On April 3, 2020, the Texas Supreme Court published its opinions on 3 tax cases in connection with a taxpayer’s eligibility to subtract COGS as well as which costs are eligible to be subtracted as COGS for purposes of the Texas Franchise Tax. In Sunstate Equipment Co. v. Hegar, the Court denied Sunstate’s subtraction for costs related to the delivery and pick-up of the equipment rented to their customers. In Hegar v. Gulf Copper & Manufacturing Corp., the Court allowed for Gulf Copper to exclude from total revenue certain payments made to subcontractors. The Court also denied Gulf Copper’s subtractions for labor and materials related to their rig survey, repair, and upgrade jobs holding that these costs did not qualify for subtraction since they were not in connection with a project for the improvement of real property as required by the operative provisions of the Texas Tax Code. Finally, in Hegar v. American Multi-Cinema, Inc., the Court denied American Multi-Cinema’s subtractions for film exhibition costs as COGS.
Sunstate Equipment Co. v. Hegar
Sunstate rents heavy construction and industrial equipment to customers in a number of states. This equipment includes forklifts, bulldozers and other similar machinery. Sunstate employees would deliver, set up, and pick up the equipment to and from their customers’ construction sites using a fleet of Sunstate vehicles capable of hauling the machinery. Sunstate incurred costs of acquiring and using the equipment and subsequently subtracted costs on their 2009 and 2010 Texas franchise reports including labor costs for employees driving the delivery vehicles, as well as depreciation, property taxes, maintenance, insurance, and fuel used by the delivery vehicles.
Sunstate was audited and paid the tax assessed by the Comptroller and filed suit seeking adjustments to include labor, fuel, depreciation, maintenance, and property tax costs in its COGS subtraction. The 53rd Texas District Court ruled in favor of Sunstate and ordered a full refund of the tax, penalties, and interest paid. Upon appeal, the Court of Appeals ruled in favor of the Comptroller and disallowed the pick up and delivery costs as part of Sunstate’s COGS subtraction.
Texas Supreme Court Opinion
Sunstate took the position that they qualified to subtract COGS under Texas Tax Code 171.1012(k-1) and therefore allowed to subtract as COGS all direct costs associated with acquiring or producing goods as allowed in subsections (c) and (d) of TTC 171.1012. Subsection (k-1) allows for heavy construction equipment rentals companies to utilize the COGS subtraction and can calculate COGS similar to other companies that sell, rather than rent, similar equipment.
The Court upheld the Court of Appeals decision and ruled that only Sunstate’s initial costs of acquisition were allowed to be subtracted and that Sunstate could not continually subtract the acquisition costs each time a pick up and delivery was made to another customer. Additionally, the Court ruled that the pick up and delivery costs were specifically disallowed under TTC 171.1012(e) as rehandling and distribution costs.
The Court further rejected Sunstate’s argument that they could subtract these costs because of Sunstate’s connection with real property improvement projects, as allowed for under TTC 171.1012(i). Subsection (i) allows a taxable entity that is “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.”
Sunstate argued that its employees delivered heavy equipment to construction jobs where other contractors would use it to improve real property. The Court did not dispute that the construction equipment was ultimately used on real property but did rule that Sunstate was a step removed from the actual real property improvement project and therefore subsection (i) did not extend to Sunstate. The Court stated that Sunstate instead “furnishes labor to fulfill its own obligations under its rental agreements.”
Hegar v. Gulf Copper & Manufacturing Corp.
Gulf Copper is primarily engaged in the business of surveying, manufacturing, upgrading, and repairing drilling rigs. Gulf Copper utilized subcontractors to perform some of these services and on their 2009 Texas franchise tax report claimed an exclusion from revenue based on Texas Tax Code 171.1011(g)(3). Subsection (g)(3) allows for an exclusion from total revenue for payments made to subcontractors mandated by contract that “provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property.” Gulf Copper also claimed subtractions for COGS based on TTC 171.1012(i).
Under audit, the Comptroller found that some of the payments made to subcontractors were not eligible for the subsection (g)(3) exclusion and that certain costs subtracted for COGS could not be included in Gulf Copper’s COGS subtraction. Gulf Copper paid the assessment under protest and filed suit. The 201st District Court decided in favor of the Comptroller on both the exclusion from revenue and the COGS subtraction. The Court of Appeals went on to side with the Comptroller on the exclusion, but the Court of Appeals reversed the District Court’s ruling on the costs allowable for COGS. Both the Comptroller and Gulf Copper filed petitions to the Texas Supreme Court to make judgment on the exclusion and the allowable costs.
