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On March 16, 2018, the Texas Comptroller of Public Accounts amended the administrative rule governing the Revised Texas Franchise Tax (RTFT) cost of goods sold (COGS) deduction.1
Notably, the changes impact the determination of which taxable entity is the “owner of the goods” and entitled to the COGS deduction, as well as the costs includible in the COGS deduction for taxable entities furnishing labor or materials to certain real property projects. The amendments have varying effective dates, including some retroactive to January 1, 2008 (the effective date of the RTFT) to the extent a taxpayer’s statute of limitations remains open.
The RTFT Statutory COGS Deduction
In computing their RTFT base, taxpayers may generally include a deduction based on the maximum of four amounts: (i) 30 percent of total revenue; (ii) $1 million; (iii) COGS; or (iv) compensation.2
The COGS deduction is allowed only to taxpayers who acquire or produce “goods,” which are defined as real or tangible personal property sold in the ordinary course of business.3
The costs to acquire or produce a service or intangible property are excluded from the COGS deduction.4
Further, a taxable entity may only include costs related to goods the entity owns. The determination of ownership is statutorily based upon all facts and circumstances, including the various benefits and burdens of ownership vested with the taxable entity.5
The Comptroller’s amendments to its rule interpret the existing statute that authorizes and defines the COGS deduction.6
Significant Rule Changes
Owner of the Goods
The Comptroller amended the rule included in renumbered paragraph 34 Tex. Admin. Code Sec. 3.588(c)(9) by adding a presumption that the legal title holder is the owner of the goods.7
A taxable entity may rebut the presumption by proving an ownership right superior to the legal title holder.
Labor and Materials Furnished to Certain Real Property Projects
The Comptroller’s amendments to renumbered subparagraph 34 Tex. Admin. Code Sec. 3.588(c)(9)(B) provide new definitions for labor and materials includible in the COGS deduction when furnished to projects for the construction, improvement, remodeling, repair, or industrial maintenance of real property. The related statute does not define the terms “labor” or “materials.”8
The newly-adopted definition of includible labor specifies that such term means “labor used in the direct prosecution of the work.”9
Similarly, the new definition of “material” includes material, machinery, fixtures or tools that are incorporated into the project, consumed in the direct prosecution of the project, or ordered and delivered for incorporation or consumption, in addition to certain types of rent and consumable items.10
The Comptroller has stated that these new definitions will be applied on a prospective-only basis.11
Other Rule Changes
The amended rules include a new paragraph concerning movie theaters which implements 2013 legislation enacting Tex. Tax Code Ann. Sec. 171.1012(t).12
The regulatory language mirrors the statute and indicates that, for a taxable entity that is a movie theater electing to subtract the COGS, the COGS generally includes costs related to the acquisition, production, exhibition, or use of a film or motion picture, as well as costs in relation to concessions sold.
The rules also include a new paragraph addressing pipelines which implements 2013 legislation enacting Tex. Tax Code Ann. Sec. 171.1012(k-2) and (k-3).13
The regulatory language is consistent with the statute and generally clarifies that a pipeline entity that provides services for others related to the product that the pipeline does not own may subtract as a COGS its depreciation, operations, and maintenance costs related to the services provided.
Taxable Entities Renting and Leasing Certain Tangible Personal Property
Several amendments are made to the rules applicable to taxable entities renting or leasing certain motor vehicles, heavy construction equipment and railcar rolling stock.14
These changes generally provide that such entities may subtract as COGS “the costs otherwise allowed by this section in relation to tangible personal property that the entity rents or leases in the ordinary course of business of the entity,” and are retroactive to January 1, 2008 to the extent a taxpayer’s statute of limitations remains open.15
Notably, the COGS deduction is generally denied to lessors of real or tangible personal property, except when specifically allowed.
Research and Developments Costs for Non-Producers
A rule is amended to clarify that non-producers of goods, as well as producers, are entitled to include in the COGS related to research and development costs as part of direct costs, including all research or experimental expenditures described by Internal Revenue Code (IRC) Sec. 174.16
This change is consistent with the policy change previously announced by the Comptroller and is retroactive to January 1, 2008 to the extent a taxpayer’s statute of limitations remains open.17
The significant changes to the COGS rule, many of which were in reaction to Texas court decisions interpreting the COGS deduction, are virtually certain to be sources of ongoing controversy. In particular, several of the adopted rule provisions seem to be more restrictive than their statutory counterparts. Also, the Comptroller declined to conduct a public hearing or a roundtable discussion regarding the amendments, despite requests from taxpayers. As such, the rule amendments could be indicative of a trend toward more stringent and adversarial tax enforcement by the Comptroller’s office. This could be a function of the still-unsolved structural budget deficit the Texas Legislature has dealt with for the past several prior legislative sessions.
The Comptroller’s previous (2013) COGS rule changes18
to labor costs and other costs (e.g., property taxes) relied heavily on federal UNICAP principles (i.e., Treas. Reg. § 1.263A-1), based upon Tex. Tax Code Ann. Sec. 171.1012’s incorporation of that federal provision, principle and methods. That reliance has been abandoned in the current rule amendments and may be at variance with the RTFT statute itself and with standing judicial precedents.
As stated above, the Texas Tax Code is very clear that ownership of the goods (and entitlement to the COGS deduction) “is based on all of the facts and circumstances, including the various benefits and burdens of ownership vested with the taxable entity.” The amended rule, including its rebuttable assumption of ownership, may deny the COGS deduction to contract manufacturers who may have historically claimed the COGS deduction under the “benefits and burdens of ownership” test. In addition, the provision could be construed to yield the principal (customer) in a contract manufacturing arrangement to be self-producing goods and therefore not be entitled to the lower retail/wholesale franchise tax rate.19
With respect to the subject labor and material costs includible in the COGS deduction as being furnished to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property, the terms “labor” and “materials” are undefined by the Texas Tax Code for this specific purpose, with no evidence of any such legislative intent.20
By adopting restrictive definitions, the new rules will certainly inspire further controversy in this area.
The changes with respect to ownership and COGS related to rented and leased property are effective retroactively. In that this amendment establishes a change in policy with respect to the regulatory language, as well as of observed practice in the case of the “ownership of the goods” issue, matters of equity are sure to arise. Taxpayer challenges to the rule changes will eventually reveal if the amendments are within the Comptroller’s regulatory authority that is statutorily granted by Tex. Tax Code Ann. Sec. 111.002.
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