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Jamie C. Yesnowitz
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The Texas Supreme Court held that a taxpayer was entitled to exclude revenue related to flow-through payments from its Texas Franchise Tax calculation.1
However, with respect to the taxpayer’s cost of goods sold (COGS) deduction for labor, the Court determined that the taxpayer’s survey, repair and upgrade costs were not considered a direct cost of acquiring or producing a good, and the specific costs to be included in the calculation must be identified on a cost-by-cost basis. The Court remanded the case to the trial court for further consideration.
The taxpayer, Gulf Copper and Manufacturing Corporation (Gulf Copper), surveys, repairs and upgrades offshore oil and gas rigs which are used to drill offshore wells. After a project is completed, the rigs are brought to a Gulf Copper facility so that when another drilling contract is executed, the rig can be prepared for the next drilling project.
When a rig is brought to a Gulf Copper facility, a Gulf Copper subsidiary surveys the rig to determine the modifications required to be made to prepare the rig for the next project. After the survey has been completed, Gulf Copper and its subcontractors will make necessary repairs, which can include replacing portions of the rig that are corroded, as well as sandblasting and painting parts of the rig that have not been replaced.
Gulf Copper contracted with both its customers (the owners of the oil rigs) as well as with its subcontractors to complete this work. Gulf Copper entered into two types of contracts with its customers. One type of contract, using the “hourly method,” provided that the customer would pay Gulf Copper an hourly rate that was 15% to 20% more than Gulf Copper’s anticipated costs. The second type of contract is referred to as the “cost plus” method. Under this type of contract, the customer would pay Gulf Copper a specified percentage in excess of the rate Gulf Copper paid to its subcontractors.
Revenue exclusion for subcontracting payments
On its 2009 Texas Franchise Tax return, Gulf Copper subtracted payments to its subcontractors as flow-through funds entitled to an exclusion from revenue under Tex. Tax Code Ann. Sec. 171.1011(g)(3).2
Further, as Gulf Copper elected to take the COGS deduction from total revenue, Gulf Copper subtracted additional costs not excluded from revenue as a COGS deduction under Tex. Tax Code Ann. Sec. 171.1012(i).3
Following an audit, the Comptroller disallowed the exclusions from revenue and disallowed some costs that Gulf Copper had subtracted as a COGS deduction. The trial court rendered judgment in favor of Gulf Copper.4
After the Comptroller appealed, the Texas Court of Appeals held that the trial court correctly allowed the exclusion from revenue, and that the Comptroller erroneously limited the costs that Gulf Copper was able to subtract. However, the Court of Appeals also held that the methodology used to determine the COGS subtraction was improper, and therefore, remanded the case to the trial court to correctly calculate the COGS subtraction using the proper method.5
Supreme Court allows revenue exclusion for subcontracting payments
The Supreme Court agreed with the appellate court that the subcontractor payments made by Gulf Copper qualified for the exclusion because the payments were “in connection with” the drilling of oil wells and qualified as “flow-through funds that are mandated by contract.” In addressing the revenue exclusion issue, the Comptroller agreed that the work done by Gulf Copper on the rigs qualified as “services, labor or materials” and that drilling an oil well constituted “construction . . . of improvements on real property.” However, the Comptroller argued that the work done by Gulf Copper was not “in connection” with the drilling of oil wells. While the phrase “in connection with” broadened the work to which the revenue exclusion applies, the Comptroller did not believe the work done on the oil rigs was linked closely enough to the oil wells to meet the “in connection with” requirement.
In rejecting that argument, the Court stated that if Gulf Copper’s subcontractors had worked directly on the oil wells, the exclusion would certainly apply. Since neither the statute nor regulations define the word “connection,” the Court then looked to other subsections within the Texas Franchise Tax statutes to determine the legislative intent of the phrase “in connection with.” Based on this analysis, the Court found that the requisite relationship must be “more than a remote, tangential relationship.” However, the Court disagreed that the labor had to be in either physical, temporal or contractual proximity to the work on the oil wells. The Court found that since Gulf Copper’s work on the oil rigs was a necessary component required for the rigs to dig oil wells, Gulf Copper’s payments to subcontractors were considered to be “in connection with” the oil wells.
The Comptroller further argued that Gulf Copper’s payments were not “mandated by contract,” because such payments were made in Gulf Copper’s contract with its subcontractors, not its customers, and therefore, did not qualify for the exclusion under Tex. Tax Code Ann. Sec. 171.1011(g)(3). Specifically, the Comptroller claimed that Gulf Copper’s contract using the “hourly method” did not meet the requirements of the statute, because it did not specify the amount that would be paid to the subcontractors and the amount that would be kept by Gulf Copper.
