The last several months have seen an abundance of developments in the treatment of the COGS deduction for purposes of the Revised Texas Franchise Tax (RTFT). These developments will have prospective, and in some cases, retroactive effect. In an effort to effectively report on these items, we are taking the "shotgun" approach – short, compact summaries of the issues within the COGS calculation that have captured the attention of taxpayers and the Texas Comptroller.
The COGS deduction is one of three deductions from total revenue that may be available for election by taxpayers. The COGS deduction is allowed to taxpayers that acquire or produce "goods," defined as "real or tangible personal property sold in the ordinary course of business of a taxable entity."1 The Texas Tax Code generally adopts the federal UNICAP principles of Internal Revenue Code (IRC) Sec. 263A, but with substantial modifications.2 The modifications have become the general source of significant and ongoing controversies between taxpayers and the Comptroller.
Deductions Allowed
Expansion of COGS to some service providers
The Texas Court of Appeals for the Third Appellate District recently upheld a trial court's determination that a movie theater was entitled to take a COGS deduction in computing its margin for the RTFT.3 The ruling potentially expands the application of the COGS deduction to certain service providers that were not previously thought to be eligible to claim the COGS deduction. In addition, for taxpayers eligible to claim the COGS deduction absent the ruling, the ruling potentially expands the items that may be included in that deduction.
Research and development costs to non-producers of goods
The Comptroller's Tax Policy Division recently issued a letter ruling on the subject of whether a taxpayer could include in COGS expenses for research, experimental, engineering and design activities related to products that it did not produce because it contracted out of the manufacturing of the product, including manufacturing contracted out to foreign affiliates excluded from a combined group report filing.4
For federal income tax purposes, taxpayers who produce, as well as acquire but do not produce, goods for sale may claim all research and experimental costs described by IRC Sec. 174. The term "research or experimental expenditures" means expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense.5 A Treasury Regulation also provides that the term includes all costs incident to the development or improvement of a product.
Historically, with respect to an entity not considered a producer, the Comptroller limited the COGS deduction to costs related to the acquisition, storage, handling and other costs specified in Tex. Tax Code Ann. Sec. 171.1012(d). Certain costs directly related to the production of goods that were typically allowed a producer, such as research, experimental, engineering and design activity costs, were not allowed as COGS for an entity that used an unrelated third party to produce its goods.6 In this recent ruling, the Comptroller reversed course and will allow a taxpayer eligible for COGS to claim as COGS all research and experimental costs described in IRC Sec. 174. The policy is effective both prospectively, and for all open periods under the statute of limitations.7
This development reflects the continuing evolution of the Comptroller's thinking with respect to significant COGS issues, and the ability of the Comptroller to make these policy changes public in the form of policy letter rulings that it issues on its own accord. Prior such changes in position include the making of the COGS election on an amended franchise tax report8 and the inclusion of certain costs of printers in the COGS deduction.9
Combined group is single taxpayer for purposes of COGS
The Texas Court of Appeals affirmed a trial court's decision that a combined group of companies engaged in an oilfield service business could include a subsidiary's costs in the group's COGS deduction, including labor and third party expenses relating to waste removal and disposal (third parties transported and disposed of the waste).10 Additionally, the appellate court made a clear and concise determination that, for (at least) COGS purposes, a combined group is considered to be a single taxpayer and each member of a combined group's business is considered in the context of the combined group's business as a whole, rather than treating each member as if it were a separate taxpayer.
Importantly, the decision reconciles the conflicting unitary provisions: (a) combined unitary group treated as a single taxpayer;11 and (b) COGS determined for each group member as if the entity were an individual taxable entity.12 The case also favorably interprets costs that qualify for full inclusion in the COGS deduction.
