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Texas: State Supreme Court Issues Opinions in Three Costs of Goods Sold Cases

Listen to a brief overview of state tax developments this week, including Texas, or read full Texas development below.

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Detailed Texas Development

On April 3, 2020, the Texas Supreme Court issued opinions in three cases addressing certain aspects of the costs of goods sold (COGS) deduction under the Texas franchise tax.  The first, Hegar v. American Multi-Cinema, Inc., addressed whether a movie theater could subtract film exhibition costs as costs of goods sold for the 2008 and 2009 tax years at issue. Under Texas law, a cost may be included in COGS when: (1) the cost relates to “goods,” (real or tangible personal property) that are “sold” in the ordinary course of the taxable entity’s business and (2) the taxable entity “owns” the goods it is selling. In its original decision, the appeals court held that because a movie is “perceptible to the senses” the taxpayer was selling tangible personal property when it sold tickets to movies.  The decision arguably would have provided opportunities for other taxpayers not selling traditional tangible personal property to deduct COGS.  In a subsequently-revised opinion, the appeals court limited its review of the evidence presented at trial to determine whether AMC’s product fell within the definition of tangible personal property under Tex. Tax Code § 171.1012(a)(3)(A)(ii), which was amended in 2013 to address films and other similar property.  The court concluded that this provision was intended to clarify existing law and that the taxpayer was entitled to the COGS deduction. On appeal, the Texas Supreme Court held that AMC could not rely on the 2013 amendment, which was prospective only, to subtract the exhibition costs in the earlier years. Furthermore, the statute requires a taxable entity to “sell” the tangible personal property to qualify for the COGS subtraction. In the Court’s view, a “sale” requires a “transfer” and the taxpayer was not transferring tangible personal property when it exhibited films. Because no tangible personal property was transferred through AMC’s film exhibitions, the Court concluded the exhibitions were not goods as contemplated under the statute.

The second case, which addressed both a COGS question and whether the taxpayer qualified for a flow-through exclusion from total revenues, was Hegar v. Gulf Copper and Manufacturing Corp.  The taxpayer at issue was primarily engaged in the business of surveying, manufacturing, upgrading, and repairing offshore drilling rigs.   To compute franchise tax liability, a taxpayer must first determine its total revenue, which is generally defined with reference to certain line items on the taxpayer’s federal income tax return. In computing total revenue, certain types of flow-through payments that are mandated by contract to be distributed to other entities are subtracted, including subcontracting payments handled by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of the boundaries of real property. The taxpayer filed its franchise tax return for the year at issue deducting from total revenue those payments made to subcontractors for labor on the oil rigs. Following an audit, the Texas Comptroller determined that the taxpayer could not exclude the subcontractor payments from total revenue, but that certain of the labor costs could be deducted as COGS. The appeals court ruled in the taxpayer’s favor on the subcontracting exclusion, but remanded the case back to the trial court on the COGS issue.

The Comptroller subsequently appealed to the Texas Supreme Court, arguing that the taxpayer did not qualify for the subcontracting exclusion because the payments were not “in connection with” the construction of improvements on real property. Specifically, the labor was for work done on oil rigs, which were not considered real property, but that were subsequently used to drill oil wells, which were real property.  The Comptroller also argued that the taxpayer’s contracts did not specifically mandate that the payments be distributed to the subcontractors.  The High Court ruled in the taxpayer’s favor on the flow-through question. In the Court’s view, the rig survey, repair, and upgrade work provided by the taxpayer’s subcontractors was “in connection with” the drilling of oil wells, despite being performed on oil rigs. Further, the taxpayer’s contracts with subcontractors mandated that they be paid for their work, so the payments were mandated by contract and qualified for the flow-through fund exclusion.

The Court next addressed the COGS issue. Under Texas law, “a taxable entity furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance . . . of real property is considered to be an owner of that labor or materials and may include the costs, as allowed by this section, in the computation of cost of goods sold.” The issue was whether the taxpayer’s activities, which occurred on oil rigs in shipyards and dry-docks far from the drilling sites, fell  within the scope of “furnishing labor or materials to” a project for the construction of real property (an oil well).  The Court ruled that the requisite labor or materials had to be furnished to or incorporated into the real property itself. To the extent that the taxpayer furnished labor or materials, it furnished labor and materials to the oil rigs it surveyed, repaired, and upgraded, and those rigs—although subsequently used on well sites to drill wells—were not and did not become part of the wells or well sites themselves. Finally, the Court addressed the taxpayer’s method of computing COGS, which started with the federal calculation under IRC section 263A and adjusted for amounts expressly disallowed under Texas law. In the Court’s view, this methodology was “flawed” and the taxpayer was required to use a cost-by-cost method. In response to the taxpayer’s argument that this method would be burdensome on its business, the court noted the taxpayer could always simply pay based on 70 percent of total margin. “If a taxable entity wishes to avail itself of a COGS subtraction, it must be willing to meet the concomitant requirements.”

Finally, in Sunstate Equipment Co. v. Hegar, the Court affirmed an appeals court holding that a taxpayer in the business of renting and leasing construction equipment could not deduct the costs associated with delivery and pick-up of its equipment as COGS. Although the Texas Legislature authorized heavy equipment rental or leasing companies to subtract COGS, the COGS subtraction was limited to the costs allowed to all other taxpayers under the statute. The costs the taxpayer proposed to deduct were not for the acquisition or production of the equipment it rented to customers and did not fall within the allowed direct, related, or administrative overhead costs. Furthermore, the Court concluded that the taxpayer was not furnishing labor or materials to a project for the construction of real property and so did not qualify for a COGS deduction under that section either. Please contact Doug Maziur at 713-319-3866 or Jeff Benson at 214-840-6911 with questions on these Texas Supreme Court decisions. 

This Week's Developments

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Sarah McGahan

Sarah McGahan

Director, State & Local Tax, KPMG US