United States: Texas Appellate Court Addresses Potential Application Of COGS Deduction To Service Providers And Sellers Of Intangible Property

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 cost of goods sold (COGS) deduction in computing its margin for the Revised Texas Franchise Tax (RTFT).1 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.

Procedural History and Background

The taxpayer, which operates a movie theater business and primarily exhibits motion pictures and other content to customers, claimed a COGS deduction on its 2008 and 2009 RTFT reports. The COGS deduction consisted of motion picture licensing fees and other expenses associated with the commercial display of motion pictures, including facility rent and depreciation. Upon audit, the Texas Comptroller disallowed the COGS deduction, arguing that the taxpayer either provided a service or sold intangible property. The taxpayer paid the assessment under protest and filed suit in district court.

The parties agreed to a bifurcated bench trial. In phase one of the trial, the issue before the trial court was whether the taxpayer's product amounted to a "good" under Tex. Tax Code Ann. Sec. 171.1012(a)(1), or whether the taxpayer provided a service or an intangible product. The trial court held that the taxpayer's product amounted to a "good" under the definition of a good under Tex. Tax Code Ann. Sec. 171.1012(a)(1) and therefore, the taxpayer was entitled to claim a COGS deduction. Having concluded that the taxpayer was entitled to claim a COGS deduction, phase two of the trial centered on the costs associated with acquiring or producing the goods eligible for the COGS deduction. The Comptroller and the taxpayer reached an agreement delineating the majority of exhibition costs eligible for the COGS deduction. However, the parties did not agree to the treatment of certain costs such as facility-related rent and depreciation eligible for the COGS deduction. The taxpayer argued that the entire amount of square footage in the auditorium qualified for the COGS deduction, while the Comptroller argued that the square footage should be limited to the square footage involving the speakers and screens within the auditorium that produced the images that were perceptible to the senses. The trial court sided with the Comptroller and limited the deduction to the square footage associated with the speakers and the screen. The Comptroller appealed the trial court's decision with respect to the court's findings associated with phase one of the trial, and the taxpayer appealed the trial court's findings with respect to phase two of the trial.

Third Appellate Court's Decision

In appealing the trial court's ruling in phase one, the Comptroller asserted that the trial court erred in finding that the taxpayer produces tangible personal property. The Comptroller argued that exhibiting a film does not constitute a "good" because the taxpayer does not sell tangible personal property. Rather, the taxpayer sells either intangible property or a film-watching service, and therefore, is precluded from taking the deduction under Tex. Tax Code Ann. Sec. 171.1012(a)(3)(B).

The Court of Appeals found that the trial court's determination that the taxpayer's product satisfied the legislature's definition of tangible personal property was supported by the weight of the evidence. According to the Court, the legislature crafted a very specific definition of the term "tangible personal property" and defined that term to include personal property that can be "seen" or "that is perceptible to the senses in any other manner." The Court found this definition to be unambiguous and that the taxpayer's product satisfied this definition since the movie screening could be seen and was otherwise perceptible to the senses.

The Comptroller argued that the taxpayer was not a film producer or distributor, and did not sell the film. Rather, the taxpayer sold the right to watch the film, which was more akin to a license. The Court of Appeals dismissed the Comptroller's argument, holding that the definition of "tangible personal property" did not have a "take-home requirement." Therefore, the Court upheld the trial court's determination that it was entitled to claim the COGS deduction for all costs associated with acquiring or producing this "good."

As for the conclusions reached in phase two of the trial court's ruling, the Court reversed the trial court's findings of fact denying the inclusion of certain costs in the COGS deduction as not supported by the evidence. The Court found that the taxpayer introduced evidence that the entire "auditorium is integral to the visual and acoustic production" and that it uses the entire auditorium space for production. Rejecting the Comptroller's assertion that the auditorium should be classified as "consumption space" instead of "production space," the Court noted that the Comptroller did not introduce any evidence rebutting the taxpayer's assertions, and that the trial court's denial of certain costs that were stipulated by the parties prior to the trial was not supported by the evidence.


While American Multi-Cinema concerned a taxpayer in the business of screening motion pictures, the Court's decision potentially expands the availability of the COGS deduction to other taxpayers that might have previously been considered service providers or sellers of intangible property. For example, an accounting firm that historically has viewed itself as a service provider may consider taking the position that it is entitled to a COGS deduction, arguing it produces audit reports and tax returns that meet the definition of "tangible personal property" under Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A)(i) since the end products can be seen, weighed, felt, measured, and are perceptible to the senses.

Other perceived "service providers" to which this decision, if upheld, may apply include operators of sporting events, performing arts and other forms of visual and aural entertainment and telecommunications. Similarly, the expansion of direct costs qualifying for the COGS deduction could apply to restaurants and other businesses that currently qualify for the COGS deduction.

