (6.5% Texas-receipts rule for unidentifiable-buyer exchange sales)
• Franchise Tax Rule 3.555(k) (federal-obligation definition for the earned-surplus exclusion)
• Franchise Tax Rule 3.591(e)(2); STAR 201604972C (2021 change to net-gain/loss computation under § 171.105)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9609115L

Original ruling text

STAR Superseded Information

Supersede type: partial

Document superseded on: 01/26/2021

Issue(s) that caused the document to be superseded: netting gains & losses from sale of investments and capital assets

Reason(s): The Supreme Court of Texas (in 2016) held that Section 171.105 does not require the inclusion of net losses from the sale of investments and capital assets in its apportionment-factor denominator. See STAR 201604972C. Rule 3.591(e)(2) has been amended to require that net gains and losses be determined on a sale-by-sale basis and only net gains are to be used in the apportionment factor for franchise returns due on or after 01/01/2021.

September 24, 1996

Dear **:

Thank you for your letter concerning the sourcing of income from the sale of

various securities by your client.

You stated in your letter that your client is a financial institution,

incorporated and commercially domiciled in the State of Texas. It is a banking

corporation as defined by Texas Tax Code Section 171.001(b)(1). All of its

financial institution dealings occur within Texas. The company proposes to

establish a program whereby it would buy and sell, for its own account, federal

government obligations such as treasury bills and treasury notes. As a result

of acquiring, holding, and selling these federal government obligations, the

company may generate interest income, as well as gain or loss upon disposition

of the obligations.

Based on the facts in your letter, it appears that the obligations, bought and

sold by your client for their own account, would be classified as investment

securities and not trading securities. If the obligations (securities) would

not be treated as inventory under generally accepted accounting principles

(taxable capital) or for federal income tax purposes (earned surplus), then

they would not be treated as inventory for franchise tax reporting purposes.

The obligations (securities) will be treated as investments and only the net

gains or losses will be included in the calculation of gross receipts [Rule

3.549(e)(3) and Rule 3.557(e)(3)].

The net gain or loss from the sale of your client's securities should be

sourced based on the location of the payor. However, if the securities are

sold through a stock exchange where the buyer cannot be identified, 6.5% of the

receipts are Texas receipts [Rule 3.549(e)(39) and Rule 3.557(e)(35)].

Dividends and interest earned on the securities held by your client will be

considered unitary income and will be considered Texas receipts. Section

171.1031 of the Texas Tax Code provides that interest and dividends received by

a banking corporation are gross receipts from its business done in this state

if its commercial domicile is in Texas. If the dividends and interest are from

federal obligations as defined in Franchise Tax Rule 3.555(k), then they will

be excluded from the calculation of Texas and everywhere receipts for the

earned surplus component of the tax as well as from the calculation of earned

surplus.

This response is based on the facts presented. If there are different or

additional facts, the response may change.

If you have any questions about this or any other franchise tax matter, please

call me at 1-800-531-5441, extension 34612. My direct number is (512)

463-4612. You may write me at Tax Policy Division, Comptroller of Public

Accounts, Austin, Texas 78774.

Sincerely,

Janet Spies

Tax Policy Division