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 onLandlords 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 withmargin tax

The Bullock AmendmentArticle 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.”

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  . . .”

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

• 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

• 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

$4.7 Billion Actual $ As Of December 4, 2008

$5.9 Billion Fiscal Note

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”

• “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)

Trucking/Transportation Industry

Cost of Goods “Sold” or “Leased”

1099 Payments = W2 Wages (Opens Pandora’s Box)

Property Tax Relief Of $7 Billion ?

• HB1 passed in 2006 reduced school maintenance and operations taxes by one-third 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

• HB1 passed in 2006 reduced school maintenance and operations taxes by one-third 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

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

0%

2%

4%

6%

8%

10%

12%

14%

1994-2005 2005-2007

Economic Growth

Appraised Value

6.7%

5.1%

8.0%

13.3%

Property Taxes: 2005 & 2007Taxing Entity 2005 2007 Change

School M&O $17.8 $15.5 ($2.3)School Debt $2.4 $3.3 $0.9 City $4.9 $6.1 $1.2 County $4.8 $5.8 $1.1 Special District $3.6 $4.5 $0.8

Total $33.5 $35.2 +$1.7

Taxing Entity 2005 2007 Change

School M&O $17.8 $15.5 ($2.3)School Debt $2.4 $3.3 $0.9 City $4.9 $6.1 $1.2 County $4.8 $5.8 $1.1 Special District $3.6 $4.5 $0.8

Total $33.5 $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)

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)

• Margin tax is a “hybrid”

• Landlords want to include tax in operating expenses

• Tenants want to exclude it

• Both see aspects of the tax that support their respective views

Application of Margin Tax to Commercial Real Estate Leasing:

• Substitute for property tax

• Enacted in conjunction with reduction in school property taxes

• Like a tax on rents

Landlord’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

Tenant’s Perspective:

• Pass-through is ultimately business issue, not legal issue

• Result mostly depends on negotiating strength of the respective parties

Business Realities:

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

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, . . .

In a new lease, Landlord says:

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).

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”).

Tenant says:

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.

Share the Burden:

Assume: School tax rates:2006: 1.33%2008: 1.00%

Taxable Value $100,000Margin tax payable $500

Calculation:$100,000 value at 1.33% $1,330 school

tax Minus:

$100,000 value at 1.00% $1,000 school tax

$ 330

Result: $330 margin tax included in Tax Expenses

Illustration:

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)

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 pass-through of the margin tax on the entire space.

Expansions:

• 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. MooreJackson 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

Steven D. MooreJackson 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

Michael K. KuhnJackson Walker L.L.P.1401 McKinney Street, Suite 1900Houston, Texas 77010713-752-4309 (Direct Dial)713-308-4136 (Direct Facsimile)mkuhn@jw.com

Michael K. KuhnJackson Walker L.L.P.1401 McKinney Street, Suite 1900Houston, Texas 77010713-752-4309 (Direct Dial)713-308-4136 (Direct Facsimile)mkuhn@jw.com

April B. Vasquez Jackson Walker L.L.P.1401 McKinney Street, Suite 1900Houston, Texas 77010713-752-4254 (Direct Dial)713-308-4190 (Direct Facsimile)avasquez@jw.com

April B. Vasquez Jackson Walker L.L.P.1401 McKinney Street, Suite 1900Houston, Texas 77010713-752-4254 (Direct Dial)713-308-4190 (Direct Facsimile)avasquez@jw.com