Meeting the definition of "tangible personal property" is important for COGS purposes because the definition of "goods" for which the COGS deduction may apply only includes "real or tangible personal property sold in the ordinary course of business of a taxable entity."2 In turn, the definition of "tangible personal property" for purposes of the COGS deduction specifically excludes: (i) intangible property; and (ii) services.3 Interestingly, the Court of Appeals only briefly considered this issue as it related to the taxpayer in American Multi-Cinema, specifically whether film viewing is a good that is intangible property or a service (both terms undefined by the Texas Tax Code). In Newpark Resources,4 the Court went to great lengths in addressing and resolving the overlapping definitions of the terms "service" and "labor." In American Multi-Cinema, however, the Court noted the "conflict" and summarily resolved that conflict in favor of the taxpayer. The analysis is of interest not in defining motion picture films as tangible personal property (given, particularly, the Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A)(ii) definition of the term) but more in identifying the costs of "production" that may be includible in COGS.

Notably absent from American Multi-Cinema is the mantra that "to promote uniformity and equality in taxation, [courts] construe tax exemptions--and provisions tantamount to tax exemptions--strictly against the taxpayer and in favor of the taxing authority."5 It is also of interest that the auditorium costs were not considered in the light of excluded "distribution costs, including outbound transportation costs."6

The Comptroller's announced intention of seeking a rehearing of the case and/or of appealing to the Texas Supreme Court7 will be followed closely. It should be noted that those procedures ultimately were unsuccessful in the Newpark Resources and Titan Transportation cases.8

Envisioning that numerous types of businesses, even those that primarily engage in the sale of services and intangibles, will consider the Court's decision as an invitation to markedly expand the availability and scope of the COGS deduction, the Comptroller estimates an annual revenue loss of $1.5 billion and cumulative refunds to exceed $6 billion if the Court's decision ultimately stands.9 The Comptroller has already filed a motion for an en banc rehearing before the Third District, and this motion will be considered before any appeal is made to the Texas Supreme Court. The Comptroller's other potential remedy is through legislative action. The 84th Texas Legislature appears to have adjourned without any actions as a result of American Multi-Cinema or of the Comptroller's warning of potential revenue losses.

While a full consideration of the Texas sales and use tax implications of this case is beyond the scope of this alert, these issues deserve some mention and preliminary consideration. This is especially important due to the distinctions between taxable services, which are listed in Tex. Tax Code Ann. Sec. 151.0101, non-taxable services, which are not defined (but presumably are services not enumerated in the list of taxable services), and sales of tangible personal property. The potential impact from a sales tax perspective may be felt by taxpayers that are solely focused on obtaining RTFT refunds, as well as taxpayers that want to proactively seek sales and use tax refunds based on the rationale in American Multi- Cinema.

Taxpayers advancing the argument for RTFT purposes that was accepted in American Multi-Cinema should be particularly careful. Specifically, a taxpayer that previously considered itself a service provider for RTFT purposes but now seeks to claim that it is a producer of tangible personal property may unwittingly subject itself to sales tax liability for failing to collect and remit sales tax on the "tangible personal property" it now purportedly produces. That said, a taxpayer challenged by the Comptroller on this point could counter that it is manufacturing tangible personal property, and therefore, treat most of the activities in the production process as exempt.10 The Comptroller made both of these points in his briefing sheet filed with the Texas Legislature in response to American Multi-Cinema.

Likewise, taxpayers that decide to proactively pursue sales tax refunds based on American Multi-Cinema if the Comptroller loses an appeal to the Texas Supreme Court should think about how the Comptroller might respond. The opportunities for non-taxable service providers such as lawyers and accountants to claim an exemption for the tangible personal property that they purchase that is transferred to customers, or used in producing property that is transferred to customers, may be limited and more than offset by the likely assessment by the Comptroller of uncollected sales tax on sales of tangible personal property. It should be noted that if a transaction is treated as a sale of tangible personal property instead of a taxable service, the general requirement that a "transfer of title (to) or possession (of)" the property must take place in order for a sale to have occurred11 potentially may be a mitigating factor to both the taxability and the refund positions.


1 American Multi-Cinema, Inc. v. Hegar, Texas Court of Appeals, Third District, Austin, No. 03-14-00397-CV, April 30, 2015.

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

3 TEX. TAX CODE ANN. § 171.1012(a)(3)(B).

4 Combs v. Newpark Resources, Inc., 422 S.W.3d 46 (Tex. Ct. App. 2013).

5 Texas Utilities Electric Co. v. Sharp, 962 S.W.2d 723 (Tex. Ct. App. 1998), petition for review denied (citation omitted).

6 TEX. TAX CODE ANN. § 171.1012(e)(3).

7 E-mail Update, Texas Taxpayers & Research Association, May 7, 2015 (citing Texas Comptroller's briefing sheet filed with the Texas Legislature in response to American Multi-Cinema).

8 Titan Transportation, Inc. v. Combs, 433 S.W.3d 625 (Tex. Ct. App. 2014), petition for review denied, May 1, 2015.

9 E-mail Update, Texas Taxpayers & Research Association, May 7, 2015 (citing Texas Comptroller's briefing sheet filed with the Texas Legislature in response to American Multi-Cinema).

10 Sales and use tax manufacturing exemptions are provided by TEX. TAX CODE ANN. § 151.318.

11 TEX. TAX CODE ANN. § 151.005(1).

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions