Real Estate Leases And Margin Taxes: Who Pays?
Law360, New York (April 8, 2011) -- In May 2006, the Texas Legislature dramatically overhauled the Texas Franchise Tax[1] by expanding the tax base to include virtually all entities whose owners receive liability protection under state law and by changing the manner in which the franchise tax was calculated.
These sweeping changes make most landlords in Texas subject to the new “margin” tax because limited partnerships, which were previously exempt, are now subject to the new tax. Although this new tax was imposed upon the landlord, most landlords have attempted and succeeded in passing financial responsibility for these new taxes onto their tenants.
Many landlords have sought to revise their lease agreements at renewal time to expressly include the new franchise or “margin” tax within the definition of operating expenses or taxes that are the responsibility of the tenant under the lease. Landlords have also included in leases executed after May 2006 similar provisions to ensure that the tenant, and not the landlord, ultimately pays for the new margin tax.
This article will review the former franchise law, the background for changes to the Texas Tax Code, the new margin tax and its general applications and what these changes mean for leases executed both before and after May 2006. This article is not intended as a primer on the new Texas margin tax, but rather is intended as a guide to real estate practitioners for use in connection with negotiations between landlords and tenants on the allocation of financial responsibility for these taxes and to ensure that such allocations are consistent with the parties’ intentions.
Limited Partnerships Not Subject to Old Franchise Tax
Prior to the passage of HB3[2] in May 2006, the Texas franchise tax did not apply to limited partnerships. Consequently, virtually all Texas landlords, and many operating companies, were organized as Texas limited partnerships.
For those entities (e.g., corporations and limited liability companies) subject to the former franchise tax, the amount of tax was the greater of two numbers 1) 1/4 of 1 percent on the taxpayer’s taxable capital (an asset based test); and 2) 4.5 percent of earned surplus (an income based amount)[3].
However, as noted above, these calculations were not a concern for most Texas landlords since they were organized as limited partnerships and exempt from the former Texas franchise tax.
Legislative Changes
In November 2005, the Texas Supreme Court found the state’s school finance system, including its “Robin Hood” plan, to be unconstitutional[4]. In response to this decision, the Texas Legislature passed HB1[5] and HB2[6] in the same legislative session in which HB3 was passed.
The new school financing plan contained in HB2 decreased school tax rates and made up for the deficiency by increasing state funding to school districts in HB1. The new margin tax adopted pursuant to HB3 was intended, in part, to generate the revenue necessary to make up for the funding deficiency created by HB1. HB2 reduced and capped the tax rates that could be used by the local school district.
Most importantly to Texas landlords, HB3 expanded the definition of taxable entities to include limited partnerships and all other entities that enjoy state liability protection. As a result, most Texas landlords went from exempt to nonexempt under the new Texas margin tax, although the Legislature continued to exempt sole proprietorships, general partnerships owned directly by natural persons, real estate investment trusts (REITs) and real estate mortgage investment conduit (REMICs), and certain unincorporated passive entities, among others, from the new tax.
Businesses with annualized revenue equal to or less than $1 million for report years 2010 and 2011 ($300,000 for 2008 and 2009 report years) are also exempt.[7]
The New Margin Tax
In addition to expanding the entities subject to the new tax, the Legislature completely altered the manner in which the tax is computed. Instead of considering an entity’s capital or earned surplus, the margin tax is based upon the taxpayer’s “taxable margin,” which equals the lesser of 1) total revenues minus cost of goods sold; 2) total revenue minus compensation; and 3) 70 percent of total revenue.
Taxable margin is taxed at the rate of .5 percent (for retailers and wholesalers) or 1 percent for all other businesses, including Texas landlords. Interestingly, operating expenses and taxes that the landlord collects from the tenant are considered revenue subject to the margin tax. These items could be paid by tenant directly to the third parties and taxing authorities, but that creates its own issues for multitenant properties.
