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Jamie C. Yesnowitz
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The Texas Supreme Court concluded that sales of military jets manufactured for purchase by foreign governments made under the federal Arms Export Control Act should be treated as sales to the foreign governments, and therefore, sourced outside Texas.1
In reversing two lower court decisions, the Texas Supreme Court held that the foreign governments were the purchasers for apportionment purposes, even though federal law required the U.S. government to directly contract with the manufacturer and then separately contract with the foreign governments. Title to the military jets passed to the U.S. government in Texas, but the jets were delivered to the foreign governments outside Texas.
The taxpayer, Lockheed Martin Corporation, manufactures and sells military products. Some of Lockheed's customers are foreign governments, and sales to these customers are regulated under the federal Arms Export Control Act.2
Pursuant to this law, foreign governments may purchase certain less sensitive products directly from a U.S. manufacturer. On the other hand, more sensitive products, including the F-16 fighter jets at issue in this case, are subject to much greater oversight and can only be sold through the Foreign Military Sales (FMS) program.
Under the FMS program, the transaction begins with a request from a foreign government identifying the products or services the government seeks to purchase. The U.S. and foreign governments then enter into a Letter of Offer and Acceptance (LOA) listing the items and services to be sold and the terms and conditions of the sale. The Department of Defense either may fulfill the order from its existing stock, or enter into contracts with private contractors to help fulfill the conditions of the sale. In cases where the U.S. government contracts with private contractors, the LOA will specify the foreign buyer, the precise design specifications requested and the plans for delivery to the buyer. The price is set at the total cost to the U.S. government of procuring the items. The foreign buyer must provide the U.S. government with a “dependable undertaking” to pay the full amount of the contract and make funds available to meet the payments required by the contract. Once the LOA is finalized, the buyer remits the initial payment or assurance of payment. At that point, the U.S. government is responsible for procuring the items by contracting with a private contractor to produce the items requested in the LOA.3
The Fourth Circuit of the U.S. Court of Appeals has described the FMS program as “requir[ing] the intermediation of the United States and a back-to-back contract structure.”4
During the 2005 to 2007 tax years,5
Lockheed manufactured several F-16 fighter jets for sale to several foreign governments at its manufacturing facility in Fort Worth, Texas. As was required, each sale was handled through the FMS program. Two contracts governed each sale: (i) the contract between Lockheed and the U.S. government; and (ii) the LOA between the U.S. government and the foreign government. The contracts between Lockheed and the U.S. government identified the specific buyers and contained the specifications requested by the foreign government.
At the conclusion of the manufacturing process, a representative from the U.S. government inspected the fighter jets in Fort Worth, Texas at Lockheed’s facility once title to the jets transferred from Lockheed to the U.S. government. At that point, Lockheed was able to request payment from the U.S. government, but Lockheed was still required to provide technical assistance and other on-site support until U.S. government pilots flew the jets to the foreign government ultimately purchasing the jets.
Lockheed filed claims for refund based on the removal of gross receipts from its apportionment factor numerator claiming that the sales of the fighter jets did not qualify as Texas receipts. The Comptroller denied the claim, at which point Lockheed brought suit. The trial court, in rendering judgment for the Comptroller, found that the sales of the fighter jets were completed in Texas and Lockheed was not entitled to a refund. The Court of Appeals affirmed the trial court’s decision.6
Supreme Court determines foreign governments purchased the military aircraft
During the tax years at issue, Lockheed paid Texas franchise tax on its “earned surplus” apportioned to Texas. Former Tex. Tax Code Ann. Sec. 171.1032 described the receipts that were required to be included in the numerator of the apportionment fraction.7
Both Lockheed and the Comptroller focused on the identity of the buyer for purposes of determining whether the gross receipts should be included in the Texas apportionment numerator. Lockheed argued that the buyer was the foreign government, and therefore, the sales should not be considered Texas receipts. The Comptroller disagreed and argued that the transaction consisted of two distinct sales: (i) Lockheed’s sale to the U.S. government; and (ii) the U.S. government’s sale to the foreign government. As such, the Comptroller contended the buyer from Lockheed was the U.S. government, and since the sales were completed in Texas, they should be considered Texas receipts.
