200801034L


January 11, 2008

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Dear *********:

Thank you for your letter concerning the revised franchise tax and, 
specifically, the issue concerning beginning inventory.  The provision 
concerning beginning inventory was inserted after the public comment period of 
proposed Rule 3.588(c)(2)(A) in response to a public comment for additional 
clarity.  It is entirely consistent, however, with our process to listen to and 
consider all industry input at any time, even after the rules become adopted, 
to evaluate it for consistency with the law.

Immediately after House Bill 3 passed in 2006, we began hearing from various 
groups that were concerned about the cost of goods sold (COGS) capitalization 
provisions.  Many groups asked if the costs listed could just be expensed, 
rather than capitalized.  However, some start-up companies raised the concern 
that they may not have revenue the first few years, and they wanted to be able 
to capitalize.  HB 3928 in 2007 was drafted to allow both.

What was not made clear was whether there could be inventory at the beginning 
of a taxpayer’s accounting year for the first report due based on margin.  For 
example, a calendar year taxpayer’s 2008 franchise tax report will be based on 
financial activity for calendar year 2007.  Our agency concluded that costs 
incurred before 2007 for such a taxpayer would not be allowed as a deduction, 
just as revenue before 2007 would not be included in total revenue.

Consider this example:
Beginning inventory 1/1/2007                    $ 3,000,000,000
Purchases in 2007                                12,000,000,000
Ending inventory 12/31/2007                       4,000,000,000

Using the example above, on the 2008 franchise tax report we would have allowed 
a $12,000,000,000 COGS deduction for taxpayers electing to expense and an 
$8,000,000,000 COGS deduction for taxpayers electing to capitalize.  Over the 
life of both companies, however, the deduction for COGS would have been exactly 
the same; therefore, the establishment of this policy was not driven by revenue 
forecasts.

Our primary concern with allowing a beginning inventory for taxpayers electing 
to capitalize was a potential unequal treatment court challenge brought by 
taxpayers electing to expense COGS.  We were concerned that taxpayers electing 
to expense COGS would want to take $15,000,000,000, in the example above, as 
COGS because we allowed those same costs to be used by those taxpayers electing 
to capitalize.

After researching all of the relevant court cases in Texas, however, we have 
decided to allow a beginning inventory for taxpayers electing to capitalize 
COGS.  Our rule will be changed accordingly.

We are available to assist you and your colleagues concerning this tax at any 
time.  If you have any questions, please feel free to contact William Hamner, 
our director of Tax Administration, by e-mail at william.hamner@cpa.state.tx.us 
or by phone at 475-0545.  You may also call me directly at 463-4444.

Please let us know if we can be of any further assistance.

Sincerely,

Susan Combs

cc:  William Hamner

ACCESSION NUMBER: 200801034L  
SUPERSEDED: N 
DOCUMENT TYPE: L  
DATE: 01/11/2008  
TAX TYPE: FRANCHISE