Glenn Hegar, Comptroller of Public Accounts of the State of Texas And Ken Paxton, Attorney General of the State of Texas v. Gulf Copper and Manufacturing Corporation ( 2017 )

FILED
17-0894
12/20/2017 1:53 PM
tex-21414862
SUPREME COURT OF TEXAS
BLAKE A. HAWTHORNE, CLERK
No. 17-0894
IN THE SUPREME COURT OF TEXAS
_________________________________________________________________
Glenn Hegar, Comptroller of Public Accounts of the State of
Texas and Ken Paxton, Attorney General of the State of Texas,
Petitioners,
v.
Gulf Copper and Manufacturing Corporation,
Respondent.
_________________________________________________________________
On Petition for Review
from the Third Court of Appeals at Austin, Texas
Appeal No. 03-16-00250-CV
_________________________________________________________________
Petition for Review
_________________________________________________________________
KEN PAXTON JACK HOHENGARTEN
Attorney General of Texas Tax Division Chief
State Bar No. 09812200
JEFF MATEER Tax Division
First Assistant Attorney General P.O. Box 12548; MC-029
Austin, Texas 78711-2548
BRANTLEY STARR TEL: (512) 475-3503
Deputy First Assistant Attorney FAX: (512) 478-4013
General
Counsel for Petitioners
JAMES E. DAVIS
Deputy Attorney General for Civil
Litigation
IDENTITY OF PARTIES AND COUNSEL
Petitioner:
Glenn Hegar, Comptroller of Public Accounts of the State of Texas
Ken Paxton, Attorney General for the State of Texas
Counsel for Petitioners
JACK HOHENGARTEN
Tax Division, Division Chief
Office of the Attorney General
State Bar No. 09812200
Tax Division MC 029
PO Box 12548
Austin, Texas 78711-2548
Tel: (512) 475-3503
Fax: (512) 478-4013
Jack.hohengarten@oag.texas.gov
Appellate Counsel
CHARLES K. ELDRED
Assistant Attorney General, Tax Division
State Bar No. 00793681
Office of the Attorney General
P.O. Box 12548 (MC 029)
Austin, Texas 78711-2548
Tel: (512) 475-1743
Fax: (512) 478-4013
charles.eldred@oag.texas.gov
Appellate and Trial Counsel
Respondents
Gulf Copper and Manufacturing Corporation
Page ii
Counsel for Respondents
James F. Martens
State Bar No. 13050720
jmartens@textaxlaw.com
Danielle Ahlrich
State Bar No. 24059215
dahlrich@textaxlaw.com
MARTENS, TODD, LEONARD & AHLRICH
301 Congress Ave., Suite 1950
Austin, Texas 78701
Tel: (512) 542-9898
Appellate and Trial Counsel
and
Amanda Taylor
BECK REDDEN, PLLC
ataylor@beckredden.com
State Bar No. 24045921
515 Congress Ave., Suite 1900
Austin, Texas 78701
Tel: (512) 708-1000
Appellate and Trial Counsel
Page iii
TABLE OF CONTENTS
Identity of Parties and Counsel ................................................................ii
Table of Contents ..................................................................................... iv
Index of Authorities.................................................................................. vi
Record References ..................................................................................viii
Statement of the Case ............................................................................viii
Statement of Jurisdiction .......................................................................... x
Issues Presented...................................................................................... xii
Statement of Facts .................................................................................... 1
Summary of the Argument ....................................................................... 5
Argument ................................................................................................... 7
I. Gulf Copper’s costs in repairing and outfitting drilling rigs,
and Sabine Surveyors’ costs in surveying marine vessels,
were not deductible as costs-of-goods sold. ................................... 7
A. Background: Tax Code section 171.1012. .................................... 7
B. There was no evidence of section 171.1012(i) costs to
support a remand. ........................................................................ 9
C. The court of appeals’ decision regarding section
171.1012(i) also defeats other key provisions in the
cost-of-goods-sold statute............................................................ 14
II. Gulf Copper cannot exclude the contested subcontractor
payments from revenue under Tax Code §171.1011(g)(3). ......... 16
A. Background: Section 171.1011(g)(3)............................................ 16
B. There is no evidence that the subcontract work constituted
“services, labor, or materials in connection with the actual
or proposed design, construction, remodeling, or repair of
improvements on real property”................................................. 18
Page iv
C. There is no evidence that the subcontractor payments
constituted “flow-through funds that are mandated by contract
to be distributed to other entities.” ............................................ 21
Prayer ...................................................................................................... 25
Certificate of Compliance ........................................................................ 26
Certificate of Service ............................................................................... 26
Appendix .................................................................................................. 27
Appendix Table of Contents .................................................................... 28
Page v
INDEX OF AUTHORITIES
Cases
Combs v. Newpark Resources, Inc.,
422 S.W.3d 46 (Tex. App.—Austin 2013, no pet.) ......................... 12, 13
Owens Corning v. Hegar,
04-16-00211-CV, 2017 WL 1244444, at *3 (Tex. App.—San Antonio
Apr. 5, 2017, pet. denied) ..................................................................... 24
Sheshunoff v. Sheshunoff,
172 S.W.3d 686 (Tex. App.—Austin 2005, pet. denied) ...................... 10
Titan Transp. LP v. Combs,
433 S.W.3d 627 (Tex. App.—Austin 2014, pet. denied) .......... 18, 19, 24
Statutes
Tex. Gov't Code § 311.011(a) ............................................................. 12, 23
Tex. Gov't Code § 22.001(a) ...................................................................... ix
Tex. Prop. Code § 53.023 ......................................................................... 10
Tex. Prop. Code § 53.001(3) & (4) ........................................................... 10
Tex. Prop. Code § 53.001(4)(B) ................................................................ 11
Tex. Prop. Code § 53.021 ......................................................................... 10
Tex. Prop. Code § 56.001(1) ..................................................................... 11
Tex. Tax Code §171.1011(i) ..................................................................... 16
Tex. Tax Code § 171.1011(g)(3) ....................................................... passim
Tex. Tax Code § 171.1012................................................................ passim
Tex. Tax Code § 171.1012(a)(3)(B)(ii) and (c)(1) ....................................... 5
Tex. Tax Code § 171.1012(a)(3)(B)(ii) ............................................. 5, 8, 14
Tex. Tax Code § 171.1012(c).................................................................. 4, 6
Tex. Tax Code § 171.1012(h) ................................................................... 11
Page vi
Tex. Tax Code § 171.1012(i) ............................................................ passim
Tex. Tax Code § 171.1012(a)(1) and (c) ..................................................... 8
Tex. Tax Code § 171.1012(c), (d), (f) ...................................................... 4, 6
Rules
34 TAC § 3.588 ........................................................................................ 10
Other Authorities
79th Leg., 3d C.S., ch.1, § 5, 2006 Tex. Gen. Laws 1, 10
(amended 2013) .................................................................................... 17
Act of May 2, 2006, 79th Leg., 3rd C.S., ch. 1, § 5, 2006 Tex. Gen. Laws
1, 8 (former Tex. Tax Code § 171.101(a)), current version at Tex. Tax
Code § 171.101(a)(1)............................................................................... x
42. Tex. Reg. 5235-36 (Sept. 29, 2017) .................................................... 10
Page vii
RECORD REFERENCES
References to the Clerk’s Record are in the form “CR.[Page#]”
References to the Reporter’s Record are in the form
“[Volume#].RR.[Page#]”
References to Plaintiff’s Exhibits are in the form “PX[Exhibit#]”
References to Defendants’ Exhibits are in the form “DX[Exhibit#]”
References to items in the Appendix are in the form “App.[Appendix#]”
STATEMENT OF THE CASE
Nature of the case: Franchise tax protest suit under Chapters
112 and 171 of the Texas Tax Code.
Course of Proceedings: Lawsuit filed November 4, 2014. CR.3.
