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The Texas Supreme Court recently held that a heavy construction equipment rental company may not subtract certain delivery and pick-up costs as a cost of goods sold (COGS) deduction in computing its margin for the Texas Franchise Tax.1
The Court held that the costs did not relate to the “acquisition or production” of the goods.
The taxpayer, Sunstate Equipment Co., LLC, rents out heavy construction and industrial equipment to customers on an “as needed” basis throughout Texas and other states. In approximately 80% of its contracts performed between June 2008 and March 2011, Sunstate delivered to the customer and picked up from the customer the rental equipment based on the length of the rental term. Sunstate included separate delivery and pick-up charges in the rental fees charged. To offer this service, the company purchased and maintained a fleet of delivery vehicles, hired employees for delivery and pick-ups, and maintained facilities to store the delivery vehicles. Sunstate also incurred labor costs, vehicle depreciation, property tax and insurance costs on the vehicles and related property, along with fuel and maintenance expenses for its fleet.
For purposes of the Texas Franchise Tax, Sunstate reported these costs as COGS deductible from total revenue for its 2008 and 2009 taxable years. The Texas Comptroller disallowed the delivery and pick-up costs in the COGS deduction, and recategorized some of these costs as indirect or administrative costs, resulting in an approximately $140,000 assessment. After Sunstate paid the assessment under protest and sued for a refund, the trial court granted summary judgment in favor of Sunstate.2
The Court of Appeals reversed the trial court and ruled in favor of the Comptroller,3
which decision Sunstate appealed to the Texas Supreme Court.
At the Texas Supreme Court, Sunstate argued that it could subtract the costs in question under several provisions of Tex. Tax Code Ann. Sec. 171.1012. Tex. Tax Code Ann. Sec. 171.1012(k-1) extends to renters of heavy equipment the same COGS deductions available to retailers of the identical equipment. Tex. Tax Code Ann. Sec. 171.1012(c) and (d) specifically identify costs allowable as COGS when acquiring or producing goods. Finally, per Sunstate’s interpretation, Tex. Tax Code Ann. Sec. 171.1012(i) allowed entities that provide labor or materials to a project “for the construction, improvement, remodelling, repair or industrial maintenance of real property” to be considered as owning the labor and materials and include such costs as COGS as allowed by Tex. Tax Code Ann. Sec. 171.1012.
The Court agreed that while Sunstate qualified for a COGS subtraction under Tex. Tax Code Ann. Sec. 171.1012(k-1) as a heavy construction equipment rental or leasing company, with the “goods” being sold the equipment that it rents to its customers, the subsection limits the subtractions to COGS as determined in other parts of Tex. Tax Code Ann. Sec. 171.1012. Specifically, the Court determined that subsection (k-1) specifies only what types of entities are entitled to the COGS subtraction and not what types of costs are included in the calculation.
The Court then closely examined the requirement for a cost to be included in COGS. In the stipulated facts, Sunstate agreed that its costs arose out of contracts to deliver equipment to and pick up equipment from the construction sites. The Court determined that in order to qualify as includible direct costs, the costs must be “direct costs of acquiring or producing the goods.”4
The Court highlighted how the statutes carefully distinguish between inbound transportation costs, included in COGS, from outbound transportation costs which are excluded. Similarly, handling costs are included in COGS, while rehandling costs are excluded.5
The Court relied on the dictionary definitions of the words “acquiring” and “rehandle” as the statutes or regulations did not define these terms. Using these definitions, the Court determined that the statutes removed the possibility of subtracting costs for acquiring the same goods repeatedly. As a result, the Court concluded that the costs incurred to repeatedly pick up the heavy machinery from the constructions sites could not be deducted in calculating COGS. The statutes defined “production” to include “construction, installation, manufacture, development, mining, extraction, improvement, creation, raising or growth.”6
Since delivery is not considered a form of production, the Court concluded that Sunstate did not incur costs from the initial acquisition or production of the equipment, and so the costs could not be considered direct costs for purposes of the COGS deduction.
Denied direct cost treatment, Sunstate claimed that insurance costs associated with delivery and pick-up should be considered an indirect but related cost includible in COGS under Tex. Tax Code Ann. Sec. 171.1012(d)(6). The Court also rejected this argument, as this indirect cost was not incurred on property (the vehicles and employees operating the delivery trucks) that was “directly used in the production of the goods.” Likewise, the Court concluded that Sunstate’s costs could not be considered administrative overhead costs eligible for a partial deduction under COGS7
because the costs were for the specific purpose of delivering and picking up the rental equipment, instead of acquiring or producing the equipment.
As a final attempt to capture the pick-up and delivery costs within the COGS calculation, Sunstate contended that even if Tex. Tax Code Ann. Sec. 171.1012(k-1) did not authorize it to subtract the costs associated with delivery and pick up of equipment, Tex. Tax Code Ann. Sec. 171.1012(i) provided an independent authorization to subtract the costs. Sunstate proposed what could be characterized as a “but for” test, arguing that the labor used to provide the equipment qualified under this subsection as “an essential and direct component” of the customer’s construction projects, which could not occur without the equipment. Tex. Tax Code Ann. Sec. 171.1012(i) requires an entity to furnish labor or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property. Sunstate contended that it delivered its equipment to the customers’ job sites and picked the equipment up afterward, essentially furnishing labor to the customers’ projects. The Court rejected this analysis, noting that such a reading of the statute would allow practically all labor or materials to be deducted. The Court concluded that while Sunstate furnished labor, it did so to fulfill its contractual obligation to provide the equipment to its customers, not as a part of the customers’ projects.
The Court’s ruling has the potential to severely restrict the eligible COGS deductions available to renters of heavy construction equipment. While the question before the Court was specifically whether costs associated with the delivery and pick-up of the construction equipment could be deducted as COGS, the Court’s rationale for denying these costs could affect other costs incurred by taxpayers in this industry.
In general, the Court held that many of the costs incurred in the pick-up or delivery of equipment should be disallowed since the taxpayer is “rehandling” equipment. This could also mean that any costs incurred by this type of taxpayer in between rental jobs, like costs and labor associated with the repair and maintenance of such equipment, could be excluded as rehandling costs as well. Such a broad reading of a word that the Texas legislature left undefined in the Texas Tax Code could render the inclusion of Tex. Tax Code Ann. Sec. 171.1012(k-1) almost meaningless.
On a related note, the Court reasoned that delivery costs should be excluded from COGS under the plain wording of Tex. Tax Code Ann. Sec. 171.1012(e). On its face, this reasoning would seem to make sense. However, since the Court reasoned that because the pick-up costs should be interpreted to fit under the definition of rehandling, the Court concluded that acquisition costs as they relate to this type of taxpayer, can only mean the initial acquisition of the equipment. If that is the case, the question arises as to how a business that can only acquire equipment once, can handle that same equipment once and distribute the same equipment multiple times. Common sense would seem to dictate that one cannot distribute a piece of equipment multiple times, if it can only be acquired once. In the same vein, it would be difficult to rehandle a piece of equipment that was only acquired once.
The Court also failed to address why a taxpayer must include rental revenue for each instance in which a piece of equipment is rented in the computation of its taxable margin while simultaneously disallowing the related costs for each subsequent rental. This type of imbalance in reporting revenue from each rental but not being allowed to take the costs associated with each rental would seem to be the driving force explaining why the Texas legislature chose to include Tex. Tax Code Ann. Sec. 171.1012(k-1).
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