The Court disagreed with the Comptroller that only the contract with the customer could mandate the distribution of funds to other entities. The Court found that the statutory language did not distinguish between a contract with a subcontractor versus a contract with the customer. The Court held that since Gulf Copper’s contracts with its subcontractors required payment of a certain amount, the contract with the subcontractor satisfied the statutory language. In addition, the Court also found that the “mandated by contract” language in subsection (g) did not mandate that the “contract” was required to specify the amount of funds to be distributed to the subcontractors. The Court found that both the contract with the customer as well as the contract with the subcontractors combined to satisfy the statutory requirement.
Supreme Court considers applicability of COGS subtraction
Tex. Tax Code Ann. Sec. 171.1012(i)
The Comptroller agreed that certain costs incurred by Gulf Copper, including the parts of the rig required to be replaced in order to prepare the rig for the next project, are includible as COGS. However, the Comptroller disagreed that certain labor costs should be includible. For example, the Comptroller argued that the labor costs associated with painting portions of the rig were not includible in COGS.
The Court noted that while the language in Tex. Tax Code Ann. Sec. 171.1011(g)(3) allowing certain costs as an exclusion from revenue is similar to the language of Tex. Tax Code Ann. Sec. 171.1012(i), the two statutes do differ in relevant respects. As such, the Court’s holding that Gulf Copper was entitled to certain exclusions from revenue did not determine whether Gulf Copper could deduct the disputed costs in determining COGS. The Court agreed with the Comptroller that the language in the COGS deduction was narrower than the language in the revenue exclusion. The COGS deduction only allowed costs for activities typically occurring on-site, while the revenue exclusion could include revenues from “actual or proposed design” that could occur on-site or offsite. Further, the COGS deduction included the words “furnishing to,” which is more restrictive than the term “in connection with” that applied for the revenue exclusion. As a result, the Court held that the labor costs that Gulf Copper had subtracted as COGS could not be property deducted as COGS under this provision.
Gulf Copper had proposed what could be characterized as a “but for” test, arguing that labor and materials should be allowed as a COGS deduction if the actual project could not occur without them. The Court found that there was no basis for such a reading based on the statutory language and noted that such a test could allow just about any labor or materials into the COGS calculation. As such, the Court held that the labor or materials had to be “furnished to or incorporated into the real property itself.”
Tex. Tax Code Ann. Sec. 171.1012(c)-(d)
Gulf Copper also argued that since some of its costs qualified for the COGS subtraction and that because its work on the rigs was part of an integrated project of preparing the rigs to drill wells, all of its costs should be considered deductible. The Court disagreed with this interpretation, and held that the taxpayer was required “to show that each of its costs independently qualified under section 171.1012.” The Court found that the legislature only intended that certain costs would qualify for the COGS subtraction since they enacted a very detailed list of requirements in Tex. Tax Code Ann. Sec. 171.1012(c) and (d), and that “allowable” costs must meet those requirements.
The Court’s ruling that direct costs must be directed to the construction project itself could severely restrict the type of taxpayers that can take COGS as a subtraction for purposes of the Texas Franchise Tax. This restriction was also illustrated in the Sunstate6
decision released on the same day as Gulf Copper
, where the Court disallowed costs associated with delivering and picking up heavy construction equipment used in the improvement of real property. It is likely that if the exploration and production company elected to refurbish the oil rigs themselves, all of the costs that were disallowed by the Court as COGS for Gulf Copper would have been allowed as a COGS subtraction. Texas specifically allows the costs associated with repairing and maintaining equipment, facilities or real property directly used for the production of goods. As such, the Court essentially is determining the types of taxpayers that qualify for the COGS deduction, not just the types of activities that qualify for COGS. Except in limited circumstances, the Texas Tax Code does not restrict the costs that may be included in COGS based on the taxpayer’s activity or industry. In general, where the Texas legislature has specifically referenced a taxpayer’s overall business activity or industry, it has done so in order to expand industries that could avail themselves of the COGS subtraction.
Part of the Court’s rationale for rejecting the “but for” test advocated by both Gulf Copper and Sunstate is that such a test would be “untenable.” The Court does not explain why such a test would be untenable. In contrast, the Court dismissed Gulf Copper’s argument that analyzing a taxpayer’s every cost in determining COGS would be burdensome. The Court felt that the option to multiply total revenue by 70% was an “efficient” alternative. In coming to this conclusion, the Court failed to address two practical concerns. First, for most taxpayers that elect to subtract COGS, the 70% option often results in a far greater tax than COGS. Second, in practice upon audit, the Comptroller does not simply look at each expense to determine whether it qualifies as a COGS subtraction, but parses trial balance accounts even further by using ratios agreed to by the taxpayer and auditor. This can result in similarly situated taxpayers paying different amounts of tax simply because of a difference in the auditor assigned to that particular taxpayer.
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