Bench Trial February 1–2, 2016. Judgment
entered
February 22, 2016. CR 294–95 [App.1].
Notice of Appeal filed April 13, 2016. CR
302–03.
Trial Court : 201st District Court, Travis County, Texas
The Honorable Amy Clark Meachum.
Disposition: Judgment for Plaintiff/Appellee.
Plaintiff/Appellee entitled to refund of
$838,117.84 plus statutory interest.
Parties to the appeal: Appellants:
Glenn Hegar, Comptroller of Public
Accounts of the State of Texas, and Ken
Paxton, Attorney General for the State of
Texas
Page viii
Appellee:
Gulf Copper and Manufacturing
Corporation
Court of appeals: Third Judicial District of Texas at Austin
Justices who Chief Justice Rose,
participated: Justices Field and Bourland
Citation: Hegar v. Gulf Copper and Manufacturing
Corporation, No. 03-16-0250-CV, 2017 WL
3471064 (Tex. App.—Austin Aug. 11, 2017)
(herein, “Opinion at __.”) [App. C]
Disposition: The Third Court of Appeals, opinion by
Justice Field, affirmed in part and
reversed and remanded in part to 201st
Judicial District Court, Travis County,
Texas, for further proceedings. Motion for
Rehearing denied September 21, 2017.
Page ix
STATEMENT OF JURISDICTION
This Court has jurisdiction under Texas Government Code section
22.001(a) because the case presents issues important to the
jurisprudence of the state, specifically important issues of statutory
interpretation that impact state revenue.
Although Gulf Copper can deduct the contested amounts on its
federal corporate income tax return or its financial statements, not all
legitimate business expenses are deductible for margin tax purposes. By
restricting margin tax deductions and thereby expanding the tax base,
the Legislature was able to reduce the tax rate from 4.5 percent under
the former earned surplus tax to one percent or less under the margin
tax. See, Act of May 2, 2006, 79th Leg., 3rd C.S., ch. 1, § 5, 2006 Tex. Gen.
Laws 1, 8 (former Tex. Tax Code § 171.101(a)), current version at Tex.
Tax Code § 171.101(a)(1).
If, however, the balance between the low margin tax rate and the
limited deductions is disrupted, there could be a significant revenue
impact to the State of Texas. Accordingly, this Court should give
serious consideration to the implications of the Opinion below, which
Page x
allows service providers to take the cost-of-goods-sold deduction when
they are not selling goods, and further, allows taxpayers to exclude
revenues from margin merely because they are paying expenses owed
under a contract.
Page xi
ISSUES PRESENTED
1. Do the services performed by Gulf Copper or its subsidiary
constitute “furnishing labor or materials to a project for the
construction, improvement, remodeling, repair, or industrial
maintenance ... of real property” such that Gulf Copper may
deduct under Tax Code section171.1012(i) its costs of:
a. Repairing or upgrading drilling rigs at Gulf Copper’s
waterfront facilities, before the commencement of offshore
drilling; or
b. Surveying marine vessels, including drilling rigs at Gulf
Copper’s waterfront facilities?
2. May Gulf Copper exclude from its total revenue, under Tax Code
section 171.1011(g)(3), hourly payments made to subcontractors?
This question turns on:
a. Whether payments were “made under a contract . . . to
provide services, labor, or materials in connection with the
actual or proposed design, construction, remodeling, or repair
of improvements on real property,” when the subcontractor
payments were for work repairing or upgrading drilling rigs
at Gulf Copper’s waterfront facilities, before the
commencement of offshore drilling.
b. Whether payments Gulf Copper made to subcontractors are
“flow-through funds that are mandated by contract to be
distributed to other entities,” when Gulf Copper was not
required by contract to use customer payments to pay
subcontractors.
3. [Unbriefed] Gulf Copper had the burden of proof on its cost-of-
good-sold claim. Where Gulf Copper put on no evidence of
allowable costs according with section 171.1012 or controverting
the Comptroller’s cost-by-cost analysis—relying instead on an
erroneous legal argument—did the court of appeals err in
remanding the case for a new trial on Gulf Copper’s cost-of-
goods-sold claim?
Page xii
STATEMENT OF FACTS
The margin tax dispute.
The court of appeals correctly stated the nature of the case as a suit
“seeking a refund of franchise taxes that Gulf Copper paid under protest.”
Specifically, this franchise or “margin” tax case involves a dispute over
(1) the amounts Gulf Copper may deduct as cost of goods sold, and (2) the
amounts that it may exclude from its revenues.
Gulf Copper’s business.
The trial court made the following findings of fact regarding Gulf
Copper’s business. Gulf Copper is primarily engaged in the business of
surveying, manufacturing, upgrading, and repairing offshore drilling
rigs. CR. 296-97[App. B] (Finding of Fact 10). 1 Gulf Copper repairs rigs
0F
by removing defective portions, manufacturing replacement components,
and installing the replacement components onto the rigs. Gulf Copper
also manufactures and installs new components for rigs that do not
1 Although Gulf Copper manufactures components for the rigs, it is undisputed
that it does not own, manufacture or sell the rigs themselves. 3.RR.39–40; see
also Opinion at *4-5.
Page 1
replace an existing component. Finding of Fact 12.
Gulf Copper’s customers are primarily rig owners and drilling
contractors who use their offshore rigs to drill for oil and gas on behalf
of exploration and production (“E&P”) companies. Finding of Fact 9.
Gulf Copper’s work enables the rigs (1) to meet and maintain the
certification requirements by classification societies, (2) to comply
with governing regulations, and (3) to satisfy an E&P company’s
contractual requirement for a specific drilling project. Finding of Fact
16.
Gulf Copper owns all of the outstanding shares of a subsidiary
named Sabine Surveyors. Finding of Fact 1. Sabine Surveyors is a
limited partnership primarily engaged in the business of marine vessel
surveying. Finding of Fact 2. For franchise tax report year 2009 (the
accounting period of May 1, 2007 to April 30, 2008), Gulf Copper, Sabine
Surveyors, and others (hereinafter collectively referred to as “Gulf
Copper”) joined in the filing of combined franchise tax report. Finding of
Fact 7.
With regard to the exclusions from revenue, the trial court made
Page 2
these additional findings of fact. Gulf Copper performs its work using
both employees and subcontractors. Finding of Fact 22. Gulf Copper’s
customers often approve or require Gulf Copper’s use of certain
subcontractors to complete the work... Finding of Fact 23.
Gulf Copper charges its customers for subcontractor work using a
formula that is based upon Gulf Copper’s actual cost of the
subcontractor(s) plus a mark-up. Regardless of how the subcontractor is
billed, Gulf Copper’s resulting mark-up to the customer is generally
between 15-20 percent. Finding of Fact 24. When Gulf Copper’s
customers pay Gulf Copper for work performed by subcontractors, Gulf
Copper retains the portion of the payment attributable to its mark-up
(generally between 15- 20 percent) and flows through the remainder of
the customer’s payment to the subcontractor. Finding of Fact 25. The
subcontractor payments flow from Gulf Copper’s customer, through Gulf
Copper, to Gulf Copper's subcontractors who performed the work for the
customer. Finding of Fact 26.
Page 3
Finally, it is undisputed that “[t]he drilling rigs are delivered to
Gulf Copper’s facility where Gulf Copper performs the work…” Opinion
at * 4.
The Comptroller’s audit.
The Comptroller audited Gulf Copper and assessed additional
franchise taxes in the amount of $692,626.66 (plus interest, for a then
current total of $838,117.84). The two major adjustments were to: (1) the
cost-of-goods-sold deduction and; (2) the exclusion from revenue of
subcontractor payments.