Deductions Limited
Processing and distribution of ready-mixed cement and related dispatcher wages
A Texas administrative law judge (ALJ) ruled to disallow a portion of a taxpayer's COGS deduction related to the processing and distribution of ready mixed cement, and ruled a portion of dispatcher wages as indirect/overhead costs, the inclusion of which in the COGS deduction is limited to 4 percent of the total.13 The taxpayer, a manufacturer and seller of concrete products that were delivered by the taxpayer's fleet of ready-mix concrete trucks, claimed 100 percent of mixer truck costs, 100 percent of its operator/driver salaries and 100 percent of its dispatcher salaries as COGS. The Comptroller's auditor originally allowed only 30 percent of the equipment and repair costs associated with the ready-mix cement trucks, 15 percent of the operator/driver salaries, and none of the labor costs associated with their dispatchers. The Comptroller's staff ultimately increased the 15 percent amount for the operator/driver salaries to 59 percent after touring the taxpayer's facilities. The Comptroller's staff also agreed to a deduction for dispatcher labor costs as indirect service costs capped at 4 percent of the administrative overhead total. The taxpayer appealed the auditor's decision to the State Office of Administrative Hearings.
The key issue at the ALJ hearing was the segregation between the direct production costs and indirect costs. The taxpayer did not identify the cost of processing (outside of the manufacturing process) and distribution costs, which are disallowed as direct COGS deductions. As a result, the auditor was authorized to use an estimate based on the information available in accordance with Tex. Tax Code Ann. Sec. 111.0042(d).
The ALJ upheld the auditor estimates of amounts to be included in the COGS deduction which, in the hearing, included dispatcher salaries as 4 percent indirect/overhead costs (in lieu of a total exclusion). Equipment and repair costs were allowed as direct costs because the drum of the truck was qualified for COGS, but the entire truck itself did not qualify as a direct COGS. The trucker driver load time, the unload time and wash time were ruled to be direct costs of production. Regarding the dispatch costs, the ALJ deferred to Treas. Reg. Sec. 1.263A-3(c)(4) in distinguishing the costs allowed in and disallowed from the Texas COGS deduction. The ALJ ruled that the taxpayer's dispatch costs included both allowable and excludable components and acquiesced to the Comptroller's concession to allow inclusion of the costs at 4 percent of the total.
Based on the analysis in this determination, and our experience on COGS issues, taxpayers are advised to have a supported position for any COGS inclusion, in whole or in part, and particularly in the case of cost divided among the classification (direct costs, which may be claimed at 100 percent, administrative/overhead costs, which may be claimed at 4 percent, and excluded costs). Such classifications should consider the Treasury regulations issued pursuant to IRC Sec. 263A (i.e., Treas. Reg. Sec. 1.263A-1 et seq.). In the absence of such support, the Comptroller likely has the power to estimate such amounts, and such estimate may be endorsed in administrative hearings.
Deductions Disallowed
Benefits paid to retirees
An ALJ rejected a taxpayer's argument that the costs of medical and pension benefits paid to retired workers were direct labor costs and should be included as allowable COGS deductions.14 The taxpayer, a steel producer, originally claimed COGS deductions for benefit costs relating to its active and retired production workers. Under audit, the Comptroller allowed the COGS deductions with respect to benefits for the active employees. As for the benefits for the retired employees, the Comptroller disallowed the COGS deduction taken, on the basis that such amounts did not qualify as direct labor costs for the COGS deduction.
The ALJ referenced 34 Tex. Admin. Code Sec. 3.588(d) regarding COGS deductions and Treasury Regulation Sec. 1.263A-1(e) requiring that contributions to employee plans representing past services must be capitalized in the same manner and in the same proportion to property currently being acquired or produced as amounts contributed for current service. The ALJ acknowledged that the current version of Sec. 3.588(d) had been revised effective June 5, 2013 to expand the category of labor costs includable as a direct COGS deduction.15
The ALJ concluded that the steel producer had failed to show by clear and convincing evidence that the full amount at issue was includible as a direct COGS deduction includable at 100 percent. The Texas COGS definition differs from the corresponding federal income tax capitalization definition. Certain indirect or administrative overhead costs, including "service costs,"16 are subject to a 4 percent limitation for inclusion in the COGS deduction.17 The same costs are subject to allocation for federal income tax capitalization purposes (i.e., allocated between current deductions and costs subject to capitalization). Because the taxpayer did not prove the portion of the costs subject to full inclusion in the COGS deduction, none of the costs were allowed as 100 percent COGS deductions. The ALJ did not explain what documentation or evidence the taxpayer failed to provide or was required to provide. The Comptroller's defense may indicate that the Comptroller opposes the idea that the costs of medical and pension benefits for retirees are fully deductible as COGS deductions. In administrative hearings, the Comptroller has often successfully used this form of "burden of proof" argument as a defense.
