22 March 2017 Texas Court of Appeals rules car dealership's auto repair labor costs are not includible in cost of goods sold calculation for Texas franchise tax purposes In Autohaus,1 the Texas Court of Appeals (Court) reversed the trial court's ruling in favor of a Texas car dealership and instead held that it cannot include auto repair labor costs incurred as part of repair work to install automotive parts on customer-owned vehicles in its cost of goods sold (COGS) calculation. In reaching this conclusion, the Court determined that, based on plain statutory language, repair labor costs are costs of services rather than tangible personal property, and that the relevant statutory language in Tex. Tax Code section 171.1012 is not subject to multiple understandings, so it is not ambiguous. The Texas statute that addresses the determination of COGS to calculate Texas franchise tax — Tex. Tax Code Section 171.1012 — defines "goods" as "real or tangible personal property sold in the ordinary course of business of a taxable entity," and excludes services from "tangible personal property."2 COGS includes all direct costs of acquiring or producing the goods,3 and "production" includes, among other things, construction, installation and manufacture.4 The "direct costs of acquiring or producing the goods" include labor costs, cost of materials that are an integral part of specific property produced and cost of materials that are consumed in the ordinary course of performing production activities, among other costs.5 In addition, 34 Tex. Admin. Code Section 3.588(b)(7) (Rule 3.588(b)(7)) defines "production" as construction, manufacture, installation occurring during the manufacturing or construction process, development, mining, extraction, improvement, creation, raising, or growth.6 If a transaction contains elements of both a sale of tangible personal property and a service (a mixed transaction), a taxable entity may only subtract as COGS the costs otherwise allowed in relation to the tangible personal property sold.7 The term "installation" while listed as a production activity is not defined by statute or rule and has been subject to interpretation. The taxpayer, Autohaus, is an automotive dealership, and on its 2009 Texas franchise tax return calculated its taxable margin by subtracting its COGS from its total revenues. As part of its COGS, Autohaus included labor cost incurred as part of repair work (repair labor costs) to install automotive parts on customer-owned vehicles. Following an audit, the Comptroller of Public Accounts (Comptroller) disallowed the repair labor costs, which resulted in an additional assessment of franchise tax. Autohaus challenged the assessment and on appeal a trial court ruled in its favor, holding that Rule 3.588(b)(7), as it applied to the term "production," is unconstitutional and invalid and that Autohaus is entitled to include all of its repair labor costs in its COGS determination. The Comptroller appealed, arguing that the repair labor costs were not the "production" of automotive parts installed on customer vehicles and that its rule is valid and constitutional. Further, as a threshold matter, both parties disagreed on the issue of whether the relevant parts of Tex. Tax Code Section 171.1012 are ambiguous. The Comptroller argued that the statute is ambiguous in regard to mixed transactions and as to the use of the term "installation" in the context of the term "production" so Rule 3.588(b)(7) should be given deference. In contrast, Autohaus asserted that the statute is not ambiguous and that the plain meaning of "installation" supported its position that its repair labor costs at issue are properly subtracted as COGS and that Rule 3.588(b)(7) goes beyond the statute by adding an additional limitation and, therefore, is invalid. The Court agreed with Autohaus that the statutory language is not ambiguous as it is not subject to multiple interpretations, but rejected its argument that the statute supports inclusion of repair labor costs in its COGS. The Court reasoned that, in the context of the statutory scheme, "installation" is listed with "production" activities, such as "construction" and "manufacture." These listed activities address the direct costs of "producing the goods" (making or completing goods) as compared with the cost of "acquiring" goods for resale. A taxable entity must own the "good" to include its costs under COGS, and there are specific references to "production," "produced," and "acquiring or producing" in the enumerated categories of direct costs. Ultimately, the Court determined that Autohaus' repair labor costs were not properly included as COGS because Autohaus did not, in any way, modify, make, or complete the automotive part to "produce" it based on the plain language of the statute. Reading the statutory provisions together clarifies that the repair labor costs were not costs of "producing" the already completed automotive parts but were costs of "services," which are expressly excluded from the COGS. In so holding, the Court noted that it applied the only reasonable interpretation of "installation" in the context of the statutory scheme in concluding that Autohaus is not entitled to include its repair labor costs as COGS. Because the Court found the trial court erred in allowing Autohaus to include its repair labor costs as COGS, it did not need to determine whether the trial court erred in finding Rule 3.588(b)(7) invalid. Lastly, the Court vacated the trial court's ruling granting Autohaus relief under the Uniform Declaratory Judgment Act (UDJA), finding the trial court did not have jurisdiction to consider this claim. This ruling is one of several recent decisions further clarifying what is and is not includable in the COGS calculation for purposes of Texas franchise tax. This opinion offers guidance on what can be considered a non-deductible service and a deductible good.
1 Hegar v. Autohaus LP, LLP, No. 03-15-00427-CV (Tex. App. Ct., 3d Dist., Feb. 24, 2017). Document ID: 2017-0514 | |||||