The Comptroller allowed the cost-of-goods-sold deduction for labor
costs incurred in the production or “fabrication” of rig components and
parts installed on the rigs (and thus “sold” to the rig owners), plus other
costs specifically allowable under the statute. See Opinion at * 3; see also
Tex. Tax Code § 171.1012(c), (d), (f). But the Comptroller disallowed, as
non-deductible “services,” Gulf Copper’s labor costs incurred in installing
components, removing defective components, painting, welding, fixing
cranes, sandblasting, and coating—because none of those labor costs
were shown to be costs of acquiring or producing “goods” for sale. See id.
Page 4
§ 171.1012(a)(3)(B)(ii) and (c)(1); CR. 297 (Findings of Fact 10, 12, 13
[App. B]; 2.RR.131-32, 188, 192.
The Comptroller auditor also disallowed Sabine Surveyors’ costs in
his calculation of Gulf Copper’s cost-of-goods-sold deduction—because
surveying is a service and the costs of surveying are not costs of acquiring
or producing “goods” for sale. 5.RR.11–15.
As to the second audit issue, the Comptroller auditor determined
that the $79,405,230 in payments to subcontractors did not meet the
statutory requirements for the exclusion from revenue, and should be
considered instead in the calculation of Gulf Copper’s cost-of-goods-sold
deduction.
Gulf Copper paid the assessment under protest, and these two
adjustments are the principal issues in this Petition for Review.
SUMMARY OF THE ARGUMENT
Cost-of-goods-sold deduction
There is no evidence in the record to support the contested
deductions. Gulf Copper does not own or sell drilling rigs – it repairs
and outfits them at its waterfront facility. The repair and outfitting of
Page 5
drilling rigs is not the sale of “goods.” Therefore, Gulf Copper’s costs in
repairing and outfitting the rigs are not deductible as costs of acquiring
or producing “goods” under Tax Code § 171.1012(c), (d), or (f).
Furthermore, in performing rig work at its waterfront facility, Gulf
Copper is not “furnishing labor or materials to a project for the
construction, improvement, remodeling, repair, or industrial
maintenance . . . of real property. . .” Rather, it is providing repair and
outfitting services to the owner of equipment, who in turn, contracts with
the E&P company to provide that equipment for offshore drilling. This
indirect relationship does not qualify Gulf Copper for the cost-of-goods-
sold deduction under Tax Code § 171.1012(i). Gulf Copper’s rig work adds
value to the rigs, but it does not add value to any real-property project.
Gulf Copper’s affiliate, Sabine Surveyors, does not own or sell goods
either. And similarly, Sabine Surveyors is not by virtue of its surveying
services, furnishing labor or materials “to a project for the construction,
improvement, remodeling, repair, or industrial maintenance ... of real
property,” so as to qualify for the cost-of-goods-sold deduction under Tax
Code § 171.1012(i).
Page 6
Revenue exclusion for subcontractor payments
With regard to the flow-through exclusion from revenue, the
payment of subcontractors for rig repair, before the commencement of
drilling, does not constitute evidence of payment for “services, labor, or
materials in connection with the actual or proposed design, construction,
remodeling, or repair of improvements on real property” under Texas Tax
Code §171.1011(g)(3).
Furthermore, the flow-through exclusion is proper only where the
taxpayer is contractually obligated to pay its subcontractors from or
based on payments that it has received from other parties, and, here,
there is no such contract in evidence.
ARGUMENT
I. Gulf Copper’s costs in repairing and outfitting drilling rigs,
and Sabine Surveyors’ costs in surveying marine vessels,
were not deductible as costs-of-goods sold.
A. Background: Tax Code section 171.1012.
Gulf Copper determined its “margin” by deducting cost of goods sold
from total revenue. Opinion at *3. The cost-of-goods-sold deduction is
governed by Tax Code section 171.1012, which permits a business to
Page 7
subtract “all direct costs of acquiring or producing the goods.” Tex. Tax
Code § 171.1012(a)(1) and (c).
“Goods” means “real or tangible personal property sold in the
ordinary course of business of a taxable entity.” Id. The definition of
“tangible personal property” expressly excludes “services.” Id.
§ 171.1012(a)(3)(B)(ii)). Thus, sellers of services are not ordinarily
eligible for the cost-of-goods-sold deduction.
To take a deduction under the cost-of-goods-sold statute, the entity
must own the “goods” that it sells. Id. § 171.1012(i). Gulf Copper did not
own the drilling rigs that it repaired and outfitted, and Sabine Surveyors
did not own the marine vessels that it surveyed. The third sentence of
subsection (i), however, allows certain service providers to subtract their
costs from revenue as cost-of-goods-sold by “considering” them to be
owners of their labor and materials:
A taxable entity furnishing labor or materials to a project for
the construction, improvement, remodeling, repair, or
industrial maintenance ... of real property is considered to be
an owner of that labor or materials and may include the
costs, as allowed by this section, in the computation of cost of
goods sold.
Page 8
B. There was no evidence of section 171.1012(i) costs to
support a remand.
Because there was no evidence supporting application of the
subsection (i)’s third sentence, the court of appeals erred when it
concluded that:
Gulf Copper presented evidence at trial that, to some extent,
Gulf Copper’s employees provided labor and materials to
projects for improvement of real property (drilling oil wells).
The Comptroller was obligated to consider to what extent the
activities of Gulf Copper’s employees were essential and
direct components of those specific projects.
Opinion at *14.
Similarly, the court erred when it concluded that “Sabine
Surveyors’ costs should have been analyzed on a cost-by-cost basis to
determine which of those costs met the requirement that they be integral,
essential, and direct components of the offshore drilling process.” Id.
Remand is inappropriate here, because Gulf Copper and its
subsidiary’s services do not constitute “furnishing labor and materials to
a project for the construction, improvement, remodeling, repair, or
industrial maintenance ... of real property. . .” Thus, their services do
not qualify for the cost-of-goods-sold deduction under subsection (i). Tex.
Tax. Code § 171.1012(i).
Page 9
Subsection (i)’s phrase “furnishing labor or materials” is nearly
identical to the Property Code phrase “furnishes labor or materials.” See
Tex. Prop. Code § 53.021 (“Persons Entitled to Lien”). Therefore, it is
reasonable to assume that the Legislature intended substantially similar
meanings. See, e.g., Sheshunoff v. Sheshunoff, 172 S.W.3d 686, 692
(Tex. App.—Austin 2005, pet. denied) (“When the same or a similar term
is used in the same connection in different statutes, the term will be
given the same meaning in one as in the other, unless there is something
to indicate that a different meaning was intended.”)
The Property Code provides that a person who “furnishes labor or
materials” for the construction, repair, or demolition of a real property
improvement may establish a lien on the real property to secure payment
for the labor done or material furnished. See Tex. Prop. Code §§ 53.021
and 53.023 (“Payment Secured by Lien.”). The definitions limit “labor”
and “materials” to those used in the “direct prosecution” of the work. Id.
at § 53.001(3) & (4). 2
1F
2 The Comptroller has proposed rules amending 34 TAC § 3.588, which
would use the Property Code definitions to define “labor” and “materials”
in section 171.1012(i). See 42. Tex. Reg. 5235-36 (Sept. 29, 2017).
Page 10
Application of the Property Code definitions provides this clear test
for costs claimed under subsection (i): could Gulf Copper obtain a lien on
the offshore drilling project? Here, the answer is “no.” Mechanics and
materialman’s liens are limited to “running repairs” performed on
equipment while it is being used on the project site. See Tex. Prop. Code
§ 53.001(4)(B). 3
2F
Gulf Copper tendered no evidence that the costs it seeks to deduct
included any of these activities. Indeed, to establish its entitlement to
the disputed deductions, Gulf Copper relied solely on an erroneous legal
interpretation of subsection 171.1012(h)—which the court of appeals
expressly rejected. Opinion at *9, 12. This lack of evidence requires a
rendition of judgment regarding section 171.1012 costs rather than
remand.