It is notable that the ALJ simply affirmed the auditor's decision and did not remand the issue to the auditor to determine the proper allocation of costs between direct and indirect COGS categories. The ALJ had agreed with the taxpayer that such benefit costs facially qualify for the COGS deduction. Only the proportion of the costs fully deductible, if any, was at issue.
Settlement costs of asbestos-related personal injury lawsuits
An ALJ likewise rejected a claim by a taxpayer that settlement costs stemming from a lawsuit should be included in the COGS deduction.18 The taxpayer, a producer of fiberglass insulation materials which contained asbestos, was subject to many wrongful death and personal injury claims. The taxpayer established a "qualified settlement fund" in the form of a product liability trust to address all current and pending litigation arising from the personal injury suits. The taxpayer filed a refund claim on its 2008 franchise tax report claiming that legal expenses qualified as direct COGS under the rationale that such expenses were costs of quality control related to goods produced.19 The Comptroller denied the refund claim, and the taxpayer requested an administrative hearing.
At the hearing, the ALJ examined the statutory provision relied on by the taxpayer, which specifically includes "costs of quality control, including replacement of defective components pursuant to standard warranty policies, inspection directly allocable to the production of the goods, and repairs and maintenance of the goods."20 The taxpayer argued that the subject legal costs were in the nature of quality control costs related to goods that it produced and sold, and were therefore deductible as direct COGS since litigation costs were not specifically excluded from the statute. The Comptroller prevailed in his denial arguing that neither the statute nor the rule specifically addressed costs associated with legal expenses or litigation settlements, and the absence of such language precluded a deduction.
If appealed, the taxpayer may question the ALJ's application of the Texas Government Code in interpreting legislative intent. The taxpayer may also argue that the settlement fund costs are employee benefit costs includible in the COGS deduction pursuant to Texas Tax Code Ann. Sec. 171.1012(c)(1) and 34 Tex. Admin. Code Sec. 3.588(d)(1). If appealed, the taxpayer would do well to prepare for the Comptroller's defense successfully used in the above hearing relating to the COGS treatment of benefits paid to retirees.
Deductions Disallowed, with Other Implications
"Rent-to-own" tire business transactions and 0.5 percent tax rate
An ALJ upheld the Comptroller's assessment against a taxpayer that specialized in the business of "rent to own" tires.21 The taxpayer claimed a COGS deduction on its originally filed return on the basis that the transactions at issue were in substance, sales to customers, and that the "rental purchase agreements" resembled financing agreements rather than leases. The Comptroller disagreed and determined that the substance of the transactions between the taxpayer and its customers weighed in favor of finding them to be leases.
In support of its conclusion, the Comptroller noted that 86 percent of the taxpayer's income was accounted for as "rental income," the terms of the agreement stated that the taxpayer retained title to the property during the lease term and title only transferred to the customer at the conclusion of the lease period, the taxpayer charged sales tax on all rental payments, and the customer was free to terminate the agreement by failing to make a payment or returning the property to the taxpayer. The ALJ agreed with the Comptroller's analysis and found that the taxpayer was primarily in the business of providing rental services rather than the sale of tangible personal property. Therefore, the taxpayer was not allowed to take a COGS deduction for the transactions consummated under the "rental purchase agreements" because the rental business was not specifically allowed to take the COGS deduction.22
In addition to the COGS deduction issue, the ALJ considered whether a company in the business of rental activities should use the 1.0 percent or 0.5 percent tax rate. The taxpayer argued that it qualified as a "retailer" subject to the 0.5 percent tax rate due to the enactment of H.B. 500, which amended the definition of "retail trade" to include "rental-purchase agreement activities" regulated by Chapter 92 of the Business and Commerce Code.23 H.B. 500 was signed into law in June 2013 and became effective for report years beginning in 2014.24 The ALJ held that the passage of H.B. 500 indicated that in adding this language to the definition of "retail trade," the legislature intended for these activities not to be considered "retail activities" prior to its passage. In other words, the expansion of the definition of retail trade was not a clarification of the existing definition of "retail activities" but rather an expansion of the term that affected future periods. Thus, even though the ALJ denied the taxpayer's right to use the 0.5 percent tax rate since the period at issue under audit was prior to the 2014 report year, the hearing strongly supports the use of the 0.5 percent tax rate for taxpayers engaging in these types of transactions for report years beginning in 2014 and thereafter.
