How did a Texas bank treat mortgage-security principal payments and interest on federal funds for the former franchise tax?

Plain-English summary

Principal repayments on available-for-sale debt securities were not gross receipts, while interest on federal funds depended on whether the funds were obligations or deposits.

The bank held federal and agency obligations, including Treasury notes and GNMA, FNMA, and FHLMC mortgage-backed securities, and sold federal funds to banks and the Federal Reserve Bank.

The Comptroller answered two issues:

1. Mortgage-security principal: repayment of debt-security principal was excluded from Texas receipts and receipts from everywhere under Rules 3.549(e)(27) and 3.557(e)(22). The answer applied to debt securities held as available for sale.
2. Federal-fund interest: Rule 3.555(k) excluded interest on a qualifying federal obligation from earned surplus. Its definition covered bonds, debentures, securities, mortgage-backed securities, pass-through certificates, and other evidence of indebtedness—but specifically excluded a deposit. If the funds were deposits and did not otherwise qualify as obligations, their interest entered earned surplus and gross receipts.

For reports due before January 1, 2000, deposit interest was a Texas receipt when the bank's commercial domicile was Texas under Section 171.1031(a). House Bill 2067 changed bank interest and dividend sourcing to the payor's location for reports due on or after that date.

The letter states the classification test but does not finally say whether the bank's particular federal funds were deposits or obligations.

Currency note: These are historical bank rules under the former franchise tax. Texas replaced that tax with the margin tax effective January 1, 2008.

What this means for you

Banks holding mortgage-backed debt securities

Return of principal was not revenue for the former receipts factor when the securities were held in the available-for-sale category.

Banks placing federal funds

The label "federal" did not automatically create an exclusion. The legal form—obligation versus deposit—controlled.

Common questions

Q: Were principal payments gross receipts?
A: No.

Q: Was all interest from federal funds excluded?
A: No. Deposit interest was not covered by the federal-obligation exclusion.

Q: Did the letter finally classify the bank's federal funds?
A: No. It gave the governing test.

Citations and references

• 34 Tex. Admin. Code Secs. 3.549(e)(27), 3.557(e)(22), and 3.555(k)
• Texas Tax Code Sec. 171.1031(a)
• House Bill 2067

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9906722L

Original ruling text

June 28, 1999

Dear **:

Thank you for the information contained in your letter concerning the security
portfolio of a Texas banking corporation. This response represents the
franchise tax implications of the situation described in the ruling request.

You have indicated that the bank's security portfolio consists of various
federal obligations and federal agency obligations, including U.S. Treasury
Notes. The portfolio also includes GNMA, FNMA, and FHLMC mortgage-backed
securities. In addition, the bank maintains funds as federal funds sold to
other banks and to the Federal Reserve Bank.

The bank receives interest on the mortgage-backed securities and federal funds.
It receives periodic principal payments for the mortgage-backed securities
that reduce the principal balance of the securities.

Your first question asked how the principal payments for the mortgage-backed
securities should be treated in the computation of the bank's gross receipts.

The principal amount received as payment of a debt security is not a gross
receipt for franchise tax purposes. The principal repayment is excluded from
gross receipts everywhere and Texas gross receipts. Please see Franchise Tax
Rules 3.549(e)(27) and 3.557(e)(22). This treatment is applicable to principal
repayments of debt securities held in the available-for-sale category of the
portfolio.

The second question dealt with the exclusion of the interest received from the
federal funds sold to the Federal Reserve Bank for earned surplus reporting.
Rule 3.555(k) addresses the federal obligation exclusion.

For purposes of this exclusion, "obligation" is defined as any bond, debenture,
security, mortgage-backed security, pass-through certificate, or other evidence
of indebtedness of the issuing entity. The rule specifically excludes a
deposit from the definition. Therefore, if the funds in question are deposits
made with the bank and otherwise don't fall under the "obligation" definition,
the interest from the funds would be included in the earned surplus base and
would be included in the bank's gross receipts.

If the banking corporation's commercial domicile is in Texas, the interest is a
Texas receipt. Sec. 171.1031 (a), Texas Tax Code. This statutory provision
was amended during the past legislative session. Effective with reports due on
or after January 1, 2000, interest and dividends received by a banking
corporation or savings and loan association will be apportioned under the
location of payor rule. This amendment was passed in House Bill 2067.

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