The definitions of “labor” and “materials” in the Property Code –
limiting the terms to labor and materials used in the “direct prosecution”
of a project – accord with subsection (i)’s words and phrases in their
3 Furthermore, mineral property liens under Property Code Chapter 56 are
limited to “digging, drilling, torpedoing, operating, completing, maintaining,
or repairing an oil, gas, or water well.” Tex. Prop. Code § 56.001(1).
Page 11
proper context, as well as with the rules of grammar and usage. See Tex.
Gov't Code Ann. § 311.011(a) (West 2013). The phrase “to a project for the
construction, improvement . . . of real property” is prepositional phrase
that functions as an adjective modifying and limiting the antecedent
phrase “furnishing labor or materials.”
The court of appeals nonetheless concluded that Gulf Copper
“presented evidence at trial that, to some extent” it provided labor or
materials that were “essential and direct components” of “specific
projects.” Opinion at *14. The court’s “essential and direct components”
language comes from its opinion in Newpark. In that case, the court
distinguished labor that was an “essential and direct component” of the
drilling project from labor “too far removed” from the project. Opinion
at *14 (citing Combs v. Newpark Resources, Inc., 422 S.W.3d 46, 57 (Tex.
App.—Austin 2013, no pet.)).
The taxpayer in Newpark was able to obtain the subsection (i)
deductions for labor furnished in hauling away used drilling mud and
other waste products from oil well drilling sites. 422 S.W.3d at 48. But
that labor was provided to the oil wells. In contrast, Gulf Copper’s work
was at least two steps removed from a real-property project. It provided
Page 12
outfitting and repair services to its customers—the rig owners—who, in
turn, contracted with the E&P companies to provide them with the rigs
for offshore drilling. The E&P companies then used the rigs in projects
for real-property improvements or construction.
This Court has never adopted the “essential and direct components”
test in Newpark. But even if the Court accepts that formulation, the
repair and outfitting of a rig owned and operated by a third party, prior
to commencement of drilling by yet another third party at a different site
offshore, cannot be viewed as a “direct component” of drilling. Gulf
Copper’s work is “too far removed” from the construction project.
Gulf Copper fixed construction equipment. As a matter of law,
fixing or upgrading construction equipment prior to its utilization is
not “furnishing labor or materials to a project for the construction,
improvement ... of real property” under subsection (i). Just as fixing
a bulldozer before its delivery to and use on a construction site should be
properly classified as the repair of tangible personal property rather than
real-property improvements, so Gulf Copper’s rig work at its waterfront
yards constituted the repair and upgrading of tangible personal property,
not “furnishing labor or materials to” a construction project. Gulf
Page 13
Copper’s rig work added value to the rigs, but it did not add value to any
real-property project.
This analysis applies with equal if not greater force to Sabine
Surveyors, which inspected the rigs and other marine vessels. There is
no evidence the subsidiary inspected offshore drilling operations or any
other real-property improvements.
C. The court of appeals’ decision regarding section
171.1012(i) also defeats other key provisions in the
cost-of-goods-sold statute.
The court’s decision undermines the explicit exclusion of “services”
from the definition of “tangible personal property” and thus from the
definition of “goods.” See id. § 171.1012(a)(3)(B)(ii). It does so by
allowing the taxpayer to deduct labor costs for installing components,
removing defective components, painting, welding, fixing cranes,
sandblasting, and coating—even though these services had only an
indirect relationship to the construction or improvement of real property.
CR. 296-97 (Findings of Fact No. 10, 12 and 13)[App. B]; 2.RR.131–32,
188, 192.
The cost of a service may be allowable in a cost-of-goods-sold
deduction only if the service is a cost of acquiring or producing a “good”
Page 14
that an entity sells or is labor in the “direct prosecution” of a real-property
project. Returning to the example of a bulldozer, this is why under
section 171.1012, the salaries of employees who paint, repair, upgrade a
bulldozer for sale would be allowable in the seller’s cost-of-goods-sold
deduction. The salaries are costs of “producing” the equipment “sold.”
But apart from the acquisition or production expenses for the sale
of the bulldozer, costs of providing services to repair, upgrade, or paint
the bulldozer are not deductible. And these services do not qualify for the
deduction simply because the owner of the bulldozer repaired, upgraded
or painted subsequently provides it to a real-property project. Nor
would the person performing the repair, upgrade or painting be able to
claim the deduction.
Similarly, Gulf Copper is not selling rigs to a third-party, but
rather, is providing repair and outfitting services performed at its
waterfront facility. 4 That the rigs are then used by another third party
3F
4 Again, the comptroller has already allowed the deduction for the labor costs
incurred in “producing” “goods”—i.e., parts and components Gulf Copper
installed on the rigs and thus sold.
Page 15
to drill offshore does not transform Gulf Copper’s services into “labor”
used in “direct prosecution” of the project under subsection (i).
II. Gulf Copper cannot exclude the contested subcontractor
payments from revenue under Tax Code §171.1011(g)(3).
A. Background: Section 171.1011(g)(3)
Taxpayers such as Gulf Copper must first determine their revenue
before deducting cost of goods sold to determine “margin.” In limited
circumstances, the Texas Legislature has allowed taxpayers to exclude
receipts that they are obligated by law or contract or fiduciary duty to
pass on to another. The theory is that the receipts do not truly represent
the revenue of the taxpayers. However, taxpayers are not allowed to
exclude receipts merely because the receipts are used to pay the
taxpayers’ expenses. If that were the case, the “margin” tax would become
a net income tax. To prevent just that outcome, Tax Code §171.1011(i)
specifically provides:
Except as provided by Subsection (g), a payment made under
an ordinary contract for the provision of services in the
regular course of business may not be excluded.
In this case, the question is whether the payments were made
under an ordinary contract for the provision of services or whether they
Page 16
were flow-through payments to subcontractors under section
171.1011(g)(3), which provided during the period at issue:
A taxable entity shall exclude from its total revenue, to the
extent [reported to the IRS as income], only the following flow-
through funds that are mandated by contract to be distributed
to other entities:
....
(3) subcontracting payments handled by the taxable entity
to provide services, labor, or materials in connection with
the actual or proposed design, construction, remodeling, or
repair of improvements on real property or the location of
the boundaries of real property.
Act of May 19, 2006, 79th Leg., 3d C.S., ch.1, § 5, 2006 Tex. Gen.
Laws 1, 10 (amended 2013) (“the (g)(3) revenue exclusion”).
There are two requirements at issue: there must be “flow-
through funds that are mandated by contract to be distributed to
other entities,” and the flow-through funds must be for “services,
labor, or materials in connection with the actual or proposed design,
construction, remodeling, or repair of improvements on real
property.”
Page 17
B. There is no evidence that the subcontract work
constituted “services, labor, or materials in connection
with the actual or proposed design, construction,
remodeling, or repair of improvements on real property”
Finding of Fact 29 reads in part, “Gulf Copper, through its
employees and subcontractors, provides labor and materials in
connection with the actual or proposed construction or repair of
improvements on real property;…” CR.298 [App.2]. This finding tracks
the statutory language of section 171.1011(g)(3) and is really a conclusion
of law reviewed de novo, without deference. It should be rejected.
The court of appeals conceded that the phrase “in connection with”
is “one ‘of intentional breadth,’ but not without ‘logical limit.’” Opinion
at *7 (quoting Titan Transp. LP v. Combs, 433 S.W.3d 627, 637-38 (Tex.
App.—Austin 2014, pet. denied)). The “logical limit” has been exceeded
here for these reasons:
• Gulf Copper’s work was temporally remote from the projects to
improve real property – the work was performed before drilling
operations commenced.
• Gulf Copper’s work was physically remote from the projects to
improve real property – the work was performed on tangible
personal property at Gulf Copper’s waterfront yards and not at the
offshore drilling sites, or oil and gas wells.
Page 18
• Gulf Copper’s work was contractually remote from the projects to
improve real property – Gulf Copper’s contracts were with the rig
owners, not the project owners, and Gulf Copper was not a
subcontractor to the project owners.