Importantly, affiliated groups must file a combined margin tax report with the Texas comptroller. The comptroller considers the affiliated group to be a single taxpayer for purposes of filing the margin tax report, although transactions among or between members of the group may be disregarded.
An affiliated group is one in which 80 percent or more controlling interest is owned by a common owner and the group is engaged in a “unitary business.” A group is considered to be a unitary business if it has a single economic enterprise in which entities are sufficiently interdependent, integrated and interrelated through their activities so as to provide a synergy and mutual benefit that produces a flow of value to the separate parts.
The important thing to remember for tenants is that their landlord’s margin taxes will be based upon all of the operations of such landlord within and outside the state of Texas, although the margin tax will be apportioned for landlord’s properties in multiple states based upon a basic formula of Texas receipts divided by total receipts.
Who’s Responsible?
Prior to May 2006, a typical real estate lease would define real estate taxes as “ad valorem taxes, general and special assessments, any tax or excise on rents, and any tax or change in lieu of the foregoing, but not any franchise, estate, inheritance or income tax.”
Obviously, no provision was made for the Texas margin tax because it had not been invented. As a result, landlords and tenants have had to negotiate who should be responsible for the new tax. Such exchanges took place either when taxes were passed through to the tenant in annual operating expense/tax adjustments or in lease renewal amendments. These issues arose irrespective of whether the lease was structured as a triple net, gross or modified gross/net lease.
Landlords have made a number of arguments in support of their position that the tenant should be responsible for the new margin tax, including the following arguments:
• Margin tax is a rental tax, which is typically passed through to the tenant.
• The margin tax is a new tax “in lieu of” the reduction in real property taxes pursuant to HB2.
• In a triple-net lease, the landlord’s benefit of its bargain (i.e., rental income) would not be received by the landlord and the tenant has in concept agreed to pay all charges related to the lease.
• Tenant could be placed in default for not paying “rental” under the lease, in which case the tenant would have to file a declaratory action to adjudicate the issue.[8]
• If the margin tax is included in the base year of a new gross lease or a renewal term, then the effect upon the tenant should be negligible.
On the other hand, tenants have a number of compelling arguments that they should not be responsible for the landlord’s margin tax, including, without limitation, the following arguments:
• The Texas margin tax is similar to an income tax because it is based upon the landlord’s income similar to federal income taxes.
• That margin taxes are not expressly included in the definition of operating expenses or taxes under the lease.[9]
• There are entity-based exemptions to the margin tax just like the federal and other income taxes (e.g., REITs and certain general partnerships) and tenants of these exempt landlords do not have to pay these margin taxes.
• Tenants of landlords that are affiliated groups would have to pay margin taxes on other properties of such group and on extraordinary transactions such as sales, dispositions and refinancings.
• It is difficult and expensive for a tenant to have to audit or verify a landlord’s margin taxes as such audit could constitute an audit or review of the landlord’s (and its affiliates) income statement, and the landlord would not want to have to provide the tenant with access to such financial information and records.
Although many of the above arguments are also applicable to a real estate lease executed after May 2006, in many respects the margin tax is now a known expense and such cost can be allocated between the parties like any other lease concession.
As with other leases, tenants with more significant leases will have more success in making the landlord responsible for the margin taxes. For smaller leases, the tenant will have little luck in pushing the margin tax over to the landlord’s side of the table. Even if the landlord is exempt from the Texas margin tax, the parties should provide for such taxes in the lease in case the Texas Tax Code is ever modified or the landlord sells the property to a nonexempt entity. A typical landlord–oriented margin tax provision for a new lease or lease renewal where the tenant has little negotiating leverage may simply provide that “from and after the date hereof and notwithstanding anything to the contrary in the lease, taxes shall include the Texas margin tax and/or any other business tax imposed under Texas Tax Code Chapter 171 and/or any successor statutory provision for reports due under any such provision.”
