The Texas Supreme Court recently released opinions in three Texas franchise tax/margin tax cases. All three opinions address the applicability of the Texas franchise tax’s cost of goods sold subtraction to costs incurred by taxpayers in specific industries. Below, we discuss the industry-specific rulings in each case, and then consider what the cases, taken as a whole, mean for Texas taxpayers. (Please note that Seay & Traphagan, PLLC does not represent any of the taxpayers in these cases.)
The individual cases
Sunstate Equipment Co. v. Hegar – The Texas Supreme Court found that a company that rented out heavy construction and industrial equipment could not include certain delivery and pick-up costs in its cost of goods sold for Texas franchise tax purposes. According to the Texas Supreme Court, the taxpayer could not include these costs because they are not direct costs of acquiring or producing the heavy construction and industrial equipment in question and they are not among the other types of costs listed in the cost of goods sold statute. In doing so, the Texas Supreme Court rejected the taxpayers argument that the industry-specific statute that allows heavy equipment rental businesses to include costs related to the equipment they rent in cost of goods sold also allowed them to deduct all costs related to their business, even those not listed in the statute that businesses that sold instead of rented similar goods would not be able to include.
Hegar v. American Multi-Cinema, Inc.– The Texas Supreme Court found that a movie theater company could not include the costs of exhibiting films in its cost of goods sold for Texas franchise tax purposes. The Texas Supreme Court said that the exhibition of films did not meet the Texas franchise tax’s cost of goods sold statute’s definition of “goods” because the exhibition of films was not tangible personal property that could be sold. To be sold, the Court wrote, an item or title to it must be transferred to another in exchange for something of value. The Court concluded that the taxpayer did not transfer an item or title to an item when it exhibited films to its customers. The Court also held that an industry-specific statute treating certain mass-distributed media did not apply to the movie theater company’s exhibition of films because that statute still required the transfer of some property with physical or demonstrable presence — not just the creative content alone.
Hegar v. Gulf Copper & Manufacturing Corp. – The Texas Supreme Court found that a company that repaired offshore drilling rigs could not include most of its costs in its cost of goods sold for Texas franchise tax purposes, but it could exclude payments to subcontractors from its total revenue under an available revenue exclusion. The Texas Supreme Court’s opinion illustrates the contrast between two Texas franchise tax provisions applicable to the real property construction industry. One, a revenue exclusion, allows taxpayers to exclude from total revenue certain “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 other, regarding cost of goods sold, states that a taxpayer “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 in this section, in the computation of cost of goods sold.”
The Texas Supreme Court did not allow the taxpayer to include most of its costs in cost of goods sold as it found that the taxpayer’s repairs of offshore drilling rigs did not constitute the furnishing of labor or materials to a real property construction project, even though the repairs were related to oil well projects. However, the Court found that the labor was closely-related enough to those projects to be “in connection with” them, and allowed the taxpayer to exclude associated subcontractor payments from revenue. In doing so, the Texas Supreme Court found the language of the revenue exclusion to be more permissive and expansive than the similar cost of goods sold provision
Conclusions
As a whole, the cases show that the Texas Supreme Court has taken a fairly strict reading of the costs enumerated in the Texas franchise tax’s cost of goods sold statute. The Court seems fairly unwilling to allow more specific industry-focused provisions to expand the allowable costs based on the business models specific to a particular industry. This seems to reflect the trend in the Texas Supreme Court’s jurisprudence as a whole to focus fairly strictly on statutory text in lieu of other outside factors.
Though the Texas Supreme Court generally found against taxpayers in these three cases, it did not take the Texas Comptroller’s invitation to apply the higher standard of proof applicable to tax exemptions to either cost of goods sold or to revenue exclusions under the Texas franchise tax. The Court pointedly avoided the use of the word “deduction” in its discussion, instead referring to items such as cost of goods sold as “subtractions.” The Court recognized that because the Texas franchise tax is imposed on taxable margin, not total revenue, that any amounts subtracted to calculate taxable margin do not constitute otherwise-taxable amounts that are exempted from taxation, but are instead amounts that were never taxable in the first place.
In the wake of these decisions, taxpayers who find themselves uncertain of their Texas franchise tax obligations may wish to seek the advice of a Texas tax professional, such as a Texas tax attorney, in order to clarify their obligations.