And, when Gulf Copper finished its work, the offshore drilling
projects had no greater value than before Gulf Copper started. This is
the “logical limit” of the (g)(3) revenue exclusion. 5 4F
Of course, the rigs that Gulf Copper repairs and modifies are used
by third parties to construct oil and gas wells, and oil and gas wells are
improvements to real property. For this reason, the State does not
challenge Findings of Fact 20: “Offshore drilling rigs are necessary and
essential to the drilling of offshore oil and gas wells because the wells
could not be drilled without the drilling rigs”) or Finding of Fact 30 (“The
labor and materials provided by Gulf Copper through its employees and
subcontractors are necessary, essential, and integral to the construction
5 While this part of the (g)(3) revenue exclusion is similar to the real-property
project requirement in the third-sentence of subsection (i), there are
differences. Subsection (i) does not contain the word “services.” It refers to
“labor or materials furnished “to” a real-property project, rather than “services,
labor or materials” provided “in connection with” such projects. Nevertheless,
Gulf Copper’s work does not qualify for the revenue exclusion even under the
broader phrasing in subsection (g)(3). It is still too “remote or attenuated” to
qualify. See Titan Transp. 433 S.W.3d at 638. The court of appeals’ decision
does not account for the use of different words and phrases in these two
subsections.
Page 19
… of oil and gas wells.”). CR.298, 299 [App.2].
But just as narrow focus on necessity or indispensability would
improperly broaden the statutory test under subsection (i), these findings
are, as a matter of law, insufficient to pull the subcontractor payments
into the (g)(3) revenue exclusion. The taxpayer’s indispensability
argument—which is really none other than a “but for,” cause-in-fact
argument—“proves too much.” Undoubtedly, there are many necessary
or essential preconditions—business organization, administrative
services support, surveying, geoseismic testing, research—for oil wells
and other real-property projects. And, no doubt, these and other
necessary preconditions will themselves require the furnishing of labor
or materials.
But the mere fact that the disputed labor or materials are in the
causal chain leading up to the real-property project is not evidence
supporting the (g)(3) revenue exclusion. Another precondition of the
project would be a written drilling contract between the rig owner and
the E&P company. Should the law firm that drafted the contract for the
rig owner be able to exclude its expenses because the expenses were
incurred “in connection with” the improvement of real property? Gulf
Page 20
Copper is in the same position as the law firm, providing services to the
rig owner antecedent to the drilling project and not providing any value
to the drilling project itself.
C. There is no evidence that the subcontractor
payments constituted “flow-through funds that are
mandated by contract to be distributed to other
entities.”
Even if the Court rejects the State’s primary contention and finds
that the subcontractor payments were made in connection with the
construction or improvements of real property, there must still be
evidence that the payments were mandated by contract to be distributed
to the subcontractors.
Gulf Copper’s two biggest contracts with rig owners, the Pride and
Helix contracts, involved two types of subcontractor labor – hourly and
cost-plus.
Under the hourly labor provisions, employees of the subcontractor
worked side-by-side with Gulf Copper employees, performing the same
work. Gulf Copper paid these subcontractors a flat hourly rate. And
under the Pride and Helix contracts, the rig owners paid Gulf Copper a
higher flat hourly rate—paying the same rate for regular labor performed
Page 21
by Gulf Copper employees and its subcontractors. 2.RR.110–113.
4.RR.104–05; PX1 at P00220 (Pride Contract) [App.9]; PX2 at P0072
(Helix contract). Indeed, with respect to regular labor, the Pride and
Helix contracts said nothing at all about subcontractors.
But for the second type of subcontractor labor involving specialty
services, the Pride and Helix contracts specified that payments were cost
plus 15% (in the case of the Pride contract) and cost plus 20% (in the case
of the Helix contract). PX1 at P00221 [App.9]; PX2 at P00073 [App.10];
2.RR.112. 6
5F
At trial, the State conceded that $32.0 million in subcontractor
payments—reflecting the specialty services governed by the cost-plus
provisions in the Pride and Helix contracts—were flow-through funds
mandated by contract to be distributed to the subcontractors. But the
State continued to urge that the other payments—reflecting the hourly-
rate subcontractors—were not flow-through funds. With respect to
those payments, no contract mandated that any customer payment for
6 Gulf Copper also made subcontractor payments under six other contracts in
addition to the Pride and Helix contracts. But none of those six contracts
were cost-plus contracts. PX3, PX4, PX5, PX6, PX7, PX8.
Page 22
labor be distributed to the subcontractors. The trial court and the court
of appeals erred when they concluded these payments were nonetheless
flow-through funds mandated by contract to be distributed to other
entities. Opinion at *6.
Though Gulf Copper was contractually obligated to pay the
subcontractors for “labor,” it was not contractually obligated to pass on
or flow-through customer payments to them. That makes all the
difference under the plain language of the statute. Neither the court of
appeals nor Gulf Copper pointed to any contractual mandate in the
customer contracts or in the subcontracts that required Gulf Copper to
share customer payments with its subcontractors.
When examining statutory text, the Code Construction Act
mandates that the Court read words and phrases in context and construe
them according to the rules of grammar and usage. Tex. Gov't Code Ann.
§ 311.011(a) (West 2013); see also supra at 11-12. The phrase “flow-
through funds that are mandated by contract to be distributed to other
entities” is a single unified requirement. The dependent clause “that are
mandated by contract to be distributed to other entities” is an adjective
Page 23
that specifies and limits the type of flow-through funds excludable from
revenue.
The court of appeals’ approach effectively reads out of the statute
the requirement that a contract mandate that funds be distributed to
other entities. Gulf Copper was not contractually obligated to mark-up
anything or, for that matter, to do anything at all besides paying the
subcontractors an hourly rate.
Although the court of appeals relied on Titan Transp., LP v. Combs,
433 S.W.3d 625 (Tex. App.—Austin 2014, pet. denied), that case is readily
distinguishable. There, the taxpayer had “contracts with its
subcontractors that required [the taxpayer] to pay 84% of its gross
receipts [from customers] to independent contractors.” Titan Transp.,
433 S.W.3d at 630.
Alternatively, in the event of ambiguity, this statute is a tax
exclusion, which like tax exemptions, must be construed strictly against
Gulf Copper. See Owens Corning v. Hegar, 04-16-00211-CV, 2017 WL
1244444, at *3 (Tex. App.—San Antonio Apr. 5, 2017, pet. denied)
(holding that the cost-of-goods-sold deduction is a tax exemption for the
same reason).
Page 24
PRAYER
For these reasons, the court should grant the petition for review and
upon further briefing on the merits, reverse and render judgment.
Respectfully submitted,
KEN PAXTON
Attorney General
JEFFREY C. MATEER
First Assistant Attorney General
BRANTLEY STARR
Deputy First Assistant Attorney
General
JAMES E. DAVIS
Deputy Attorney General for Civil
Litigation
/s/ Jack Hohengarten
JACK HOHENGARTEN
Tax Division Chief
State Bar No. 09812200
Tax Division MC 029
PO Box 12548
Austin, Texas 78711-2548
Tel: (512) 475-3503
Fax: (512) 478-4013
Attorneys for Petitioners
Page 25
CERTIFICATE OF COMPLIANCE
I certify the Petitioner’s Petition for Review contains 4493 words, excluding
portions exempted by Rule 9.4(i)(1).
/s/ Jack Hohengarten
JACK HOHENGARTEN
CERTIFICATE OF SERVICE
I certify that on December 20, 2017, a copy of this document was served on
all parties and counsel of record by email and eservice, as follows:
James F. Martens
Danielle V. Ahlrich
MARTENS, TODD, LEONARD & AHLRICH
301 Congress Ave., Ste. 1950
Austin, Texas 78701
Amanda G. Taylor
BECK REDDEN LLP
515 Congress Avenue
Suite 1900
Austin, Texas 78701
/s/ Jack Hohengarten
JACK HOHENGARTEN
Page 26
No. 17-0894
IN THE SUPREME COURT OF TEXAS
_________________________________________________________________
Glenn Hegar, Comptroller of Public Accounts of the State of
Texas and Ken Paxton, Attorney General of the State of Texas,
Petitioners,
v.
