United States: Texas Court Of Appeals Holds Oilfield Service Provider’s Waste Disposal Costs Included In COGS For Revised Tax Franchise Tax Purposes

The Texas Court of Appeals has affirmed a trial court's decision that a combined group of companies engaged in an oilfield service business could include a subsidiary's waste removal and disposal costs in the group's cost of goods sold (COGS) deduction and the group was entitled to receive a Revised Texas Franchise Tax (RTFT) refund.¹ The Court made a clear and concise determination that for COGS purposes the 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. Based upon this important finding, the Court then made an involved and complex determination that a subsidiary could include its labor costs and third party expenses for waste removal and disposal in its COGS because it furnished the labor for the construction or improvement of real property. The Court concluded that the disposal of waste material was an essential and direct component of the drilling process.

Background

Newpark Resources, Inc. (Newpark), a Delaware corporation headquartered in Texas, is an integrated oilfield services company providing services to third-party exploration and production companies that are necessary for the drilling of oil and gas wells. 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 primary business activity at issue in this case involved the manufacture, sale, injection and removal of "drilling mud."²

As the parent company, Newpark uses several subsidiaries for its various operations concerning drilling mud. For example, one subsidiary manufactures the industrial materials that go into making the drilling mud and another subsidiary produces, sells, injects and removes the drilling mud from the well. Newpark Environmental Services, LLC (NES), Newpark's subsidiary, removes the resulting non-hazardous waste materials from the drilling site, transports the waste to NES's underground disposal sites and injects the waste into the sites for permanent disposal. NES hires subcontractors to operate the trucks and barges that haul waste to the disposal sites. Newpark and its subsidiaries are engaged in a unitary business and filed a single combined RTFT Report for the years at issue.

Following a desk audit of Newpark's 2008 and 2009 RTFT returns, the Texas Comptroller of Public Accounts found that Newpark owed additional tax because NES's disposal of waste material was a service that did not qualify for a COGS deduction. Newpark paid the additional tax under protest and filed a suit claiming that it was entitled to include NES's expenses in Newpark's overall COGS deduction. Alternatively, Newpark argued that it was entitled to exclude an equivalent amount from its total revenue based on NES's flow-through payments to subcontractors for hauling the waste. After a bench trial, the trial court rendered a final judgment in Newpark's favor and concluded that it was entitled to a refund. The trial court did not issue findings of fact or conclusions of law, but the refund amount supported a conclusion that Newpark could claim NES's expenses in Newpark's overall COGS deduction. The Comptroller filed a timely appeal.

Computation of RTFT

For reports due on or after January 1, 2008, the RTFT is imposed on a combined unitary basis.³ The tax base is generally total revenue reported for federal income tax purposes less the highest of three potential deductions: (i) 30 percent of total revenue; (ii) compensation; or (iii) COGS.⁴ The tax base is apportioned to Texas by a single sales factor.⁵ The general tax rate is 1.0 percent with a 0.5 percent tax rate available for certain taxpayers, primarily retailers and wholesalers.⁶

Subsidiary's Expenses Considered in Context of Group's Overall Sales

In affirming the trial court's determination that Newpark was entitled to include NES's expenses in its COGS deduction, the Court of Appeals first held that each member of a combined group's business should be considered as part of the group's business as a whole. The Court relied upon the portion of the law that provides that "a combined group is a single taxable entity for purposes of the application of the [franchise tax]."⁷ The Court rejected the Comptroller's interpretation that a provision of the combined reporting statute required each member's business to be viewed in isolation when determining the member's eligibility to take a COGS deduction. Under this provision,⁸ a combined group that elects to subtract COGS must compute the amount by determining the COGS for each of its members and then make certain additions and subtractions. The Court determined that this provision was an accounting mechanism to add each member's COGS while eliminating any double counting of intra-group sales or transfers. Because this provision is effectively a procedural tool, the Court explained that it would be inconsistent to treat this provision as an additional substantive limitation that would require each member's business activity to be viewed separately.

The Court's conclusion was supported by another subsection of the combined reporting statute providing that "[a] member of a combined group may claim as costs of goods sold those costs that qualify under Section 171.1012 [the cost of goods sold statute] if the goods for which the costs are incurred are owned by another member of the combined group."⁹ The Court noted that it would be inconsistent to treat individual members as isolated entities under one provision but allow them to deduct their costs for selling goods that are owned by other members. Under the plain language of the combined reporting statute as a whole,¹⁰ each member's COGS deduction must be determined by considering the member's expenses in the context of the combined group's overall business.

Waste Disposal Expenses Qualified for COGS Deduction

The Court held that NES's labor or material costs could be included in COGS because NES furnished these items to a project for the construction and improvement of real property. In reaching this conclusion, the Court rejected the Comptroller's argument that NES's removal and disposal of waste material is a service and that NES does not sell a good for which the COGS deduction could apply.

