Recently, a Texas appeals court addressed whether a telecommunications provider that offered Internet access, landline telephone services, and online video streams, and also sold landline phones, was entitled to a refund of Texas franchise tax. The refund was based on the taxpayer filing an amended report deducting as costs of goods sold (COGS) electricity used to generate and transmit its telecom products. The Comptroller (and later a trial court) denied the refund on the basis that the taxpayer was not entitled to deduct as COGS electricity used to provide its telecom products, which the Comptroller argued were services. In general, under Texas law, only entities that own and sell real or tangible personal property can elect to deduct COGS. However, the Comptroller did concede that costs of electricity used to power landline phones and provide a dial tone could be deducted as COGS. However, deducting these amounts did not result in a refund for the taxpayer.
On appeal, the taxpayer argued that its telecom products were “goods, “ not “services,” and as such it was entitled to deduct the cost of electricity used to generate and transmit the telecom products. The appeals court disagreed, first holding that telecom products are not goods, but are properly classified as services. Although the term “services” is not defined under the franchise tax statutes, the court looked to common definitions of “services” and concluded that supplying Internet access, telephone connectivity, and video streams to private consumers through a network of cables and wires was the provision of services as that term is commonly used. The court next addressed the taxpayer’s more specific argument that even if its telecom products were not “goods,” its video product met a narrower definition of the statute that specifically defined tangible personal property to include things such as films, sounds recordings, and other similar property regardless of method of distribution. In making this assertion, the taxpayer cited to the AMC case in which the court had previously held that a movie theater chain was entitled to deduct as COGS certain costs associated with showing its films. The appeals court held that although a section of the definition of tangible personal property encompassed films, in AMC there was still a question as to whether the movie theater (similar to the taxpayer at issue) was selling films when it showed a movie. That question was resolved in the taxpayer’s favor in AMC because the law had been amended to clarify that movie theaters could take the COGS deduction. In contrast, there was no specific law allowing the COGS deduction that applied to the taxpayer. As such, the court, after stating that it was not authorized to address the taxpayer’s Equal Protection and Due Process Clause arguments, ruled in favor of the Comptroller. Please contact Doug Maziur at 713-319- 3866 with questions on NTS Communications, Inc. v. Hegar.