On July 2, a Texas district court held that an oilfield service business was entitled to receive a Revised Texas Franchise Tax (RTFT) refund on the basis that certain costs attributable to comprehensive oilfield services are includible in the cost of goods sold (COGS) deduction.1
Background
Newpark Resources, Inc. (Newpark), a Delaware corporation headquartered in The Woodlands, Texas, is a fully-integrated oilfield services business that provides products and services to companies in the oil and gas business. As an oilfield service provider, Newpark does not conduct the drilling activities, but provides a wide range of support crucial to those activities. Newpark's products and services range from wellsite preparation to environmental disposal and reclamation services, and include support of the intermediate drilling activities.
Newpark conducts its environmental services through an affiliate, Newpark Environmental Services, LLC. Newpark Environmental Services, LLC processes and recycles waste at its facility located in Port Arthur, Texas. The resulting product is reused or transported for disposal at a waste disposal facility near Fannett, Texas (Jefferson County) under permits issued by Texas state regulatory agencies.
Newpark and its affiliates, including Newpark Environmental Services, LLC, joined in the filing of a combined RTFT report and claimed the COGS deduction. Newpark and Newpark Environmental Services, LLC collectively hire subcontractors to perform services in connection with the oilfield services provided to Newpark's drilling and production clients. These subcontracted services include the transportation of waste materials and fluids.
Upon audit of the 2008 and 2009 reports, the Comptroller disallowed approximately $42 million and $46 million of Newpark's claimed $376 million and $475 million of COGS deductions, respectively. The Comptroller alleged that the costs attributable to environmental disposal and reclamation services were not includible in the COGS deduction. Newpark filed suit in Texas District Court to recover the contested amounts paid under protest.
Computation of Revised Texas Franchise Tax
The RTFT, for reports due on or after January 1, 2008, is imposed on a combined unitary basis.2 The tax base is generally total revenues reported for federal income tax purposes less the highest of three potential deductions: (i) 30 percent of total revenue; (ii) compensation; or (iii) COGS.3 The tax base is apportioned to Texas by a single sales factor.4 The general tax rate is 1.0 percent with a 0.5 percent tax rate available for certain taxpayers, primarily retailers and wholesalers.5
Comprehensive Oilfield Service Costs Included in COGS
The District Court found in favor of Newpark with respect to the taxes paid under protest. In a cursory opinion, the Court appears to have decided, inter alia, that:
- Texas law allowed Newpark to include in COGS its costs attributable to its comprehensive oilfield services, including the costs of oilfield waste reclamation and disposal.
- Newpark was allowed to compute its COGS deduction as though the combined group were a single entity engaged in a single activity.6
- Newpark's oilfield waste and environmental disposal and reclamation costs constituted components of intangible drilling costs and/or "pollution control equipment" and "pollution control devices" allowed as COGS deductions.7
- Newpark's environmental disposal and reclamation services qualified as "furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance (as the term 'maintenance' is defined in 34 T.A.C. Sections 3.357) of real property"8 for COGS purposes.
Appeal Filed
On August 2, the Comptroller and Attorney General of the State of Texas appealed the District Court's decision to the Texas Third Court of Appeals.
Commentary
The COGS deduction has been the source of much audit and refund activity and controversy between taxpayers and the Comptroller.
Interpreting and applying the Texas law9 providing for and governing the COGS deduction is a challenge for tax practitioners and the Comptroller alike. The law incorporates some federal income tax provisions and principles and varies from those federal provisions and principles in a number of areas. The law and the legislative record provide little clarity as to legislative intent.
The Comptroller's rule10 governing the COGS deduction essentially restates the law and provides limited additional guidance. Other guidance is generally limited or lacking in the form of letter rulings, administrative hearing decisions or court case decisions. An article in the August 2010 edition of the Comptroller's Tax Policy News provides the best and most comprehensive source of guidance as to that particular topic, including the COGS deduction allowed to construction contractors.11
Despite (or in light of) the above, the positions of taxpayers and the Comptroller as to which taxpayers qualify for the COGS deduction and what costs are included in that deduction remain far apart.
The District Court's decision may provide taxpayers with favorable precedent with respect to the issues decided. The logic applied by the Court in this decision may apply to many taxpayers and not just those engaged in the oilfield service business.
Additional litigation may be anticipated with respect to the COGS deduction issues, but the resolution, and the timing thereof, of any such litigation is an unknown at this time.
Taxpayers may be placed upon the horns of a dilemma, as the extended due date for many taxpayers' 2012 reports (generally covering the tax year ended during 2011) is November 15, 2012. Taxpayers must consider and weigh taxpayer-favorable interpretations of the law and guidance (such as this decision) with the Comptroller's more limiting guidance.
In addition, the Comptroller has recently announced that taxpayers may make the election to deduct either COGS or compensation on an originally-filed return or on an amended return.12 The Comptroller has stated that this change in policy is effective for reports for periods within the statute of limitations.
For many taxpayers, the statute of limitations for the 2008 report (generally covering the tax year ended during 2007) will expire on or about November 17, 2012. Prior to filing for any refunds, taxpayers would be well-advised to consider additional refund opportunities as well as areas of exposure. These areas mutually include, in addition to the COGS deduction, issues related to nexus, the existence and composition of combined groups, total revenue (and exclusions therefrom), apportionment and the applicable tax rate.
Not to be overlooked is the treatment of filing positions and any related exposures pursuant to ASC 740, Income Taxes (formerly known as FAS 109), and ASC 740-10, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (formerly known as FIN 48).
Footnotes
1 Newpark Resources, Inc. v. Combs, District Court of Travis County, Texas, 353rd Judicial District, No. D-1-GN-11-002205, July 2, 2012.
2 TEX. TAX. CODE ANN. § 171.1014(a).
3 TEX. TAX. CODE ANN. § 171.101.
4 TEX. TAX. CODE ANN. § 171.106(a).
5 TEX. TAX. CODE ANN. § 171.002.
6 TEX. TAX CODE ANN. § 171.1014(b).
7 TEX. TAX CODE ANN. § 171.1012(c)(7), (8).
8 TEX. TAX CODE ANN. § 171.1012(i).
9 TEX. TAX CODE ANN. § 171.1012.
10 34 TEX. ADMIN. CODE § 3.588.
11 Franchise Tax and the Construction Industry, Tax Policy News, Texas Comptroller of Public Accounts, Aug. 2010. For the article, see http://window.state.tx.us/taxinfo/taxpnw/tpn2010/tpn1008.html#issue2.
12 Announcement, Texas Comptroller of Public Accounts, June 6, 2012. The announcement can be viewed at http://window.state.tx.us/taxinfo/franchise/cog_compensation.html.
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.