Texas Supreme Court Opinion – Subcontractor Exclusion
The subsection (g)(3) exclusion requires that payments made to subcontractors be in connection with the proposed or actual improvement on real property. The Comptroller argued that the subcontractor exclusion from total revenue did not apply based on the fact that Gulf Copper was a step removed from the “improvement on real property” since Gulf Copper was performing the survey, repair, and upgrade services on oil rigs that were not currently active at the well site.
The Texas Supreme Court found that Gulf Copper’s services, labor, and materials were “in connection with” the actual or proposed improvements on real property and that the exclusion from total revenue for payments made to subcontractors was properly applied. The Court also ruled that the “mandated by contract” piece of the statute was met by Gulf Copper and their subcontractors. The Court stated that the payments made to subcontractors that are “mandated by contract” meant that a contractual relationship and the contract does not need to make specific mention to the funds being passed through to the subcontractor. Gulf Copper’s contractual relationship with the subcontractor was enough to satisfy the “mandated by contract” portion of the statute.
Texas Supreme Court Opinion – Cost of Goods Sold Deduction
As part of their overall business, Gulf Copper manufactured steel plates that it installed on oil rigs that needed repairs or upgrades and deducted the costs and labor associated with the manufacturing and installation of these steel plates. Generally, a taxpayer may only utilize a COGS subtraction if the taxpayer is selling goods that they own. However, TTC 171.1012(i) allows service providers to be considered the “owner of labor and materials” if they furnish labor and materials “to a project for the construction, improvement, remodeling, repair, or industrial maintenance . . . of real property.” While this statute is similar in nature to that of the statute governing the subcontractor exclusion, there are key differences in each statute with different applications. While the Supreme Court ruled that the subcontractor exclusion was allowed based on the language of that statute, qualifying for the subcontractor exclusion does not automatically allow service companies to subtract COGS. The revenue exclusion is intended to apply to pass-through (or conduit) types of revenue and costs to avoid the pyramiding of the franchise tax upon multiple levels of taxpayers.
The main difference between the two statutes is the “in connection with” improvements on real property language provided by the subcontractor exclusion statute. TTC 171.1012(i) does not include the “in connection with” improvements on real property language, which narrowed its application for purposes of the cost allowable to be subtracted for COGS. Again, both parties were at odds whether the repair of oil rigs that were temporarily out of service while being worked on at Gulf Copper’s shipyard constituted furnishing labor and materials to the improvement on real property.
The Court ultimately found that because Gulf Copper’s labor and materials “were not directed toward real property, but toward preparing equipment for later use on real property.” The Court cited its similar decision in Sunstate which held that the labor and materials at issue were “furnished to its own project of fulfilling its contracts to repair and upgrade equipment and not to a project for the construction or improvement of real property.”
Additionally, the Supreme Court made specific mention of the method in which Gulf Copper calculated its COGS subtraction. Gulf Copper calculated its subtraction starting with COGS as reported for federal tax purposes and subtracted out costs that were specifically excluded under TTC 171.1012(e). The Court rejected this method of calculating the COGS subtraction and made it clear that the COGS subtraction needed to be a cost-by-cost analysis and each cost would be need to be substantiated by the taxpayer if they elect to utilize the COGS subtraction. While the Comptroller has unofficially taken this position in many prior cases, the Supreme Court makes it clear that the burden of proof is on the taxpayer to show each cost that is being subtracted is allowed for under the governing statutes. This approach could prove limiting to many taxpayers that are currently deducting COGS based on a methodology not supported by the Court or with cost accounting systems that are not capable of applying costs to certain jobs in great detail.
Hegar v. American Multi-Cinema, Inc.
AMC is movie theatre chain operating nationwide including many locations in Texas. AMC sold tickets to customers to watch movies that AMC rented from film distributors. The movies are displayed using audio and video equipment installed in the theatre’s auditoriums. On AMC’s 2008 and 2009 Texas franchise tax reports, AMC sought to subtract certain costs related to the exhibition of these movies including the auditorium space and the component parts within the auditorium.
Texas Tax Code 171.1012(a)(1) allows taxpayers to deduct costs relating to the sale of “goods.” Goods are defined as real or tangible personal property sold in the ordinary course of business. Furthermore, Texas Tax Code 171.1012(a)(3)(A) defines tangible personal property as “personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses.” Texas Tax Code 171.1012(a)(3)(A)(ii) also defines tangible personal property to include films and other similar property that is meant for mass-distribution. The definition of tangible personal property specifically excludes intangible property and services.
