December 11, 2008
Steven D. Moore
Michael K. Kuhn
April B. Vasquez
Jackson Walker L.L.P.
ON THE MARGIN:
The Impact of the
Margin Tax on
Landlords and Tenants
History Lesson
1. Old franchise tax was income tax, but could not
apply to Partnerships due to Bullock Amendment
2. School Finance Litigation
3. Replace 1/3 of school tax M&O rate with
margin tax
The Bullock Amendment
Article VIII, Sec. 24(a) provides:
“A general law enacted by the Legislature that
imposes a tax on the net incomes of natural persons,
including a person’s share of partnership and
unincorporated association income, must provide that
the portion of the law imposing the tax not take effect
until approved by a majority of the registered voters
voting in a statewide referendum held on the question
of imposing the tax.”
HB 3 2006 Special Session
SECTION 21. ”The franchise tax imposed
by Chapter 171, Tax Code, as amended
by this Act, is not an income tax . . .”
A Massive Change
• More Taxpayers: Expanded the franchise tax to
partnerships and other entities
• Bigger Tax Base: Expanded the tax base under
an entirely new approach
• Lower Tax Rate: Tax rate reduced to 1.0 or
0.5% (from 4.5% rate on earned surplus)
• Bigger Overall Tax: Magnitude of franchise tax
at least doubled
• Combined reports
Revenue Estimates
• January 2007: margin tax projected to generate
$5.9 billion in 2008, or $3.0 billion more than old
franchise tax
• April 2007, Comptroller warns revenue could fall
$500 to $900 million short
• August 2008 Comptroller’s office testifies that
margin tax may be $1.5 billion short by end of
first year
Rough Numbers
$5.9 Billion
Fiscal Note
$4.7 Billion
Actual $ As Of December 4, 2008
Implications for 2009 Session
• “Business didn’t pay its fair share as
promised. We must raise this tax.”
• “Tax is burdensome, we must provide
margin tax relief”
Major 2009 Legislative Issues
Small Business (Will Ask For $1M exclusion)
1099 Payments = W2 Wages (Opens Pandora’s Box)
Trucking/Transportation Industry
Cost of Goods “Sold” or “Leased”
Property Tax Relief Of $7 Billion ?
• HB1 passed in 2006 reduced school
maintenance and operations taxes by onethird over the next two years; for most
school districts this reduced rates to $1.00
• By vote of school board, districts rate
could be set as high as $1.04
• With approval of local voters, rate could be
set as high as $1.17
What Happened?
Of the state’s 1,026 school districts:
• 1,006 imposed additional local option
M&O taxes, and of those
– 121 are above $1.04
– 98 are at $1.17
Business Property Values
14%
12%
13.3%
Economic Growth
Appraised Value
10%
8.0%
8%
6.7%
6%
5.1%
4%
2%
0%
1994-2005
2005-2007
Property Taxes: 2005 & 2007
Taxing Entity
School M&O
School Debt
City
County
Special District
Total
2005
$17.8
$2.4
$4.9
$4.8
$3.6
$33.5
2007 Change
$15.5 ($2.3)
$3.3
$0.9
$6.1
$1.2
$5.8
$1.1
$4.5
$0.8
$35.2 +$1.7
Reimbursements from Tenants
COMPTROLLER FAQ
10. If you reduce your property taxes and insurance expense for IRS
reporting purposes for the amount of reimbursements received from
tenants, can you also exclude these reimbursements from total revenue
for Texas margin tax purposes?