As background, the Court provided a brief overview of the COGS deduction. For purposes of the COGS deduction, a "good" is "real or tangible personal property sold in the ordinary course of business of a taxable entity."¹¹ However, "services" are specifically excluded from the definition of tangible personal property.¹² A taxable entity that elects to take the COGS deduction may deduct "all direct costs of acquiring or producing the goods," including labor, materials, handling, depreciation and other sunk costs related to production.¹³ Finally, Tex. Tax Code Ann. Section 171.1012(i) creates what the Court characterized as a restriction and potential expansion of which entities can take the COGS deduction:

Newpark argued that NES's expenses were part of the overall labor and materials that it furnished to the drilling of oil and gas wells. Because NES's expenses did not fit under the specified costs that can be deducted under the statute, however, its expenses would only qualify for the COGS deduction if they satisfied Section 171.1012(i).

The Court rejected the Comptroller's argument that NES's removal and disposal of drilling mud was purely a service and did not constitute labor furnished to a project for the construction or improvement of real property. Because "service" and "labor" are not defined by Texas tax statutes, the Court was required to consider the meaning of these terms. The Comptroller asserted that "services" and "labor" were different activities because they are listed separately in a statute that provides for the exclusion of flow-through funds from total revenue.¹⁵ The Court agreed that the separate listing of "services" and 'labor" indicated that the terms represent different concepts. However, the fact that the terms are listed separately does not mean that they are mutually exclusive.

In determining whether NES furnished labor to a project for the construction of real property, the Court first considered the function of Section 171.1012(i) within the context of the entire COGS statute.¹⁶ Section 171.1012(i) generally operates as a broad limitation on which entities can claim the COGS deduction. The provision restricts the COGS deduction to taxpayers that actually own the goods they sell, but an exception is provided for taxpayers that furnish labor or materials to certain projects related to real property. After considering the legislative intent, the Court concluded that when viewed in the context of the entire COGS statute, Section 171.1012(i) "means that the party that supplies labor or materials to the construction, improvement, remodeling, repair, or industrial maintenance of real property can deduct its labor or material expenses as a cost of goods sold, assuming those expenses would qualify as the cost of selling real property."

Following its analysis of the function of Section 171.1012(i), the Court considered the meaning of "labor" within the context of the COGS statute. The Court determined "[t]here is no reason to believe that 'labor' under subsection 171.1012(i) means anything different than labor under section 171.1012 [the entire COGS statute] generally." A taxable entity generally may deduct "all direct costs of acquiring or producing" goods, including "labor costs."¹⁷ "Labor" has a broad definition and there is no indication that the legislature intended for it to have a more narrow interpretation as it relates to COGS.

The Court considered the facts of the case to determine whether NES's services qualified as labor for the construction or improvement of real property. There was no dispute that the drilling and construction of the wells qualified as construction or improvement of real property. Also, the injection and removal of drilling mud qualified as labor and materials that are furnished for the construction of wells. The only question was whether NES's transport and disposal of the used drilling mud and other waste was part of the labor involved in the drilling process. The Comptroller argued that NES's activities were clearly a service rather than labor because they were similar to a garbage collector that picks up waste and transports it to a landfill. The Court disagreed with this characterization, determining that NES's activities were more analogous to a demolition company that demolishes a structure and then removes the resulting debris. According to the Court, it is difficult to view NES's disposal of waste material as though it were not an essential and direct component of the drilling process. The trial court could have reasonably concluded that the removal and disposal of the waste material was labor furnished to a project for the construction and improvement of real property.

After concluding that Newpark was entitled to include NES's expenses in its COGS deduction, the Court explained that it did not need to determine whether Newpark could also exclude flow-through payments to subcontractors from total revenue.

Concurring Opinion

One of the justices issued a concurring opinion stating that the RTFT statute obligated the Court, as a threshold matter, to calculate Newpark's total revenue. To do so, the justice posited that it was necessary for the Court to address whether Newpark's flow-through payments to subcontractors could be excluded from total revenue. According to the concurring opinion, the COGS subtraction is not an "alternative legal theory" but is an element of Newpark's chosen method of computing taxable margin. Based on the wording of the RTFT statute, any determination of the amount of tax owed necessarily required a determination of whether the flow-through funds may be subtracted from total revenue thus, potentially impacting the group's apportionment factor and tax base.

Commentary

The COGS deduction has been the source of much controversy between taxpayers and the Comptroller since the advent of the RTFT. Interpreting and applying the Texas statute¹⁸ providing for the COGS deduction is a challenge for tax practitioners as well as the Comptroller.¹⁹ The statute incorporates some federal income tax provisions and principles but varies from those federal provisions and principles in a number of areas.

The Comptroller is likely to appeal this important decision to the Texas Supreme Court. The fact that the disputed expenses were incurred by a member of the combined group that did not sell any traditional "goods" further complicates this decision. The first part of the decision holding that the expenses of a member of a combined group must be considered in the context of the group's overall sales for purposes of the COGS deduction is consonant with the intent of the combined reporting statute. The Comptroller's argument that the expenses of the group members should be considered on an individual basis would conflict with some of the provisions contained in the group reporting statute.