Gulf Copper and Manufacturing Corporation,
Respondent.
_________________________________________________________________
On Petition for Review
from the Third Court of Appeals at Austin, Texas
Appeal No. 03-16-00250-CV
_________________________________________________________________
APPENDIX TO PETITIONERS’ PETITION FOR REVIEW
________________________________________________________________
KEN PAXTON JACK HOHENGARTEN
Attorney General of Texas Tax Division Chief
State Bar No. 09812200
JEFF MATEER Tax Division
First Assistant Attorney General P.O. Box 12548; MC-029
Austin, Texas 78711-2548
BRANTLEY STARR TEL: (512) 475-3503
Deputy First Assistant Attorney FAX: (512) 478-4013
General
Counsel for Petitioners
JAMES E. DAVIS
Deputy Attorney General for Civil
Litigation
Page 27
APPENDIX TABLE OF CONTENTS
Tab
Final Judgment of the Trial Court……………………………………….A
Findings of Fact and Conclusions of Law……………………………….B
Opinion and Judgment of the Third Court of Appeals………………..C
TEX. TAX CODE § 171.1012………………………………………………....D-1
TEX. TAX CODE § 171.1011………………………………………………....D-2
TEX. PROP. CODE § 53.001……………………………………………….....D-3
TEX. PROP. CODE § 53.021…………………………………………....…….D-4
TEX. PROP. CODE § 53.023……………………………………..……..…….D-5
Page 28
APPENDIX A
Flied In The District Court
of Travis County, Texas
CAU SE NO. D-\-( ;N-1 4-004620
At FE~ 2jj016 Q ~
Velva L. Price , District Clerk
c; ULF COP PER & :vtA NUF ACT llRIN G
~ IN THF. DIST RIC T COl iRT OF
COR POR ATIO N,
§
Plain tiff §
§
v. §
§ TRA VIS COU NTY , TfX AS
GLENN HEG AR §
COM PTR OI.L F.R OF PUB LI C
§
ACC OUN TS OF TIIF . STATF: OF TEX AS;
§
AND KEN PAX TON , ATT ORN EY
~
GF:NF.RAL OF THE STA TE OF TEX AS,
§
Defendants
§ 53rc.t .JUl )ICIA L DIST RIC T
FINAL .JlJDG ME~ T
l)urin g the week o(Te hrua r:, I, 2016. the abov
e-entitled ma!tcr was tried to the bench in
the 20 I st District Court of Trav is County. Texas.
After cons idering the evickncc. the brid i ng. the
plead ings. and argument s of counsel, the Court
order s that Plaintiff is (.'t1titlc d t1) a fu ll refun J of
it s franchise ta:-: protest paym ent for repor t year
2009.
IT IS Tl !ERi TOR E ORDERED. AD.ll.:l)(iED /\ND
DECREE D that D-:lc ndant s shall pay
Plaintiff the full amou nt paid by Plain tiff unde
r prote st in thi s matte r ($838.1 17.84 ). plus al
l
statutory interest and costs as allow-:433 S.W.3d 625, 627-29 (Tex. App.—Austin 2014, pet.
denied); Combs v. Newpark Res., Inc., 422 S.W.3d 46, 47-48 (Tex. App.—Austin 2013, no pet.).
Under the current franchise-tax scheme, franchise taxes are assessed against a taxable entity’s
“taxable margin.” Tex. Tax Code § 171.002(a). The franchise-tax statute has been substantively
amended several times since its enactment, and the provisions applicable to this case are those
that were in effect on January 1, 2009.3 Under that version of the franchise-tax statute, the taxable
entity first calculates its “total revenue” in the manner directed by Tax Code section 171.1011. See
id. § 171.1011 (determination of total revenue). In general, total revenue is income reported to the
federal Internal Revenue Service less various categories of revenue that the statute specifies are to
be excluded, excepted, deducted, or otherwise limited. Id. For example, all taxpayers may deduct
certain flow-through funds, while only taxable entities in select industries are permitted to exclude
other types of flow-through funds. Compare id. § 171.1011(f), (g) (flow-through-funds exclusions)
with id. (g-1), (g-3), (g-4) (flow-through-funds exclusions for specific industries); see also In re
Nestle USA, Inc., 387 S.W.3d 610, 615 (Tex. 2012) (discussing franchise-tax scheme). “A manifest
purpose of excluding ‘flow-through funds’ is to except from taxation gross receipts that do not
constitute actual gain or income to the taxpayer.” Titan Transp., 433 S.W.3d at 628.
After calculating total revenue, the taxpayer computes its “taxable margin” by first
determining its “margin.” See Tex. Tax Code § 171.101(a)(1) (“The taxable margin of a taxable
entity is computed by . . . determining the taxable entity’s margin.”). The “margin” is the lesser of
3
Citations in this opinion will be to the current version of the Tax Code when intervening
amendments are not relevant to the disposition of the issues on appeal.
3
(1) 70% of the taxable entity’s total revenue or (2) the taxable entity’s total revenue minus, at the
entity’s election, either cost of goods sold, as determined under section 171.1012 (the COGS
calculation) or compensation, as determined under section 171.1013 (the compensation calculation).
See Act of May 19, 2006, 79th Leg., 3d C.S., ch.1, § 5, 2006 Tex. Gen. Laws 1, 8, as amended by
Act of June 15, 2007, 80th Leg., ch. 1282, § 11, 2007 Tex. Gen. Laws 4282, 4287 (amended 2013)
(current version at Tex. Tax Code 171.101).4 After applicable deductions have been taken, “taxable
margin” is determined by apportioning the adjusted revenue between in-state and out-of-state
business and, except for E-Z computation filers, subtracting any other allowable deductions. Id.
§§ 171.101(a)(2), (3), .1016(b)(2), (c). The franchise-tax obligation is determined by multiplying
the “taxable margin” by the applicable tax rate. Id. § 171.002.
Nature of Gulf Copper’s Business Activities5
Gulf Copper is a corporation primarily engaged in the business of surveying,
manufacturing, upgrading, and repairing offshore drilling rigs. Gulf Copper’s work enables the drilling
rigs to (1) obtain and maintain the certification requirements imposed by marine classification
societies;6 (2) comply with regulations, both state and federal, applicable to offshore drilling rigs
4
Not relevant to this case is the option to use the E-Z computation method to determine
margin for taxable entities whose total revenue is $20 million or less. See Tex. Tax Code § 171.1016
(E-Z computation method and rate for taxpayers with no more than $20 million in total revenue).
5
The following description of Gulf Copper’s business activities is derived from unchallenged
findings of fact made by the trial court and from testimony elicited at trial, which, unless otherwise
indicated, is undisputed.
6
A marine classification society is a non-governmental organization that establishes and
maintains technical standards for the construction and operation of marine vessels. Steven Hale,
Gulf Copper’s Chairman and Chief Executive Officer, testified that the International Association of
4
and their operations;7 and (3) meet the requirements imposed by contracts entered into between
exploration and production companies and the drilling rigs’ owners related to specific drilling
projects.8 The drilling rigs are delivered to Gulf Copper’s facility where Gulf Copper performs the
work to satisfy the requirements of the particular classification society certifying the drilling rig,
the other regulatory authorities involved, the drilling rig’s owner representative, and often a
representative from the exploration and production company for whose project the drilling will be
performed. Gulf Copper repairs rigs by removing defective portions, manufacturing replacement
components, and installing the replacement components on the rigs. Gulf Copper also manufactures
and installs new components for rigs that do not replace an existing component.