Under audit, the Comptroller disallowed these exhibition costs for the years at issue. Later, the Court of Appeals found that AMC’s product qualified as tangible personal property since the movie is “perceptible to the senses” and AMC was eligible to deduct the exhibition costs as COGS. This decision and interpretation opened the doors to many taxpayers that previously may not have been eligible to deduct COGS. This decision by the Court of Appeals brought much concern and alarm to the Comptroller and could have cost the State Treasury billions of tax revenue due to refunds claims and additional taxpayers claiming COGS that weren’t believed to be previously eligible.
Court of Appeals revised its opinion and limited the review to only determine if AMC qualified for COGS specifically under the film prong included in the definition of TPP. This opinion backtracked from the previous ruling that AMC qualified for COGS under the “perceptible to the senses” prong of the TPP definition, essentially closing the door on many other taxpayers seeking to deduct COGS such as concerts, aquariums, zoos, and sports teams that were seeking to claim COGS under the “perceptible to the senses” definition.
Interestingly enough, in 2013 Texas revised TTC 171.1012 to include subsection (t), which specifically allows for movie theatres to subtract COGS, including exhibition costs. Texas revised the statute stating that the additional subsection was a clarification of prior law and AMC was subject to the COGS deduction.
Texas Supreme Court Decision
AMC appealed to the Texas Supreme Court seeking review of the costs eligible to be subtracted as COGS on the 2008 and 2009 reports. The Court ruled in the Comptroller’s favor, disallowing the exhibition costs subtracted on the 2008 and 2009 reports. The Court’s opinion was centered on TTC 171.1012 and determined that AMC was not a seller of “goods” as defined. In order for goods to be sold, the Court ruled that a “transfer” must exist and AMC was not transferring tangible personal property when it exhibited the films.
The Court ruled that although the 2013 amendment to the statute was meant to clarify existing law, the amendment can only be applied prospectively and cannot impact the governing statutes in place at the time of the originally filed 2008 and 2009 reports. Therefore, for the years at issue, the Court ruled that AMC was not eligible to deduct exhibition costs based on the statutes in place for the periods that were being examined. The 2013 amendment was also a “stop the bleeding” provision, limiting the COGS deduction to film exhibition costs and excluded other theater costs (rent, lighting, sound, interminable coming previews, etc.) from the COGS deduction.
Impact to Our Clients
There are a few major takeaways from the Sunstate and Gulf Copper decisions. The first being taxpayers that do not sell TPP in the ordinary course of business (ex: service providers, especially those in the oil and gas industries) and are taking COGS subtractions for Texas franchise tax based on TTC 171.1012(i) and TTC 171.1012(k-1) should revisit their eligibility for the COGS subtraction and also examine which costs qualify for COGS subtraction, at least prospectively. Secondly, all taxpayers need to be aware of the Supreme Court’s explicit warnings about how COGS should be calculated. It may be common practice for many taxpayers and tax practitioners to begin with Federal COGS and subtract costs that are excluded based on Texas law, but all taxpayers and professionals need to understand the impact their calculations may have on current or future audits. The COGS subtraction needs to be built from the bottom up and on a cost-by-cost basis. Other methods of calculating COGS for Texas franchise tax may be the subject of Comptroller scrutiny and could risk their COGS subtraction being disallowed under audit. Finally, taxpayers that have previously included in total revenue any payments mandated by contract to subcontractors may have the opportunity to amend returns and claim refunds for report years in which this exclusion from revenue may apply, in addition to claiming such exclusions prospectively.
While the Supreme Court’s decision in AMC to disallow exhibition costs on the 2008 and 2009 reports was in favor of the Comptroller, the 2013 amended statute allows for movie theatres to subtract COGS and specially allows for exhibition costs as a part of the COGS subtraction going forward. This can be viewed as a small win for the Comptroller, but the current law allows for movie theatres to deduct the exhibition costs, so there is no major impact to movie theatres going forward. This case had many ups and downs on its path to the Texas Supreme Court. Once thought to be potentially the costliest COGS case since the inception of the Texas franchise tax, the Supreme Court’s decision coupled with the 2013 statute revision generally closed the door on many other taxpayers that sell services or intangible property and not “goods.”
If you have any questions regarding the Supreme Court’s decisions and their impact on Texas franchise tax, please contact us.