CFR §1.61-8(c) states, "As a general rule, if a lessee pays any of the expenses
of his lessor such payments are additional rental income of the lessor…" Total
revenue for franchise tax reporting is specifically defined in Texas Tax Code
§171.1011 and is tied to the amounts entered on specific lines from the federal
return, to the extent the amount entered complies with federal income tax law,
minus statutory exclusions. Based on the above IRS regulation, the
reimbursement of expenses should be reported for federal tax purposes in
gross rental income and not offset with the expenses. Therefore, for franchise
tax reporting purposes the expense reimbursements are included in total
revenue. (Updated 4/10/08)
Application of Margin Tax to
Commercial Real Estate Leasing:
• Margin tax is a “hybrid”
• Landlords want to
operating expenses
include
tax
in
• Tenants want to exclude it
• Both see aspects of the tax that support
their respective views
Landlord’s Perspective:
• Substitute for property tax
• Enacted in conjunction with
reduction in school property taxes
• Like a tax on rents
Tenant’s Perspective:
• Akin to an income tax, not an operating
expense
• Still the “franchise tax”, excluded from
operating expenses
• Tax relief more than offset by actual
dollar increase due to increased
valuations
Business Realities:
• Pass-through is ultimately business
issue, not legal issue
• Result mostly depends on negotiating
strength of the respective parties
Property Tax Reduction:
• Actual amount of property tax
reduction is a calculable amount
• Possible to determine how much of
the margin tax is actually attributable
to property tax reduction
• Inclusion of balance of tax is often an
open issue
In a new lease, Landlord says:
Operating Expenses shall include all “Tax
Expenses”, meaning all taxes on the rent
or other revenue from the Property,
including any business, gross margins, or
similar tax payable by Landlord (including
without limitation the Texas margin tax
imposed pursuant to the provisions of
Chapter 171 of the Texas Tax Code, as the
same may be amended or supplemented)
which is attributable to rent or other
revenue derived from the Property, . . .
any tax or charge allocable to or measured
by the area of the Premises or the Rent
payable
hereunder,
and
any
tax
substituted, in whole or in part, for a tax
previously in existence, or assessed in
lieu of a tax increase. Tax Expenses shall
not include Landlord’s estate, excise,
income or franchise taxes (except to the
extent provided above).
Tenant says:
Notwithstanding anything contained in
this Lease to the contrary, Operating
Expenses shall not include the Texas
margin tax imposed pursuant to the
provisions of Chapter 171 of the Texas Tax
Code, as the same may be amended or
supplemented (the “Margin Tax”).
Share the Burden:
First, the “to the extent” approach – that is, including the
tax “to the extent” it represents an actual reduction in
school property taxes :
Tax Expenses for each calendar year after 2007 shall include
a portion of the Margin Tax payable by Landlord with respect
to such calendar year up to, but not to exceed, an amount (but
not less than zero) (the "Tax Reduction") equal to (a) the
amount that such school district maintenance and operations
Tax Expenses would have been if calculated based upon the
applicable school district maintenance and operations tax
rate(s) for 2006, minus (b) the actual amount of school district
maintenance and operations Tax Expenses that are assessed
for such calendar year after 2007.
Illustration:
Assume:
School tax rates:
2006:
2008:
1.33%
1.00%
Taxable Value
Margin tax payable
$100,000
$500
$100,000 value at 1.33%
$1,330 school tax
$100,000 value at 1.00%
$1,000 school tax
$ 330
Calculation:
Minus:
Result:
$330 margin tax included in Tax Expenses
Second, inclusion of a stipulated sum (based on current
tax rates) as the tenant’s contribution toward the margin
tax:
Tax Expenses for each calendar year during the Term shall
include Tenant’s share of the Margin Tax, which shall be
calculated strictly for purposes of this Lease as 1% of 70%
of Tenant’s annual Base Rent plus Additional Rent paid to
Landlord. However, Landlord and Tenant hereby stipulate
and agree that, notwithstanding anything in this Lease to
the contrary, in no event shall a modification or
amendment to the Margin Tax obligate Tenant to pay any
amount with respect to the Margin Tax in addition to or
greater than the amount that is due pursuant to the
immediately preceding sentence.