Gulf Copper also owns all the outstanding shares of a subsidiary named Sabine
Surveyors, a limited partnership primarily engaged in the business of marine vessel surveying. Hale
Classification Societies promulgates rules and regulations that offshore drilling rigs have to meet
to operate safely and in an environmentally sound manner. According to Hale, the classification
standards are met through a regimen of inspections and surveys on a prescribed, periodic basis to
ensure the integrity and safety of the vessel. That a rig meets classification rules and standards is of
critical importance to both an exploration and production company considering using a particular
rig on its project and to the underwriter who insures the drilling rig.
7
Hale testified that offshore drilling rigs and their operations are subject to regulations
promulgated by entities such as the United States Coast Guard, the Environmental Protection Agency,
the International Maritime Organization, and the “Bureau of Offshore Environmental Management.”
We assume that the last reference was to the Bureau of Ocean Energy Management, one of three
independent entities created when the federal Minerals Management Service was reorganized in the
wake of the Deepwater Horizon oil spill. The Bureau’s mission is “managing development of the
nation’s offshore resources in an environmentally and economically responsible way.” See The
Reorganization of the Former MMS, BOEM.GOV, http://www.boem.gov/Reorganization/ (last visited
June 15, 2017).
8
Hale testified that individual wells have “different requirements relative to the equipment
on the rig.”
5
testified that Sabine Surveyors inspects marine vessels, including offshore drilling rigs, and cargo.
Surveys are also conducted after a drilling rig is involved in a collision with another vessel while it is
offshore and the owner or underwriter requests an inspection to determine the extent of the damage.
According to Hale, in certain circumstances Sabine Surveyors must “separate itself from” Gulf
Copper’s shipyard activities because it might be deemed a conflict of interest for Sabine Surveyors
to refer a job for which Sabine Surveyors represents the drilling rig’s underwriter to Gulf Copper.
Hale testified that Sabine Surveyors also prepares “desk appraisals” of drilling rigs for use by
entities with a financial interest in a rig.
Gulf Copper’s Franchise-Tax Dispute
The underlying tax protest concerns Gulf Copper’s 2009 franchise-tax report.
Gulf Copper excluded from its total gross revenue $79,405,230 in “flow-through” payments to
subcontractors, which, along with other exclusions amounting to $163,303,9 reduced its total
revenue from $173,875,422 to $94,306,889. Gulf Copper then elected to use the COGS deduction
to calculate its margin, subtracting $70,396,219 from its total revenue to arrive at a margin of
$23,910,670. Gulf Copper calculated its apportionment factor at 0.8808, application of which
resulted in a taxable margin of $21,060,518. Accordingly, Gulf Copper reported a franchise-tax
obligation of $210,605.18—1% of its taxable margin—which it timely paid in full.
In claiming a revenue exclusion of $79,405,230, Gulf Copper relied on former section
171.1011(g)(3) of the franchise-tax statute, which provided:
9
The Comptroller does not dispute that the $163,303 qualified for a revenue exclusion.
6
A taxable entity shall exclude from its total revenue, to the extent [reported to the
federal IRS as income], only the following flow-through funds that are mandated by
contract to be distributed to other entities:
AAAA
(3) subcontracting payments handled by the taxable entity to provide services,
labor, or materials in connection with the actual or proposed design, construction,
remodeling, or repair of improvements on real property or the location of the
boundaries of real property.
Act of May 19, 2006, 79th Leg., 3d C.S., ch.1, § 5, 2006 Tex. Gen. Laws 1, 10 (amended 2013)
(“the (g)(3) revenue exclusion” or “former section 171.1011(g)(3)”). After conducting an audit,
however, the Comptroller determined that the $79,405,230 in payments to subcontractors did not
meet the requirements for the (g)(3) revenue exclusion. Instead, the Comptroller determined that
the subcontractor payments should be considered in the calculation of Gulf Copper’s COGS
deduction. The Comptroller also audited the amount that Gulf Copper had calculated as its COGS
deduction and significantly pared down the expenses it believed could properly be included in the
COGS calculation. In essence, the Comptroller concluded that only costs either directly or indirectly
related to “fabrication” of goods could properly be included in the calculation of Gulf Copper’s
COGS deduction.
After concluding its audit, the Comptroller determined that Gulf Copper had:
(1) $163,303 in allowed revenue exclusions,10 and (2) a total COGS deduction of $77,140,769. As
a consequence of moving the subcontractor payments from the (g)(3) revenue exclusion, Gulf
10
This number is the difference between the total flow-through revenue exclusions Gulf
Copper originally took minus the $79,405,230 in subcontractor payments the Comptroller
determined were not properly excluded from revenue as qualifying flow-through funds under the
(g)(3) revenue exclusion.
7
Copper’s apportionment factor increased from 0.8808 to 0.9353. The Comptroller thus calculated
that Gulf Copper had an additional franchise tax obligation for franchise-tax report year 2009 of
$692,626.66. Gulf Copper paid the assessed deficiency plus interest (a total of $838,118.00) under
protest. See Tex. Tax Code § 112.051. Along with its protest payment, Gulf Copper submitted
a letter to the Comptroller outlining its reasons for claiming the (g)(3) revenue exclusion for
subcontractor payments and explaining its method of calculating its COGS deduction. Gulf Copper
subsequently filed the underlying lawsuit, seeking a refund of all amounts paid under protest. Gulf
Copper maintained that it was entitled to take the (g)(3) revenue exclusion based on the nature of its
business activities and its contractual obligations to make the excluded payments to subcontractors
who were performing activities in connection with oil and gas well construction and improvement.
Gulf Copper asserted that the subcontractors were engaged in providing services, labor, and materials
in the form of manufacturing, constructing, developing, improving, creating, and installing
component parts for offshore drilling rigs used to construct, remodel, or repair oil and gas wells,
which it contended are improvements on real property. Gulf Copper claimed that the payments to
its subcontractors satisfied the statutory prerequisites for claiming the (g)(3) revenue exclusion
because (1) the payments were mandated by contract, (2) to be paid to an entity other than Gulf
Copper (the taxable entity), and (3) the funds paid to the subcontractors were for the provision of
“services, labor, or materials in connection with the actual or proposed . . . construction, remodeling,
remediation, or repair of improvements on real property.” See id. § 171.1011(g)(3).11
11
Relatedly, Gulf Copper asserted that, by refusing to allow Gulf Copper to claim the
subcontractor payments as a revenue exclusion, the Comptroller had erroneously increased Gulf
Copper’s apportionment factor from 0.8808 to 0.9353.
8
Gulf Copper also asserted that the Comptroller had improperly limited the costs that
could be included in the calculation of its COGS deduction. Gulf Copper challenged the Comptroller’s
conclusion that none of Gulf Copper’s expenses could be included in COGS pursuant to Texas
Tax Code subsection 171.1012(i). This subsection provides that “[a] taxable entity furnishing
labor or materials to a project for the construction, improvement, remodeling, repair, or industrial
maintenance [] of real property is considered to be an owner of that labor or materials and may
include the costs, as allowed by [section 171.1012], in the computation of cost of goods sold.” Id.
§ 171.1012(i); see Hegar v. CGG Veritas Servs. (U.S.), Inc., No. 03-14-00713-CV, 2016 WL 1039054,
at *3 (Tex. App.—Austin Mar. 9, 2016, no pet.) (mem. op.) (taxable entity that provides “labor and
materials” to project for the construction or improvement of real property, which includes oil and
gas wells, is entitled to include costs of that labor and materials, as allowed by section 171.1012, in
computation of its cost of goods sold and deduct that amount from its total revenue to calculate its
“margin” for franchise-tax purposes); Newpark Res., 422 S.W.3d at 54-57 (holding that, under Texas
Tax Code subsection 171.1012(i), certain labor expenses of subsidiary that does not itself produce
“goods” but that does supply labor to projects for construction of real property improvements may
be included in combined entity’s COGS calculation, and that term “labor” in statute encompasses
wide range of labor expenses, including those associated with activities that might also be described
as “services”). The Comptroller had concluded that Gulf Copper did not have any expenses that
could be included in the calculation of the COGS deduction by virtue of being costs of labor or
materials furnished to a project for construction or improvement of real property under section
171.1012(i) and, consequently, it could only include in its COGS calculation the direct and some
9
indirect costs of acquiring or producing “goods.”12 See Tex. Tax Code § 171.1012(c), (d), (f). In
the Comptroller’s view, each of Gulf Copper’s facilities13 was engaged in both fabrication and non-
fabrication activities and only the costs of labor and materials associated with the fabrication
activities were “costs of acquiring or producing goods” that could properly be included in calculating
the COGS deduction.
