How were three tiers of related-party product sales sourced when Texas inventory was drop-shipped to U.S., Canadian, and overseas customers?

Plain-English summary

Each related-party title transfer produced a gross receipt, drop-shipment sourcing followed the ultimate customer delivery, and holding title to Texas inventory created nexus.

Texas Corporation manufactured and stored products in Texas, sold them to Foreign Corporation, which resold them to Marketing Corporation or Client Corporation's Sales Division, which then sold to ultimate customers. The first two purchasers took title but not possession; Texas Corporation shipped the products directly to customers by common carrier.

The Comptroller applied three sets of rules.

Revenue recognition at every sale

Each transfer of title for consideration caused the selling entity to recognize revenue and a gross receipt under Sections 171.112(a) and 171.1121(a).

Drop-shipment and delivery sourcing

Because Foreign, Marketing, and Client did not take possession in the intermediate transfers, the chain qualified as a drop shipment. Location of title passage did not control; ultimate delivery did.

• Delivery to a customer in Texas produced Texas receipts for the relevant sellers.
• Delivery to a customer in another U.S. state could be thrown back to Texas if that seller was not subject to tax in the destination state.
• Delivery to overseas customers was a foreign export, not delivery to "another state," so those receipts were non-Texas and not thrown back.

These principles governed Texas Corporation's sale to Foreign, Foreign's sales to Client and Marketing, Client's U.S. and Canadian customer sales, and Marketing's overseas sales. The letter also clarified that Marketing had no transactions with Client's Sales Division.

Texas inventory nexus

Foreign Corporation and Marketing Corporation held title to products stored in Texas. Rule 3.546(c)(3) made that inventory ownership taxable-capital nexus, and Rule 3.554(d)(20) extended it to earned surplus because holding inventory was not protected by Public Law 86-272.

Currency note: This is a pre-2008 separate-entity, drop-shipment, and inventory-nexus ruling. Texas later adopted the margin tax and current combined-reporting rules.

What this means for you

Related companies selling from shared inventory

Intermediate entities can recognize receipts even without physical possession. Ultimate delivery and each seller's destination-state taxability drive sourcing.

Foreign corporations holding title to Texas goods

Title to inventory stored in Texas created nexus even when another related entity physically held and shipped the goods.

Common questions

Q: Did every title transfer create a receipt?
A: Yes, because each transfer was for consideration and recognized revenue.

Q: What controlled drop-shipment sourcing?
A: Ultimate customer delivery, not title passage.

Q: Were overseas exports thrown back to Texas?
A: No.

Q: Did title to Texas inventory create nexus?
A: Yes, for both former tax components.

Citations and references

• Texas Tax Code Secs. 171.112(a), 171.1121(a), 171.103(1), and 171.1032(a)(1)
• 34 Tex. Admin. Code Secs. 3.549(e)(41), 3.557(e)(37), 3.546(c)(3), and 3.554(d)(20)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9902586L

Original ruling text

February 5, 1999

Dear Mr. **:

Thank you for the information contained in your letter of September 11, 1998
concerning a series of sales transactions involving several related
corporations. This response represents the franchise tax implications of the
transactions described in the ruling request.

Because of the number of entities involved, the nature of the transactions, and
different rule provisions affecting these transactions, I'll begin with an
overview of the facts presented and then make a series of statements applicable
to those facts along with the relevant statute and rule cites. The responses
to the specific questions will follow.

Facts

Texas Corporation manufactures tangible personal property (Products) and stores
these Products at its Texas facilities. Texas Corporation sells the Products
to Foreign Corporation (Transaction 1). Foreign Corporation does not take
delivery of the Products, but does sell Products to either Marketing
Corporation or Client Corporation/Sales Division. Neither Marketing nor Client
take delivery of the Products (Transaction 2).

Marketing sells Products to overseas customers; Client sells Products to
customers located in the United States or Canada. Marketing and Client's sales
will be described as Transaction 3. After Marketing or Client take title to
the Products, Texas Corporation transfers possession and control of the
Products to a common carrier for delivery to the customer.

Apportionment Guidelines

Based on the above facts, the following statements apply to the responses about
apportionment.

I. In each transaction described, title to the Products transfers for
consideration. Based on this fact, we would conclude that revenue would be
recognized by the entity transferring the Products in each respective
transaction. That entity would have a gross receipt pursuant to Sections
171.112(a) and 171.1121(a) of the Tax Code.

II. We understand that Transactions 1, 2, and 3 represent the flow of the
sales to the ultimate customers. With Transactions 1 and 2, the respective
purchasers do not take possession of the Products; therefore, the ultimate
sale would qualify as a "drop shipment" as such is defined in Franchise Tax
Rules 3.549(e)(41)(H) and 3.557(e)(37)(H).

