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The Texas Supreme Court recently issued its opinion in Hegar v. American Multi-Cinema, Inc.
holding that a movie theater was not entitled to take a cost of goods sold (COGS) deduction in computing its margin for the Texas Franchise Tax. In reversing the Texas Court of Appeals for the Third Appellate District’s substitute opinion,2
the Court concluded that film exhibitions do not constitute “tangible personal property sold in the ordinary course of business” eligible for the COGS deduction.
Procedural history and background
American Multi-Cinema, Inc. (AMC), 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 Texas Franchise Tax reports. AMC claimed a COGS deduction consisting 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, and AMC paid the assessment under protest.
the district court held that AMC’s product amounted to a “good” to which the COGS deduction could apply, but limited the deduction to the square footage associated with the speakers and screen. The Comptroller appealed the ruling that AMC provided a “good,” and AMC appealed the limitation of the deduction to the square footage of the screen and speakers.
On appeal, the Texas Court of Appeals originally held that the film product was a “good” consisting of “tangible personal property” for purposes of the COGS deduction and that AMC could deduct all of the costs associated with acquiring or producing this good, including auditorium costs. However, the Court of Appeals later issued a substitute opinion and judgment to replace its prior opinion. In doing so, the Court of Appeals retained AMC’s right to an expansive COGS deduction, but retreated from its conception that the term “tangible personal property” should be defined for the purpose of COGS as “property that can be seen, weighed, measured, felt, or touched or that is perceivable to the senses in any other matter.” Rather, the Court of Appeals applied a more limited industry-specific definition for media companies, including theaters.4
At the same time, the substitute opinion expanded AMC’s COGS deduction to include costs associated with its film product.5
Texas Supreme Court requires mass-distribution medium for ‘film prong’
The Texas Supreme Court’s analysis focused on the two substantive parts of the definition of tangible personal property in Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A). The first part of the definition defines the term as personal property perceptible to the senses (the “perceptibility prong”).6
The second part of the definition is far more industry-specific, applying to films and like creative content in a medium intended or reasonable likely to be mass distributed (the “film prong”).7
The Court of Appeals’ substitute opinion had accepted AMC’s argument that the exhibition of films through speakers and screens in its auditoriums created film product or creative content that met the film prong.
At the Texas Supreme Court, AMC argued that its costs of film exhibition qualified as COGS under the film prong, as well as under Tex. Tax Code Ann. Sec. 171.1012(o), applicable to film producers and distributors of tangible personal property as defined by the film prong.8
The Comptroller argued for a reversal of the Court of Appeals’ substitute opinion on the grounds that AMC does not sell “tangible personal property” when it exhibits films to customers and that the Court of Appeals erred by considering Tex. Tax Code Ann. Sec. 171.1012(t), as added in 2013, as a “clarification of law” to Subsection (o).9
The Court considered primarily whether AMC’s “creative content” was actually being “sold” as the relevant law defines “goods” as “tangible personal property sold in the ordinary course of business.”10
The relevant Tax Code statute does not define “sold,” and the parties disagreed as to whether “a more limited, or precise definition is apparent from the term’s use in the context of the statute.”11
The Comptroller argued that the plain and ordinary meaning of the term “sold,” which requires some transfer of property or title or an exchange for value, should apply. AMC pointed to Tex. Tax Code Ann. Sec. 171.1012(o) as providing a more precise meaning to the term “sold,” specifically arguing that mere “distribution” as described in this provision created a sale under the film prong.
The Court ruled that the terms “production” and “distribution” in Tex. Tax Code Ann. Sec. 171.1012(o) should be given more precise industry-specific definitions due to the “difference in context” of this subsection rather than the meaning of “production” in Tex. Tax Code Ann. Sec. 171.1012(a)(2).12
With more precise definitions applied to both terms “as understood in the film industry,” the Court ruled that AMC did not qualify as a “producer” or “distributor” in the context of the film industry, but rather an “exhibitor.” Therefore, the Court ruled that Tex. Tax Code Ann. Sec. 171.1012(o) did not apply to AMC, and could not be used to determine whether AMC distributed “tangible personal property” and ruled that the mere “distribution” of creative content was insufficient to constitute a sale of tangible personal property. The Court also concluded that changes made to Tex. Tax Code Ann. Sec. 171.1012(t), which clarified Tex. Tax Code Ann. Sec. 171.1012(o), were not retroactive to this case.13
With both Tex. Tax Code Ann. Sec. 171.1012(o) and (t) being ruled inapplicable, the Court looked to the plain and ordinary definition of “sold.” The film prong required that the “medium in which the property is embodied” to be intended or reasonably likely to be mass-distributed.14
The Comptroller argued that AMC’s film exhibitions are a service and did not transfer or mass-distribute any medium embodying the film’s creative content. AMC argued that when read in context, the film prong gave no regard to the “medium” in which the creative content was embodied.
