Major Texas Franchise Tax Policy Change: Comptroller Gives Up on the “Physical Change” Rule for Subcontractor Exclusion and COGS Deduction

The Texas Comptroller recently published a very significant policy letter to the Comptroller’s online database. The letter announces a significant change in Texas franchise tax policy that could affect entities even only somewhat involved with the design, construction, remodeling, repair, or industrial maintenance of real property. The Comptroller’s previous policy was that only entities that physically changed real property could qualify for certain beneficial provisions that could significantly reduce an entity’s Texas franchise tax. The Comptroller has now dropped its physical-change requirement. Now, an entity’s activity must only have “a reasonable nexus” with  real-property design, construction, remodeling, repair, or industrial maintenance to qualify.

More specifically, these are the beneficial provisions that the Comptroller now admits apply to a larger number of taxpayers:

Provision #1: Revenue exclusion for flow-through payments to certain subcontractors

Section 171.1011(g)(3) allows taxpayers to exclude from their franchise tax revenue certain “flow-through funds that are mandated by contract to be distributed to other entities.” This includes “subcontracting payments handled by the taxable entity to provide services, labor, or materials in connect with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of boundaries of real property.” Previous to the recent Texas franchise tax policy change, the Comptroller required an entity to meet three conditions before it qualified for the revenue exclusion:

1. The entity must have a contract with its customer that states that subcontractors will be used, and that payment to the subcontractors will be made by the entity from the funds  paid by the customer;
2. The entity pays the subcontractor only after receiving the “flow-through” funds from its customer; and
3. The entity is physically engaged in design, construction, remodeling, or repair of real property.

The recent policy change drops the third condition. Now the Comptroller concedes that an entity need not be physically engaged in a design, construction, or repair activity. Now, an entity’s subcontracted activity  must merely “have a reasonable nexus” with a design, construction, remodeling, or repair activity. For example, before the change in Texas franchise tax policy, the Comptroller would not allow entities that paid subcontractor drivers to deliver materials to construction sites to exclude the subcontractor payments. Now, the Comptroller concedes that these type of entities do qualify for the revenue exclusion, if they meet the other two requirements.

Note that the Comptroller still argues that the taxpayer’s contract with the customer (not the subcontractor) must mandate the payment to the subcontractor. The Comptroller may also still require a taxpayer to receive funds from the customer before paying the subcontractor. The Texas Third Court of Appeals rejected both of these additional requirements in the Titan Transportation case. However, in May, the Comptroller asked the Texas Supreme Court to review the Titan Decision, and the Texas Supreme Court has not yet decided whether to hear the case. Also note that in 2013, the Legislature clarified section 171.1011(g), and made it clear that either the contract with the customer or the subcontractor could mandate the flow-through. Therefore, for report years 2014 and later, even the Comptroller should agree that the first condition no longer applies.

Provision #2: Cost-of-Goods-Sold deduction for real-property construction, maintenance, and repair

Generally, an entity may only deduct cost of goods sold if it produces or resells a “good,” and owns the good before selling it. The Tax Code defines a “good” to include real property. However, without a special provision, real-estate construction, repair, and maintenance companies could not deduct labor costs as cost of goods sold. This is because they usually do not own the real property they work on.

However, the Tax Code provides a beneficial exception for these companies. Section 171.1012(i) states that “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 costs of goods sold.” Therefore, entities engaged in construction, improvement, remodeling, repair, or industrial maintenance of real property may deduct cost of goods sold even though they do not own the real property under construction.

Before the Texas franchise tax policy change, the Comptroller only allowed entities that “physically touched the property” or “made a change to the property” to qualify for the special provision. For example, the Comptroller did not allow companies engaged in hauling away construction debris to deduct their labor as cost of goods sold. Likewise, the comptroller did not allow transportation companies delivering materials to a construction site to deduct labor as cost of goods sold.

The Comptroller now states that it “will no longer require an entity to actually physically touch the property or make a change to the property to qualify for the COGS deduction.” Presumably, the entity’s activity must only “have a reasonable nexus” with the construction, repair, or maintenance activity to qualify.  In the Newpark Decision, the Third Court of Appeals stated that the labor and materials at issue needed to be “an essential and direct” part of the construction, repair, or maintenance project to qualify. The Comptroller did not appeal the Newpark Decision.

Who might this Texas franchise tax policy change affect?

The Comptroller infers that this Texas franchise tax policy change could affect the following industries, and acknowledges that these entities may be due refund claims:

• Transportation companies delivering aggregate and other materials to construction sites;
• Waste removal companies;
• Demolition companies;
• Inspectors;
• Architects;
• Engineering Firms.

Other types of entities may also qualify:

• Insurance claim adjusters;
• Custodial companies;
• Oilfield service companies;
• Software and IT companies that consult with real-property contractors;
• Other professionals that provide services to real-property contractors;
• and others.

If you believe your company may qualify for a refund claim, then you should quickly contact your CPA or a Texas tax lawyer. This is because refund claims must be filed within the four-year statute of limitations.