On the other hand, a tenant-friendly provision in a situation where a tenant is entering into a long-term lease for a large space might include the following proviso:
"[P]rovided, however, that 1) tenant will have the right to review the books and records of landlord and its affiliates (to the extent landlord is part of an affiliated group that conducts a unitary business and is required to file a combined Texas margin tax report) to confirm the calculation of landlord’s margin tax, including revenue and deductions therefrom, use of any available tax credits and appropriate allocation or apportionment of landlord’s revenue and deductions from revenue if landlord files a combined Texas margin tax report; 2) tenant’s obligations to pay landlord’s margin taxes will be reduced by the benefit of landlord being able to deduct (or use as a credit) its margin tax from federal income taxes or other payments; 3) tenant will not be responsible for landlord’s margin tax if the state of Texas repeals the reduction in real property tax rates that was enacted in connection with the adoption of the Texas margin tax; and 4) landlord’s margin taxes paid by tenant will not include revenue from sales of real property or other extraordinary transactions consummated by landlord."
In many instances, the margin tax issue leads to a compromise where the lease provision falls somewhere between the two provisions provided above and might appear as follows:
"From and after the date hereof and notwithstanding anything to the contrary in the lease, “operating expenses” shall specifically include the Texas margin tax and/or any other business tax imposed under Texas Tax Code Chapter 171 and/or any successor statutory provision for reports due under any such provision; provided that such margin tax and/or any other business tax shall not be based upon any revenue from sales of real property or other extraordinary transactions consummated by landlord. For the purposes hereof, any margin tax and/or any other business tax payable by tenant shall be calculated as if the building were the only income-producing asset belonging to landlord." Conclusion
Although the Texas margin tax has been in existence for the past three tax years, many landlords and tenants are still determining its application to existing leases and how to provide for it in new leases or lease renewals. Given the current budgetary shortfalls, it is certainly possible that additional changes may be made to the margin tax rates, the entities exempt therefrom or the mechanics of the tax in order to derive more revenue for the state of Texas.
Regardless of whether the margin tax remains the same or changes, its effect upon the Texas real estate market has been, and will continue to be, profound and dramatic, and real estate leases should be carefully crafted to address the responsibility for these taxes.
--By Larry L. Shosid, Bell Nunnally & Martin LLP
Larry Shosid is a partner in the transactional section of Bell Nunnally in the firm's Dallas office. He has more than 20 years of experience counseling clients on various real property and energy transactions, mergers and acquisitions, securities offerings, general corporate and other entity representations, credit transactions and intellectual property matters.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Texas Tax Code § 171.001 et. seq.
[3] Texas Tax Code §§ 171.002, 171.101 and 171.101 (in effect prior to Jan. 1, 2008)
[4] Shirley Neeley, Texas Commissioner of Education, et al., v. West Orange-Cove Consolidated Independent School District, et al., No. 04-1144, consolidated with Alvarado Independent School District, et al. v. Shirley Neeley, Texas Commissioner of Education, et al., No. 05-0145, consolidated with Edgewood Independent School District, et al. v. Shirley Neeley, Texas Commissioner of Education, et al., No. 05-0148, Supreme Court of Texas, on appeal from the 250th District Court of Travis County, Texas, 176 S.W.3d 746; 2005 Tex. LEXIS 868; 49 Tex. Sup. J. 119
[5] HB1, 79the Leg., 3d Spec. Sess., §§ 2 – 26 (2006) [6] HB2, 79the Leg., 3d Spec. Sess., §§ 2 – 26 (2006)
[7] Window on State Government; Texas Franchise Tax – Which Forms Should I File; http://www.window.state.tx.us/taxinco/franchise/whichforms.html.
[8] The author is not aware of any Texas cases that have described any of these issues
[9] This argument is arguably supported by Wilbur v. Vill. Lane Ltd. v. Cinemark Corp., 2002 Tex. App. LEXIS 3716 (Tex. App. — Houston [14th Dist.] 2002, no pet.) (not designated for publication) (affirming judgment that tenant was not responsible for management fees because same is not expressly permitted by the lease).