Interestingly, a recent subsequent development could impact the precedential effect of this decision. The Texas Third Court of Appeals decided on June 11, 2015 that a taxpayer in the rent-to-own business dealing in tangible personal property was entitled to the 0.5 percent tax rate.25 The Court remanded to the trial court the taxpayer's entitlement to the COGS deduction determination. Taxpayers with total revenues generated predominantly from rental-purchase agreement activities regulated by Chapter 92 of the Business and Commerce Code are entitled to the 0.5 percent tax rate as a result of 2013 legislation.26
Treatment of concessionaire payments
In a letter ruling request, the Comptroller examined the flow-through fund and COGS treatment of concessionaire payments. The taxpayer, a provider of food services throughout the country, entered into concession agreements with facility owners for the right to sell food during events. Under the concession agreements, the taxpayer was required to make payments to the facility owners based on a percentage of receipts from the sales of all food made during events. The taxpayer wished to exclude the payments to facility owners from total revenue as flow-through funds pursuant to Tex. Tax Code Ann. Sec. 171.1011(g). Alternatively, the taxpayer wished to treat the payments to facility owners as licensing or franchise costs deductible as COGS pursuant to Tex. Tax Code Ann. Sec. 171.1012(d)(10).
The Comptroller determined that the payments made by the taxpayer to the facility owners did not qualify for exclusion from total revenue as flow-through funds mandated by contract to be distributed to other entities.27 The concession agreement only mandated the taxpayer to pay the facility owner. There was no flow-through payment made to any other entities. In addition, only three specific types of flow-through fund arrangements under Tex. Tax Code Ann. Sec. 171.1011(g) can be excluded and the funds at issue are not one of the types allowed.
With regard to the COGS deduction, the taxpayer stated that the concessionaire agreement granted the exclusive right to sell food and was identical to the licensing and franchise costs incurred by a film or television producer under Tex. Tax Code Ann. Sec. 171.1012(d)(10). However, Tex. Tax Code Ann. Sec. 171.1012(e)(2) specifically excludes from COGS "selling costs, including employee expenses related to sales." Tex. Tax Code Ann. Sec. 171.1012 only allows costs related to acquisition and production of goods, and the rights the taxpayer received were to sell food and were not related to the acquisition or production of food. Thus, the payments were determined to be selling costs excluded from the COGS deduction pursuant to Tex. Tax Code Ann. Sec. 171.1012(e)(2).
This ruling brings together several different provisions of the Texas franchise tax code in the analysis of a single type of transaction. The ruling reflects only a portion of the complexity related to the determination of total revenue and the COGS deduction. For example, the COGS deduction for "licensing or franchise costs, including fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right directly associated with the goods produced"28 reads generously in isolation. But that generosity is tempered by the exclusion from the COGS deduction of "selling costs, including employee expenses related to sales."29
Commentary
When the Comptroller initially adopted rules effective January 1, 2008 interpreting the franchise tax law, commentators observed that the rules added little guidance beyond the existing law, and that some of the additional guidance exceeded the Comptroller's authority. Since that time, a body of authorities has developed that provides taxpayers with some clarifying rules, policies, administrative hearing decisions and court decisions.