The Court concluded the requirement that “tangible personal property” be “owned” and “sold” was still in effect, despite the language in the “film prong” that may have implied otherwise. AMC consistently represented that the “medium” embodying exhibited films was its auditorium’s speakers and screen; this argument was especially relevant in the Court of Appeals’ opinions addressing the auditorium square footage used for “production” for refund determination. The “medium” in which content is shared, including the speakers, screens, sights and sounds was not owned by AMC, and not intended to be mass-distributed, despite meeting the perceptibility prong. The Court’s opinion found that no “tangible personal property” was “transferred,” under the plain and ordinary meaning of “sold,” and therefore AMC’s film exhibitions could not be considered “goods” eligible for the COGS deduction.
While American Multi-Cinema
concerns a movie theater business, the Court’s decision represents success for the Comptroller in the further narrowing of the “tangible personal property” definition applicable to the COGS deduction. The Court did not directly address the perceptibility prong in Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A)(i), seemingly further reducing its relevancy to this case. The lower Court’s reliance on the perceptibility prong drew consternation from the Comptroller as other perceived “service providers” or sellers of intangible property may have qualified for the COGS deduction under the Court of Appeals’ ruling that film exhibition constituted a sale of tangible personal property.
The Court addressed the film prong, but further narrowed its applicability, finding that while the films themselves are tangible personal property, the “medium” in which the films themselves are embodied is not intended or reasonably likely to be mass-distributed for the “creative content” to be considered tangible personal property. In a footnote, the Court confirmed its disagreement with AMC’s contention that distribution of the content alone, without actual transfer of property with physical or demonstrable presence, satisfied the film prong. The same footnote further addressed “digital forms of media,” but the Court was silent on whether these digital forms of media (such as e-books or DVDs) constituted tangible personal property that is sold. The Court did opine that “some medium is transferred to the consumer in these scenarios,” drawing a dichotomy to film exhibitions which are not transferred to the customer in a tangible form. As technological growth further shifts the economy to digital platforms, the Court may be called upon again to address what constitutes “tangible personal property” for the COGS deduction.
Contrary to prior opinions, the Court keyed in on the definition of “goods” under Tex. Tax Code Ann. Sec. 171.1012(a)(1), and specifically looked to the “sold” requirement. Further, the Court relied on the plain and ordinary meaning of sold as “transferred,” denying AMC’s argument to define “sold” by the more precise definition of “distribution of tangible personal property described by [the film prong]” set forth in Tex. Tax Code Ann. Sec. 171.1012(o). The Court’s determination that Tex. Tax Code Ann. Sec. 171.1012(o) was inapplicable to AMC, as their “principal business activity” was not “production” or “distribution” per film industry standards, relied on the more precise definitions of this specific subsection. While the Court ruled that the surrounding context must be considered when determining the legislative intent for a term’s definition, the surrounding context was seemingly limited to each specific subsection of this statute.
The Court did not address the requirement in Tex. Tax Code Ann. Sec. 171.1012(i) that a taxable entity “may make a subtraction . . . only if that entity owns the goods.” The Court declined to address ownership of the goods, stating “we need only address the first [requirement]” of “sold” as the Court determined that AMC did not meet the “sold” requirement, deeming ownership under Subsection (i) unnecessary to its analysis. In this case, AMC did not dispute that it did not “own” the films used to develop its “creative content” as the facts provide that AMC rents and later returns the films.
The Court’s simultaneously issued opinions in Gulf Copper
and Sunstate specifically rely on Tex. Tax Code Ann. Sec. 171.1012(e)(3) to exclude the “distribution costs” and “outbound transportation costs” of both COGS taxpayers. While not mentioned in this opinion, AMC’s film exhibition costs would also presumably be disqualified from the COGS deduction as “distribution costs” if not for the existence of the “film prong.”
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