The Court's holding that the waste removal costs are includable in the COGS deduction may be more open to debate. In the decision, the Court uses a lengthy and involved analysis to arrive at the conclusion that these expenses are deductible. The Court seems to be specifying a new test by holding that "labor or material expenses" qualify as COGS "assuming those expenses would qualify as the cost of selling real property." In this case, the waste removal costs were includable in COGS because they were a cost of the real property or drilling process. The Court acknowledges that in other factual situations, the labor may be "too far removed from the construction, improvement, remodeling, repair, or industrial maintenance of real property to qualify for the cost-of-goods-sold deduction under section 171.1012(i)." Accordingly, the practical application of this decision may be more limited to factual situations (particularly in the Comptroller's view) than some taxpayers may perceive. The fact that the Court determined that the waste disposal costs qualify for the COGS deduction under Section, 171.1012(i) only (and not under Sections 171.1012(c), (d) or (f)) may be problematic for manufacturers of tangible personal property who incur such costs. Finally, it would appear that the decision selectively provides taxpayers engaged in the demolition and waste disposal service businesses authority to take the COGS deduction.

The Court did not address Newpark's federal income treatment of the costs or the treatment of the costs under the recently amended COGS rule.²⁰ Nor did the Court consider or compare to the Texas sales/use tax treatment of the transactions, which is of particular interest in that Section 171.1012(i) includes a specific reference to a Texas sales/use tax rule.²¹ Given that the amendments to the COGS rule are retroactive to the tax years at issue in this case and that the federal income treatment of the costs is now more relevant than under the original COGS rule, failing to extend the analysis to the amended version is a notable omission in the decision (though the issue may have been covered in the parties' briefs).

In 2012, the Comptroller announced that taxpayers may make the election to deduct either COGS or compensation on an originally-filed return or an amended return.²² The Comptroller has stated that this change in policy is effective for reports for periods within the statute of limitations. Based on this decision, taxpayers may want to consider filing amended returns or refund claims. The Court's conclusion that a combined group represents a single taxpayer for purposes of the RTFT should be evaluated for possible refund opportunities by taxpayers in other industries. Also, taxpayers should consider the treatment of filing positions and any related exposures under 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 Combs v. Newpark Resources, Inc., Texas Court of Appeals, Third District, at Austin, No. 03-12- 00515-CV, Dec. 31, 2013.

2 As explained by the Court of Appeals, "[d]rilling mud is a product that is injected into a well hole as it is being drilled to cool and lubricate the drill as well as to facilitate the removal of rock, soil, and other 'waste material' from the hole."

3 TEX. TAX CODE ANN. § 171.1014(a).

4 TEX. TAX CODE ANN. § 171.101. Note that this statute has been amended effective January 1, 2014 to provide a permanent exemption for taxpayers with a taxable margin of $1 million or less.

5 TEX. TAX CODE ANN. § 171.106(a).

6 TEX. TAX CODE ANN. § 171.002. For RTFT reports due in 2014, the rates are temporarily reduced to 0.975 percent and 0.4875 percent. If certain state revenue targets are met, the rates will be further reduced to 0.95 percent and 0.475 percent for RTFT reports due in 2015. If the state revenue targets are not met, the rates will revert to 1.0 percent and 0.5 percent for RTFT reports in due in 2015. In addition, without further action by the Texas legislature, the tax rates will revert to 1.0 percent and 0.5 percent for RTFT reports due in 2016 and beyond. TEX. TAX CODE ANN. §§ 171.0022; 171.0023.

7 TEX. TAX CODE ANN. § 171.1014(b).

8 TEX. TAX CODE ANN. § 171.1014(e).

9 TEX. TAX CODE ANN. § 171.1014(d-1).

10 TEX. TAX CODE ANN. § 171.1014.

11 TEX. TAX CODE ANN. § 171.1012(a)(1).

12 TEX. TAX CODE ANN. § 171.1012(a)(3)(B)(i), (ii).

13 TEX. TAX CODE ANN. § 171.1012(c), (d).

14 TEX. TAX CODE ANN. § 171.1012(i) (emphasis added by Court of Appeals).

15 See TEX. TAX CODE ANN. § 171.1011(g)(3).

16 The entire COGS statute is TEX. TAX CODE ANN. § 171.1012.

17 TEX. TAX CODE ANN. § 171.1012(c)(1).

18 TEX. TAX CODE ANN. § 171.1012.

19 The Comptroller's Web site provides guidance concerning the propriety of the COGS deduction for oil and gas drilling and wells at http://window.state.tx.us/taxinfo/franchise/faq_questions.html#cogs. Under COGS, see items 17, 21 and 22.

20 See 34 TEX. ADMIN. CODE § 3.588.

21 34 TEX. ADMIN. CODE § 3.357.

22 Announcement, Texas Comptroller of Public Accounts, June 6, 2012.

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.