Third, inclusion of a fixed percentage (commonly, 50%) of
the margin tax:
Notwithstanding anything to the contrary in the Lease,
there shall be included in Tax Expenses fifty percent
(50%) of those taxes paid by Landlord under Chapter
171 of the Texas Tax Code, as the same may be
amended or supplemented, attributable to the “total
revenue” (as defined in Section 171.1011(2)(a) of
Chapter 171 of the Texas Tax Code) received by
Landlord from Tenant pursuant to this Lease.
Fourth, the tenant may want to exclude any portion of the
margin tax attributable to the landlord’s sale of the
property:
Provided further, no portion of the Margin Tax
attributable to revenues derived from the sale or other
conveyance of the Property (or any portion thereof or
interest therein) shall be included in Tax Expenses for
purposes of this Lease.
A Word About Base Year Leases:
• Base Year operating expenses would
include the Margin Tax (or alternatively,
Margin Tax is excluded altogether)
• Landlord with Base Year lease factors the
Margin Tax into the Base Rent (the same
as other expenses of operation and
ownership)
Expansions:
Will the expansion of the premises result in the
margin tax applying as a pass-through item for
the entire premises? Or only the expansion
space? Or not at all?
• Landlord’s perspective – For an existing lease
that does not clearly allow for the pass-through of
the margin tax, the landlord may use the
occasion of an expansion of the premises as an
opportunity to amend the lease to allow the passthrough of the margin tax on the entire space.
• Tenant’s perspective – The lease provisions
regarding taxes should remain unchanged for the
current premises (and arguably for the expansion
space as well) until the expiration of the current
term. At worst, the new margin tax language
should only apply to the expansion space.
• The outcome may depend on the language of the
existing lease.
 A compromise: The margin tax pass-through will
only apply to the expansion space.
Defer
resolution of dispute to a subsequent date while
agreeing to inclusion of the margin tax with
respect to the expansion space.
Landlord and Tenant agree that, notwithstanding anything
to the contrary contained in the Lease or this Amendment,
Operating Expenses include taxes paid by Landlord during
the term of the Lease pursuant to the provisions of Chapter
171 of the Texas Tax Code, as the same may be amended
or supplemented (the “Margin Tax”) for the Expansion
Space and any future space leased by Tenant. The
immediately preceding sentence, and its inclusion in this
Amendment, shall have no effect on the language of the
Lease concerning whether Operating Expenses includes
the Margin Tax with respect to the current Premises, both
Landlord and Tenant reserving all rights, legal arguments
and claims that each may have with respect thereto.
Renewals:
• Landlord may seek to clarify include new margin
tax provisions
• Tenant may argue in response that renewal
should be on same terms and conditions as the
lease
Landlord’s response: “market rental rate” should
include the margin tax pass-through
Closing Observations:
• The economic impact of the margin tax varies
depending on the gross rental revenues of the property
in question:
• Landlords of Class A office buildings within the
Houston CBD: 25¢ to 30¢ per sq.ft. per year based
on 2008 rental rates
• Class A suburban landlords: 20¢ to 25¢ per sq.ft. per
year
• Class B and C suburban landlords: 15¢ to 20¢ per
sq.ft. per year
Thus, the financial value of negotiating the margin tax
issue is very much dependent upon the property’s
rental revenue.
• It may not make sense to dwell on this issue for small
tenants as the cost of the tax per square foot may not
justify the legal fees and costs involved in negotiating
a compromise margin tax lease provision
THANK YOU!
Steven D. Moore
Michael K. Kuhn
Jackson Walker L.L.P.
Jackson Walker L.L.P.
100 Congress Avenue, Suite 1100
Austin, TX 78701
512-236-2074 (Direct Dial)
512-391-2132 (Direct Facsimile)
smoore@jw.com
1401 McKinney Street, Suite 1900
Houston, Texas 77010
713-752-4309 (Direct Dial)
713-308-4136 (Direct Facsimile)
mkuhn@jw.com
April B. Vasquez
Jackson Walker L.L.P.
1401 McKinney Street, Suite 1900
Houston, Texas 77010
713-752-4254 (Direct Dial)
713-308-4190 (Direct Facsimile)
avasquez@jw.com