The succession of Comptroller Hegar and his administration to that of former Comptroller Combs may result in additional policy changes, some of which may be reflected above. Nevertheless, given the inherent difficulties of interpreting the franchise tax law, controversies are expected to continue unabated regarding COGS matters.
The decisions related to COGS determinations issued by the State Office of Administrative Hearings and the courts of Texas have increased as such controversies have matured. Further decisions and developments may be expected to be at a brisk pace. Practitioners are well-advised to keep abreast of developments to identify and capitalize upon opportunities and to avoid traps for the unwary.
Other Contributors (Houston office)
Cynthia Brake
Stephen Webster
Simon Wu
K.J. Lee
Cecily Anderson
Niki Tello
Curtis Springfield
Earl Flowers
Footnotes
1 TEX. TAX CODE ANN. § 171.1012(a)(1).
2 TEX. TAX CODE ANN. § 171.1012.
3 American Multi-Cinema, Inc. v. Hegar, Texas Court of Appeals, Third District, Austin, No. 03-14-00397-CV, April 30, 2015. For a detailed discussion of this case, see GT SALT Alert: Texas Appellate Court Addresses Potential Application of COGS Deduction to Service Providers and Sellers of Intangible Property.
4 Letter No. 201504069L, Texas Comptroller of Public Accounts, April 24, 2015.
5 TEX. TAX CODE ANN. § 171.1012(c)(9); Treas. Reg. § 1.174-2.
6 Tax Policy News, Franchise Tax, Oct. 2009 (presumably superseded).
7 It should be noted that on a related note for taxpayers involved in significant research and development activities, on April 5, 2015, the Comptroller adopted 34 Tex. Admin. Code § 3.599, Margin: Research and Development Activities Credit, providing additional guidance with respect to that credit.
8 Letter No. 201206444L, Texas Comptroller of Public Accounts, June 12, 2012.
9 Letter No. 201406921L, Texas Comptroller of Public Accounts, June 18, 2014.
10 Combs v. Newpark Resources, Inc., 422 S.W.3d 46 (Tex. Ct. App. 2013). For further discussion of this case, see GT SALT Alert: Texas Court of Appeals Holds Oilfield Service Provider's Waste Disposal Costs Included in COGS for Revised Tax Franchise Tax Purposes.
11 TEX. TAX CODE ANN. § 171.1014(b).
12 TEX. TAX CODE ANN. § 171.1014(e)(1).
13 Hearing No. 108,959, State Office of Administrative Hearings, Sep. 26, 2014.
14 Hearing No. 110,597, State Office of Administrative Hearings, Nov. 3, 2014.
15 For further information, see GT SALT Alert: Texas Comptroller Amends Revised Texas Franchise Tax Cost of Goods Sold Rule.
16 34 TEX. ADMIN. CODE § 3.588(b)(9).
17 34 TEX. ADMIN. CODE § 3.588(f).
18 Hearing No. 110,183, State Office of Administrative Hearings, March 17, 2015.
19 TEX. TAX CODE ANN. § 171.1012(d)(9).
20 Id.
21 Hearing No. 108,751, State Office of Administrative Hearings, Oct. 6, 2014.
22 TEX. TAX CODE ANN. § 171.1012(k-1).
23 TEX. TAX CODE ANN. § 171.0001(12)(D).
24 For further information, see GT SALT Alert: Texas Enacts Franchise Tax Reform Legislation Temporarily Lowering Tax Rates, Excluding Items from Tax Base and Enacting Research Credit.
25 Rent-A-Center, v. Hegar, Texas Court of Appeals, Third District, Austin, No. 03-13-00101-CV, JUNE 11, 2015.
26 TEX. TAX. CODE ANN. § 171.0001(12); amended by Ch. 1232 (H.B. 500), Laws 2013, effective Jan. 1, 2014.
27 Letter No. 201412007L, Texas Comptroller of Public Accounts, Dec. 30, 2014.
28 TEX. TAX CODE ANN. § 171.1012(d)(10).
29 TEX. TAX CODE ANN. § 171.1012(e)(2).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
