Recently, in American Multi-Cinema, Inc.,¹ a Texas Court of Appeals (Court) withdrew its April 30, 2015, opinion and substituted a new one, upholding a trial court's ruling that a movie theater company, American Multi-Cinema, Inc. (AMC), may include its costs of exhibiting films and other content in its cost of goods sold (COGS) subtraction for purposes of calculating its Texas Franchise "Margin" Tax (Margin Tax) based on a different definition of tangible personal property than the originally issued opinion. The Court also reversed the trial court's determination regarding which facility-related costs associated with the square footage of AMC's movie theater should be included in the COGS subtraction, ultimately holding that AMC established that its costs associated with the square footage of its auditoriums are direct costs of producing its product and, therefore, properly includable in its COGS subtraction.

Background

AMC is in the business of exhibiting films and other content to customers. For the tax years at issue (2008-09), AMC used the COGS subtraction method to determine its total revenue subject to the Margin Tax, and included the exhibition costs as COGS. Following an audit, the Comptroller of Public Accounts (Comptroller) disallowed the inclusion of the exhibition costs as COGS and assessed AMC with additional Margin Tax. AMC challenged the assessment arguing that the exhibition costs were properly included in the COGS subtraction.

A trial court held that AMC properly included the exhibition costs as COGS, but limited the costs included in the COGS subtraction to those associated with the square footage of the theater occupied by the speakers and the screens. AMC and the Comptroller cross-appealed.

First issue: exhibition costs can be included in COGS calculation

On appeal, the Comptroller argued that that the trial court erred in allowing AMC to include exhibition costs in its COGS subtraction under Tex. Code Ann. Sec. 171.1012, arguing that "exhibiting films does not constitute a 'good' because AMC does not sell 'tangible personal property' but intangible property, or a film-watching service, or non-property." Texas law defines "tangible personal property" as "personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the sense in any other manner" (Tex. Code Ann. Sec. 171.1012(a)(3)(A)(i)), or as

"films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and other similar property embodying words, ideas, concepts, images, or sound, without regard to the means or methods of distribution or the medium in which the property is embodied, for which, as costs are incurred in producing the property, it is intended or is reasonably likely that any medium in which the property is embodied will be mass-distributed by the creator or any one or more third parties in a form that is not substantially altered." Tex. Code Ann. Sec. 171.1012(a)(3)(A)(ii).

The Court found that AMC may include its exhibition costs in its COGS calculation if either definition of tangible personal property applies. The Court, however, limited its review of the evidence to AMC's theory that it could include its exhibition costs in its COGS calculation under Tex. Code Ann. Sec. 171.1012(a)(3)(A)(ii)'s more narrow definition of tangible personal property specifically targeted at films and similar media.

The Comptroller argued that customers' purchases of tickets were not sales of film, but rather were sales of a license, noting that customers left the theater with "experiences and memories but without a copy of the film." The Court was not persuaded by this argument, stating that the definition of tangible personal property "[does] not have a take-home requirement." The Court further ruled that the Comptroller's proposed interpretation of the statute is at odds with a subsequent statutory amendment in 2013, which states that, when a movie theater elects to subtract COGS, the COGS are the costs related to the acquisition, production, exhibition, or use of a film or motion picture, including expenses for the right to use the film or motion picture. In addition, the Comptroller conceded that AMC may include its exhibition costs based on this amendment going forward.

Second issue: which costs qualify as COGS

AMC challenged the trial court's ruling that only AMC's costs associated with the square footage housing the speakers and screens in its auditoriums qualified as COGS under the statute,² arguing instead that the costs of the entire auditorium were direct costs of producing the films it sells to customers. The Court agreed with AMC, holding that the entire square footage of AMC's auditoriums should be included in the COGS calculation. In so holding, the Court found the definition of production in Tex. Tax Code Ann. Sec. 171.1012(a)(2) is not ambiguous and, therefore, the trial court erred by deferring to the Comptroller's interpretation of the statute to limit the costs AMC could include in its COGS subtraction to only those costs associated with the square footage housing the speakers and screens in the auditoriums.

The Court explained that the term "production" is broadly defined to include "construction, installation, manufacture, development, mining, extraction, improvement, creation, raising, or growth." Because the terms "creation" and "improvement" are not defined by statute, the Court applied their common meaning and held that "create" means to "bring into existence" and "improve" means "to make greater in amount or degree" and "to enhance in value or quality." Applying these definitions, the Court found that AMC presented evidence showing that its entire auditorium space is directly used in production because it is creating a unique audio and visual experience in the auditorium.

Implications

As a result of the Court's decision, items that have historically been considered "services" have grounds to be considered "goods" under the Court's interpretation of the term "tangible personal property." By doing so, related production costs could be deductible for purposes of the COGS subtraction. This could ultimately result in expanded COGS subtractions across the board, as well as added benefits for traditional service providers that previously considered themselves ineligible to claim the COGS deduction method of computing their Margin Tax.

Though the decision appears taxpayer-friendly in the context of the Margin Tax, the benefit likely has no relevance whatsoever in the sales tax arena since it was decided purely upon definitional issues isolated to the Margin Tax law. Service companies applying this interpretation of tangible personal property under the Margin Tax might try to apply consistency in applying under the sales tax law, creating the responsibility to collect and remit on the sale of these "goods." Taxpayers are reminded that definitions under the Margin Tax law may not apply in the context of the sales and use tax.

This decision could have a significant and potentially negative fiscal effects on the Texas state budget. Taxpayers should analyze their Texas COGS eligibility and calculations for 2016 reports, as well as for open periods up to four years back. The Comptroller is reviewing the latest decision and considering next steps, such as an appeal to the Texas Supreme Court. It is not anticipated that the Comptroller's office will change its tax policy and/or audit approach until this case is finally settled through the appellate process.

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ENDNOTES

¹ American Multi-Cinema Inc. v. Hegar, No. 03-14-00397-CV (Tex. Ct. App., 3rd Dist., April 30, 2015).

² Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A)(ii).