How does a Texas bank treat interest from, and gains and losses on the sale of, U.S. government obligations for franchise tax?

Plain-English summary

Texas-domiciled banks asked how to treat, for franchise tax, both the interest they earn on U.S. government obligations and the gains and losses when they sell those obligations. The example: a bank whose federal gross income included a $49,557 net loss on selling federal obligations, plus $107,823 of interest from federal obligations and $100,000 of interest on federal funds sold.

The Comptroller's guidance:

• Interest — earned surplus: Both the $107,823 and the $100,000 of interest are excluded from the gross-receipts factor and the earned-surplus base, provided they are interest from federal obligations as defined in Rule 3.555(k)(2) and (3). The net loss from the sales, however, is included in earned surplus and in gross receipts for apportionment.
• Interest — taxable capital: The federal-obligations exclusion applies only to earned surplus. For taxable capital, the interest is included in the bank's gross receipts, and a bank commercially domiciled in Texas reports it as Texas receipts under § 171.1031.
• Gains vs. gross proceeds: For obligations held as investments, the Tax Code requires reporting the net gain from the sale as gross receipts (§§ 171.105, 171.1051), with net gains and losses added together. For obligations held for resale in the regular course of business (carried as inventory), the bank reports the gross proceeds, not net gain.
• Sourcing: Gross receipts from selling the obligations are sourced by the buyer's legal domicile — Texas receipts if the payor's legal domicile is Texas, otherwise everywhere-but-not-Texas. "Legal domicile" is defined in Rule 3.549(a)(6) (state of incorporation for a corporation; principal place of business for a partnership or trust). A broker's location does not affect sourcing unless the broker is actually the buyer.

Important currency note — this document has been partially superseded. A STAR editor's note reports that, effective January 26, 2021, the treatment of netting gains and losses here was superseded: after a 2016 Texas Supreme Court decision (STAR 201604972C) holding that § 171.105 does not require including net losses from the sale of investments and capital assets in the apportionment-factor denominator, Rule 3.591(e)(2) was amended so that, for reports due on or after January 1, 2021, net gains and losses are figured sale-by-sale and only net gains go into the apportionment factor. The rest of this letter also predates the 2008 margin-tax restructuring. Rely on it only for historical context and confirm current law.

What this means for you

Banks and financial institutions

The core distinction is durable in spirit: interest on genuine federal obligations was excluded from the earned-surplus base (but not from taxable capital), and whether you report net gain or gross proceeds on a sale turned on whether the security was an investment or inventory. But do not apply the letter's netting-of-losses approach today — the 2021 rule change (only net gains, computed sale-by-sale) supersedes it, and the margin tax changed the base entirely.

Multistate sourcing

Sale receipts followed the buyer's legal domicile, and a broker's location was irrelevant unless the broker was the actual buyer. That buyer-domicile sourcing concept is worth understanding, but verify the current rule.

Accountants and tax professionals

Flag two things on any historical reliance: (1) the federal-obligations interest exclusion applied to earned surplus only, not taxable capital; and (2) the loss-netting holding is expressly superseded by Rule 3.591(e)(2) (2021) following the 2016 Texas Supreme Court decision. Re-verify under current law and the margin tax.

Common questions

Q: Is interest on U.S. government obligations subject to Texas franchise tax?
A: It is excluded from the earned-surplus component (if it qualifies under Rule 3.555(k)), but it is included in gross receipts for the taxable-capital component, and a Texas-domiciled bank reports it as Texas receipts (§ 171.1031).

Q: Do banks report net gain or gross proceeds on selling federal obligations?
A: Net gain if the obligations are held as investments (§§ 171.105, 171.1051); gross proceeds if they are held for resale as inventory.

Q: How are the sale receipts sourced?
A: By the buyer's legal domicile — Texas receipts if the payor's legal domicile is Texas (Rule 3.549(a)(6)). A broker's location doesn't matter unless the broker is the buyer.

Q: Is this still current?
A: Not fully. STAR marks it partially superseded (January 26, 2021) on netting gains and losses — under amended Rule 3.591(e)(2), only net gains, computed sale-by-sale, go into the apportionment factor for reports due on or after January 1, 2021. It also predates the 2008 margin tax.

Citations and references

Statutes and rules:

• Tex. Tax Code § 171.1031 (Texas receipts; commercial domicile)
• Tex. Tax Code §§ 171.105, 171.1051 (net gain from sale of investments/capital assets as gross receipts)
• Franchise Tax Rule 3.555(k)(2), (3) (federal obligations — earned-surplus exclusion)
• Franchise Tax Rule 3.549(a)(6) (legal domicile for sourcing)
• Franchise Tax Rule 3.591(e)(2); STAR 201604972C (2021 change to netting of gains/losses, per the 2016 Texas Supreme Court decision)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9805041L

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.

May 12, 1998

Dear *:

Thank you for the information contained in your letter of May 1, 1998

concerning the sales of U.S. government obligations by Texas domiciled banks.

This response represents the franchise tax implications of the situation

described in the ruling request.

You have indicated that the banks invest in U.S. Government obligations. An

example was provided in which a bank's gross income per line 11 of its federal

income tax return included a net loss of $49,557 from the sale of these federal

obligations. The bank also reported interest of $107,823 from federal

obligations and $100,000 interest earned on federal funds sold.

I will first address the treatment of the interest received from the federal

obligations for reporting the earned surplus component of the tax. Both the

$107,823 and $100,000 interest would be excluded from the gross receipts factor

and earned surplus base provided these amounts represent interest earned from

federal obligations as defined in Franchise Tax Rule 3.555(k)(2) and (3). The

net loss from the sales of these obligations would be included in the

calculation of the bank's earned surplus as well as its gross receipts for

apportionment purposes.

The federal obligations exclusion applies only to the earned surplus component.

The interest from these federal obligations would be included in the bank's

gross receipts for apportioning its taxable capital. A bank that is

commercially domiciled in Texas must report the interest as Texas receipts

pursuant to Sec. 171.1031 of the Texas Tax Code.

You also asked about using gross or net amounts with respect to the sales of

the federal obligations. The ruling request stated that banks "invest" in the

federal obligations. The Tax Code requires that a corporation report as gross

receipts the "net gain" from the sale of an investment. Sections 171.105 and

171.1051, Texas Tax Code. Net gains and losses from sales of investments and

capital assets must be added together to determine the total receipts from such

transactions.

If any of the government obligations are held for resale in the bank's regular

course of business, the bank would report the gross proceeds from the sales and

not the net gain. Generally, these securities will be carried as part of the

bank's inventory rather than as being held for investment.

In apportioning the gross receipts from the sales of the government

obligations, the banks will need to determine the legal domicile of the buyers

of the obligations. If the legal domicile of the payor is Texas, the receipts

from the sale would be reported as Texas receipts. Otherwise, the receipts

would be reported as gross receipts from everywhere, but not Texas receipts.

Franchise Tax Rule 3.549(a)(6) provides the following definition for legal

domicile:

The legal domicile of a corporation is its state of incorporation. The

legal domicile of a partnership or trust is the principal place of business

of the partnership or trust. The principal place of business of a

partnership or trust is the location of its day-to-day operations.

Where the day-to-day operations are conducted equally or fairly evenly in more

than one state, the principal place of business is the commercial

domicile.

The location of the broker selling the obligations on behalf of the banks will

not affect the sourcing of the receipts unless the broker actually purchases

the obligations. If the broker is the buyer, the broker's legal domicile will

determine the apportionment of the receipts.

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

additional facts, the response may change.

If you have any questions, please call toll-free 1-800-531-5441, extension

3-4496 or (512)463-4496.

Sincerely,

Jerry Bobbitt

Tax Policy Division