Lockheed and the Comptroller also disagreed on whether the language of former Tex. Tax Code Sec. 171.1032, which requires sourcing to Texas when “the property is delivered or shipped to a buyer in the state,” denotes a “location of delivery” test or a “location of buyer” test. In other words, does the apportionment of receipts depend on whether delivery occurred in Texas or whether the buyer was in Texas?
In holding that the U.S. government was the buyer, the Court of Appeals relied in part on its decision in Bullock v. Enserch Exploration, Inc.8
, the taxpayer sold natural gas to interstate transmission companies in Texas and delivered the gas to the companies in Texas. The transmission companies transported the gas outside Texas and resold the gas to out-of-state purchasers. The Court held that the taxpayer was not selling gas to out-of-state customers. The taxpayer’s transaction was with the transmission companies, which began and ended in Texas.
The Texas Supreme Court agreed with Lockheed’s characterization that the transaction was a single transaction and effectuated by two interrelated and interdependent contracts. In support of Lockheed’s position, the Court agreed that: (i) the items purchased never entered the U.S. government’s inventory; (ii) the buyers specified that they would like to purchase and remit payment or assurance of payment upfront; and (iii) the U.S. government was statutorily forbidden from recognizing any gain or loss from an FMS sale.
In reaching its decision, the Supreme Court determined that the requirement for the U.S. government to take possession of the goods is a “condition of the sale” that should be disregarded for franchise tax purposes. The Court reasoned that federal law mandates the sale of some military items be accomplished by two contracts in order to allow the U.S. government to act as a required intermediary so that it may retain maximum oversight to preserve the country’s national security interests. As a result, the U.S. government’s involvement is essential to the sale of the goods. Since the sale of the goods could not happen without the U.S. government’s involvement as mandated by federal law, the Court determined that the contract with the U.S. government was a condition of the sale and should not be considered for franchise tax purposes.
The Court distinguished Enserch
and explained that the two-contract structure undertaken by Lockheed and the U.S. government did not fit the “sale for resale” model at issue in Enserch
. Lockheed custom built the jets to the foreign buyer’s specifications, and Lockheed was paid from funds provided by the foreign buyers. In addition, the Court reasoned that the sales factor should reflect the contribution of the market state to the taxpayer’s income. Since the U.S. government was never the “market” for the military products, the Court’s holding was consistent with how it believed receipts should be apportioned.
Military jets ‘delivered’ to buyer outside Texas
The Comptroller also argued that even if the foreign governments were deemed to be the relevant buyers, the jets were still “delivered” in Texas, and therefore, should be included in the numerator of the receipts factor. The Comptroller argued that “in this state” modifies “delivered or shipped” so that the place of delivery controls for apportionment purposes even if the buyer is located outside the state. Lockheed took the opposite position, insisting that the buyer must be located in Texas in order for a sale to be considered a Texas receipt. Ultimately, the Court declined to resolve the issue because the jets were delivered to the foreign governments as buyers outside Texas, requiring sourcing outside Texas.
The dissenting opinion filed by one justice considered the plain language of the statute and noted that it only looks to whether goods were delivered to a “buyer” in the state. The dissent reasoned that the U.S. government was indisputably a “buyer” of the items sold by Lockheed. Furthermore, the dissent opined that the statute does not account for any of the other unique circumstances cited by the majority opinion in concluding that the U.S. government was not a “buyer” for franchise tax purposes.
Interestingly, the Court did not discuss the plain language of the statute, as noted in the dissent. The Court determined that the U.S. government’s role in the transaction should be viewed as a condition of the sale, and therefore, should be disregarded. However, the Court did not explain how its holding can be reconciled with the statute. The statute provides that a receipt should be considered a Texas sale “if the property is delivered or shipped to a buyer in this state regardless
of the FOB or other condition of the sale.”9
The Court took great pains to ensure that it did not reject the holding in Enserch
and similar cases in “sale for resale” situations. Thus, it appears the holding in this case is attributable to the specific requirements of the FMS transactions. Thus, taxpayers entering into “sale for resale” transactions should evaluate whether their fact patterns contain similarly unique conditions. If they do not, it is likely that a court (and the Comptroller) would honor the two-contract structure and require sourcing to the immediate purchaser in the transaction, rather than an ultimate purchaser following resale.
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