III. The sales made from the Texas inventory and delivered to customers in
another state will be subject to the throwback provisions of Sections
171.103(1) and 171.1032(a)(1) if the seller is not subject to taxation in the
other state. See Rules 3.549(e)(41)(I) and 3.557(e)(37)(I) for additional
throwback guidelines.

IV. The facts presented indicate that delivery of the Products is made by
common carrier. For purposes of apportioning the gross receipts from the sales
of tangible personal property, delivery in Texas to a purchaser results in
Texas gross receipts. Location of title passage is not relevant to the
determination of Texas gross receipts. See Rules 3.549(e)(41)(A)-(D) and
3.557(e)(37)(A)-(D) for additional guidelines concerning delivery in Texas,
completion of delivery, and shipment by common carrier.

Responses

1. Texas Corporation would recognize gross receipts with respect to its
   transaction with Foreign Corporation (Transaction 1). Those receipts would be
   apportioned as Texas receipts in the transactions in which the customers of
   Client Corporation/Sales Division take delivery of the Products in Texas. If
   delivery occurs in another state, the receipts would be Texas receipts if Texas
   Corporation is not subject to taxation in that state.

2. As indicated in No. 1 above, the transaction between Texas Corporation and
   Foreign Corporation would result in the recognition of gross receipts to Texas
   Corporation. Those receipts would not be Texas receipts in the transactions in
   which the customers of Marketing Corporation take delivery of the Products
   outside Texas. As long as the sales were exports (i.e., delivery was not made
   to "another state" in accordance with the apportionment rules), there would be
   no throwback of the receipts to Texas.

3. Client would have gross receipts from the sales made by its Sales Division
   to customers in the U.S. or Canada. Those sales would be Texas receipts when
   the customer takes delivery in Texas. If delivery occurs in another state, the
   receipts would be Texas receipts if Client is not subject to taxation in that
   state.

4. The ruling request indicates that Texas Corporation transfers title of the
   Products to Foreign Corporation. The Products are stored in Texas. Franchise
   Tax Rule 3.546(c)(3) provides that holding an inventory in Texas constitutes
   doing business in Texas for purposes of taxable capital. Therefore, Foreign
   Corporation would be subject to the taxable capital component of the tax.

5. Franchise Tax Rule 3.554(d)(20) holds that conducting any activity listed
   as doing business in Rule 3.546 which is not protected by Public Law 86-272
   constitutes doing business in Texas for earned surplus reporting. Having an
   inventory in Texas is not protected by Public Law 86-272. Foreign Corporation
   would, therefore, be subject to the earned surplus component of the tax.

6. The ruling request indicates that Foreign Corporation transfer title of the
   Products to Marketing Corporation. The Products are stored in Texas. As noted
   in Response No. 4, holding inventory in Texas will subject Marketing
   Corporation to the taxable capital component of the tax under Rule 3.546(c)(3).

7. As noted in Response No.5, Marketing Corporation's holding title to
   inventory in Texas will subject it to the earned surplus component of the tax
   pursuant to Rule 3.554(d)(20).

8. Foreign Corporation would recognize gross receipts from its transactions
   with the Sales Division of Client. Those receipts would be apportioned as
   Texas receipts in the transactions in which the customers of Client/Sales
   Division take delivery of the Products in Texas. If delivery occurs in another
   state, the receipts would be Texas receipts if Foreign Corporation is not
   subject to taxation in that state.

Marketing Corporation would recognize gross receipts from its sales to
customers located overseas. Those receipts would not be Texas receipts in the
transactions in which the customers take delivery of the Products outside
Texas. As long as the sales were exports (i.e., delivery was not made to
"another state" in accordance with the apportionment rules), there would be no
throwback of the receipts to Texas.

Based on our understanding of the facts presented, Marketing Corporation has no
transactions with the Sales Division of Client. Therefore, the Client/Sales
Division's transactions will not impact Marketing Corporation's gross receipts.

9. Foreign Corporation would recognize gross receipts from its transactions
   with Marketing Corporation. Those receipts would not be Texas receipts in the
   transactions in which the customers of Marketing Corporation take delivery of
   the Products outside Texas. As long as the sales were exports (i.e., delivery
   was not made to "another state" in accordance with the apportionment rules),
   there would be no throwback of the receipts to Texas.

Based on our understanding of the facts presented, Marketing Corporation's only
gross receipts would be from its sales to customers located overseas. The
response to No. 8 above addresses how Marketing Corporation would recognize and
apportion its 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