Read the appeals court decision [PDF 136 KB]
Under Texas law (as in effect for the tax years at issue), taxable “margin” is the lesser of:
- 70% of total revenue, or
- Total revenue minus either (1) cost of goods sold (COGS) or (2) compensation and benefits
The COGS statute allows a company to deduct “all direct costs of acquiring or producing goods,” and up to 4% of other “indirect or administrative overhead costs.” Generally, only entities that own and sell real or tangible personal property can elect to deduct COGS, and an election to deduct COGS applies to the combined group as a whole.
In this case, the parent company’s primary business activity involved the manufacture, sale, injection, and removal of drilling mud (a product injected into an oil 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).
Several subsidiaries were involved in its drilling-mud operations—including one that claimed the disputed COGS expenses (that subsidiary removed nonhazardous waste materials from drilling sites, transported the waste to underground disposal sites, and injected the waste into the sites for permanent disposal).
On audit, the Comptroller disallowed the deduction on the basis that the disposal and removal of drilling waste was a service that did not qualify for as COGS for Texas franchise tax purposes.
The parent company paid the additional tax under protest, and subsequently filed suit for refund. The trial court held in favor of the taxpayer. However, the trial court did not issue findings of fact and conclusions of law.
The Comptroller filed an appeal.
Issues on appeal
On appeal, the central issue was whether the subsidiary was entitled to a COGS deduction for its labor and materials associated with the waste removal services.
A second, ancillary issue was whether the subsidiary could deduct certain amounts paid to subcontractors from total revenue.
The parties conceded that if the subsidiary was entitled to deduct COGS, then the trial court’s ruling in favor of the taxpayer must be affirmed. As such, the appeals court addressed the COGS issue first.
To reach the amount of the refund, the appeals court assumed that the parent company was entitled to claim the subsidiary’s expenses in the parent’s overall COGS deduction.
Expenses considered part of the combined group’s activity or separate entity basis?
The Comptroller appeared to argue that the subsidiary must be viewed in isolation to determine the eligibility of its expenses as COGS. Thus, because the subsidiary did not own or sell goods, it was not entitled to deduct its labor and materials as COGS.
In contrast, the taxpayer argued that the Comptroller must look at the overall combined group’s business to determine whether the expenses of each group member were eligible to be deducted as COGS.
After analyzing a number of statutory provisions illustrating that a combined group must be viewed as a whole, the appeals court concluded that it would be inconsistent to:
…consider a combined group as a single taxable entity, require each member to take the same general deduction, but nevertheless treat each member as an isolated entity for purposes of determining eligibility to take the cost-of-goods-sold deduction.
Labor provided to a project for the improvement of real property?
The appeals court next addressed whether the subsidiary’s expenses qualified as COGS for Texas franchise tax purposes.
In general, only expenses related to goods owned and sold qualify for the COGS deduction. However, an exception to the general rule applies for expenses incurred to furnish labor or materials to a project for the construction, improvement, remodeling, repair or industrial maintenance of real property.
The appeals court concluded that the legislature’s likely intent for this exception was to allow certain expenses related to real property to qualify for the COGS deduction—despite the fact that the entity incurring those costs may not own the underlying real property.
In this case, it was undisputed that (1) drilling oil and gas wells constituted a project for the construction and improvement of real property and (2) the injection and removal of drilling mud qualified as labor and materials that are furnished for the construction of oil and gas wells.
The Comptroller argued, however, that the subsidiary’s transport and disposal of the drilling mud was a service—similar to that of a garbage collector—not the provision of labor for the construction of an oil or gas well. In the Comptroller’s view, because the subsidiary was not providing labor for the construction of the oil or gas well, its expenses did not qualify for the COGS deduction. The appeals court disagreed, noting that labor is a broad term that encompasses many activities and that the terms “services” and “labor” are not mutually exclusive.
In the court’s view, the subsidiary’s function was more akin to that of a demolition and removal company. Without the labor associated with the removal and disposal of demolished materials, there would be little point to a demolition service. Similarly, removal and disposal of the waste material was essential to continue drilling. Without the waste being disposed of, the drilling process would come to an immediate halt. As such, because the subsidiary was providing labor that was essential to the drilling process (which qualified as construction or improvement to real property), the labor and materials used by the subsidiary to provide the waste removal services qualified as COGS for Texas franchise tax purposes.
The court did observe that, in other instances, labor may be too far removed from the construction, improvement, remodeling, repair or industrial maintenance of real property to qualify for a COGS deduction.
It remains to be seen whether the Comptroller will appeal the decision to the Texas Supreme Court. However, in the interim, this decision may provide opportunities for other Texas taxpayers.
- First, the decision confirms that even if a combined group member itself does not produce and sell goods, this does not necessarily preclude the entity from having qualifying COGS expenses. Rather, the entity’s activities must be viewed in the context of the overall group’s business.
- Second, with respect to labor related to real property projects, the decision indicates that it is the essential nature of the labor or service that determines COGS qualification and that labor is to be defined broadly. As such, certain taxpayers may be entitled to an additional COGS deduction based on the court’s rationale.
For more information, contact a KPMG State and Local Tax professional