16 April 2020 Texas Supreme Court issues three opinions analyzing the cost-of-goods-sold deduction under franchise tax In three franchise tax decisions issued April 3, 2020, the Supreme Court of Texas (Court) primarily analyzed the cost-of-goods-sold (COGS) deduction, ruling largely in favor of the Texas Comptroller of Public Accounts (Comptroller); the Court, however, did find in favor of one taxpayer with regard to certain flow-through funds that could be excluded from total revenue. In Sunstate Equipment Co. v. Hegar,1 the Court held that a heavy construction rental company could not deduct equipment delivery and pick up costs as part of its COGS deduction, affirming the judgment of the Texas Court of Appeals. Sunstate Equipment Co. (Sunstate) was in the business of renting heavy construction and industrial equipment to customers throughout Texas. In filing its Texas franchise tax report, Sunstate sought to include as COGS the costs related to dropping off and picking up the equipment, asserting that such costs were deductible under Texas Tax Code Sections 171.1012(k-1) and 171.1012(i). The Court held that Sunstate, as a heavy equipment leasing company, could claim a COGS deduction under Texas Tax Code Section 171.1012(k-1) but could only include the costs that were otherwise allowable under the general COGS statute in Texas. The Court found the taxpayer's delivery and retrieval of equipment was akin to outbound distribution and rehandling (both of which are expressly excluded from COGS by the Texas statute). As such, the costs did not qualify as includable COGS expenses. The Court also held that Sunstate could not subtract the equipment delivery and pick up costs under the real property construction provisions in Texas Tax Code Section 171.1012(i) because the labor was not furnished to a project for the construction or improvement of real property. In Hegar v. Gulf Copper & Manufacturing Corporation,2 the Court held that Gulf Copper & Manufacturing Corporation (Gulf Copper) could exclude payments made to subcontractors from its total revenue for Texas franchise tax purposes, but the Court was more restrictive than the trial or appellate court in allowing a COGS deduction. Gulf Copper surveys, repairs and upgrades offshore oil and gas rigs for rig owners and drilling contractors that in turn use the rigs to drill offshore wells for exploration and production companies. In providing these services, Gulf Copper utilized various subcontractors. Gulf Copper sought to exclude these payments to subcontractors from total revenue for Texas franchise tax purposes under Texas Tax Code Section 171.1011(g)(3). Gulf Copper also sought to deduct repair-related costs as a part of its COGS deduction under Texas Tax Code Section 171.1012(i). The Court concluded that Gulf Copper could exclude its subcontractor payments from total revenue as flow-through funds under Texas Tax Code Section 171.1011(g)(3), as its payments to a subcontractor were mandated by contract, and the underlying payments were made in connection to real property construction or repair services. The Court determined, however, that certain costs related to Gulf Copper's repair work were not eligible for a COGS deduction under Texas Tax Code Section 171.1012(i), as those costs did not qualify as construction or repair of real property as defined in Texas Tax Code Section 171.1012(i). The Court expressly stated that a taxpayer could not build its COGS deduction from what was reported on its federal return. For Texas COGS purposes, costs need to independently meet the requirements of Texas Tax Code Section 171.1012. In Hegar v. American Multi-Cinema, Inc.,3 the Court reversed the decision of the appeal court, which had affirmed the trial court's opinion; instead, it held that film exhibitions are not tangible personal property that is sold, so the taxpayer could not include exhibition-related costs in COGS for Texas franchise tax purposes for 2008 and 2009. Effective September 1, 2013, Texas Tax Code Section 171.1012 was revised to add new subsection (t), which expressly allows movie theaters to subtract exhibition costs as COGS in future years. American Multi-Cinema, Inc. (AMC) sought to include costs incurred in exhibiting films, including film acquisition costs and costs associated with theater auditoriums in COGS for 2008 and 2009. To qualify as COGS in Texas, the cost must relate to tangible personal property that is sold in the ordinary course of the taxable entity's business or for which an industry-specific provision has been adopted. The Court determined that film exhibitions do not qualify as tangible personal property under Texas Tax Code Section 171.1012(A)(3A), as film exhibitions are not personal property subject to ownership. Further, film exhibition is not a sale, which requires some transfer of property or title in exchange for value. The Court also concluded that AMC's business activity did not constitute film production or distribution for which COGS is expressly permitted under Texas Tax Code Section 171.1012(o) and dismissed any argument that the change in statute allowing a movie theater to take such costs under Texas Tax Code Section 171.1012(t) was a clarification of law and should be applied. These Court decisions could have broad implications for taxpayers doing business in Texas. Texas COGS has always been a challenging area for taxpayers and the Comptroller alike. As the Court noted in Gulf Copper, Texas COGS must be determined by independently applying the requirements of Texas Tax Code Section 171.1012; these opinions highlight the numerous industry-specific provisions that can apply. Based on the decisions in these cases, taxpayers that are electing to take the COGS deduction should review their expenses to see whether such costs qualify for deduction as COGS under the Texas franchise tax law and to identify additional COGS that are not being deducted. Further, there may be an opportunity for certain taxpayers to qualify for a revenue exclusion for payments to their subcontractors based on the Court's analysis of flow-through funds qualifying for the revenue exclusion.
Document ID: 2020-1006 | |||||||||