At trial, the evidence concerning Gulf Copper’s business operations was essentially
undisputed. The parties joined issue, however, on whether the subcontractor payments qualified for
the (g)(3) revenue exclusion as payments made “to provide services, labor, or materials in connection
with the actual or proposed design, construction, remodeling, remediation, or repair of improvements
on real property.” See id. § 171.1011(g)(3). The Comptroller took the position that the work the
subcontractors performed was “two steps away” from actual or proposed construction of
improvements on real property and therefore was too “remote or attenuated” from any actual or
proposed construction to meet the “in connection with” requirement to qualify for the (g)(3) revenue
exclusion. In the alternative, the Comptroller argued that if the subcontractor payments met the “in
connection with” requirement, only a portion of those payments ($32 million of the $79.4 million
total) met the requirement that they be “mandated by contract” to be distributed to other entities. See
12
“Goods” are defined as “real or tangible personal property sold in the ordinary course of
business of a taxable entity.” Tex Tax. Code § 171.1012(a)(1). “Tangible personal property” does
not include intangible property or services. Id. § 171.1012(a)(3)(B).
13
Gulf Copper’s facilities include yards in Galveston, Port Arthur, and Corpus Christi. Gulf
Copper also owns Sabine Surveyors, which the Comptroller determined provided only services and
thus did not incur any costs related to acquiring or producing goods that could be included in the
calculation of Gulf Copper’s COGS deduction.
10
id. § 171.1011(g). The parties also continued to be in sharp disagreement about the correct method
for calculating Gulf Copper’s COGS deduction.
After a three day bench trial, the trial court rendered judgment in Gulf Copper’s favor
and ordered the State to refund the entire amount paid under protest. The trial court also made the
following relevant findings of fact:
FOF 2: Sabine Surveyors is a limited partnership primarily engaged in the business
of marine vessel surveying.
FOF 9: Gulf Copper’s customers are primarily rig owners and drilling contractors
who use their offshore rigs to drill for oil and gas on behalf of exploration and
production (“E&P”) companies.
FOF 10: Gulf Copper is primarily engaged in the business of surveying,
manufacturing, upgrading, and repairing offshore drilling rigs.
FOF 12: Gulf Copper repairs rigs by removing defective portions, manufacturing
replacement components, and installing the replacement components onto the rigs.
Gulf Copper also manufactures and installs new components for rigs that do not
replace an existing component.
FOF 15: In completing its work, Gulf Copper utilizes all aspects and the entire
breadth of its facility yards, whether the rig sits on the dry docks, in the yard, or in
the water. This includes the lay down areas, the warehouses, the fabrication shops,
the welding areas, and the stacking areas.
FOF 16: Gulf Copper’s work enables the rigs (1) to meet and maintain the
certification requirements imposed by classification societies, (2) to comply with
governing regulations, and (3) to satisfy an exploration and production (“E&P”)
company’s contractual requirements for a specific drilling project.
FOF 17: A rig cannot be used for drilling unless it is properly certified, compliant,
and satisfies the contractual requirements for the project.
FOF 19: Rig owners do not hire Gulf Copper to repair or upgrade their rigs or
manufacture new components unless they have a revenue-generating contract in
place for the drilling of offshore oil and gas wells.
11
FOF 20: Offshore drilling rigs are necessary and essential to the drilling of offshore
oil and gas wells because the wells could not be drilled without the drilling rigs.
The State then perfected this appeal. The State’s three appellate issues reduce to a challenge to the
trial court’s judgment on the grounds that (1) the trial court erroneously agreed that Gulf Copper
could exclude from its revenue the $79.4 million in subcontractor payments pursuant to the (g)(3)
revenue exclusion and (2) the trial court erred by concluding that Gulf Copper’s COGS calculation
was correct, leading to an oversized COGS deduction, regardless of whether the subcontractor
payments were considered in the COGS calculation rather than excluded from revenue.
DISCUSSION
Eligibility of Subcontractor Payments for the (g)(3) Revenue Exclusion
The (g)(3) revenue exclusion requires that a taxpayer exclude from total revenue
certain flow-through funds “that are mandated by contract to be distributed to other entities.”14
During franchise tax year 2009, Gulf Copper used subcontractors to perform a significant portion
of the work it did for its customers. There were essentially two types of subcontractors working for
14
Effective January 1, 2014, section 171.1011(g)(3) was amended to require the exclusion
of “flow-through funds that are mandated by contract or subcontract to be distributed to other
entities” and that are “subcontracting payments made under a contract or subcontract entered
into by the taxable entity to provide services, labor, or materials in connection with the actual or
proposed design, construction, remodeling, remediation, or repair of improvements on real property
or the location of the boundaries of real property.” Tex. Tax Code § 171.1011(g)(3) (emphases
added). The bill analysis for this enactment indicates that the amendment was proposed in response
to the Comptroller’s interpretation of section 171.1011(g)(3) as “allowing an entity to exclude
subcontracting payments only when the entity has a contract in place that states that a specific
portion of the work will be subcontracted” because the Comptroller’s interpretation was not
consistent with the practices of the affected industry. Senate Research Ctr., Bill Analysis, Tex. H.B.
2766, 83d Leg., R.S. 2013.
12
Gulf Copper. First, there were “labor” subcontractors that provided workers who performed the
same types of tasks performed by Gulf Copper’s employees. Hale testified that Gulf Copper used
a significant number of workers provided by “labor” subcontractors in franchise tax year 2009
because there was both (1) an increased volume of work due to increased offshore drilling activity
and (2) displacement of a portion of Gulf Copper’s regular workforce caused by hurricanes in the
area. According to Hale, Gulf Copper was required to look outside its geographical region and
locate subcontractors who could provide welders, fitters, and other workers to work alongside
Gulf Copper’s employees. The “labor” subcontractors charged Gulf Copper a rate of $35 to $38
per hour per worker.15 Gulf Copper in turn billed its customers for work performed by the “labor”
subcontractors’ workers at a rate of $54 per hour per worker. Gulf Copper included as “flow-through
funds” in its (g)(3) revenue exclusion only the $35 to $38 per hour per worker it paid the “labor”
subcontractor supplying the workers. The remaining $16 to $19 per hour Gulf Copper received
from its customers for work done by workers provided by the “labor” subcontractors was not
included in the (g)(3) revenue exclusion.
The second type of subcontractor was “outside specialty” subcontractors hired to
provide workers to perform certain specialized tasks such as finishing out the accommodations on
a rig or doing electrical work. The “outside specialty” subcontractors were, at times, designated to
be used for certain tasks by the customers, who had preexisting relationships with those subcontractors.
Gulf Copper charged its customers for the work done by the “outside specialty” subcontractors an
amount 15 to 20 percent greater than the amount the “outside specialty” subcontractor charged
15
The record does not reflect what portion of the hourly rate that the “labor” subcontractors
charged Gulf Copper for its workers was ultimately paid to the workers themselves.
13
Gulf Copper. Gulf Copper included as “flow-through funds” in its (g)(3) revenue exclusion only
the amount it paid to the “outside specialty” subcontractor and did not include the additional revenue
it received from its customers as a result of the 15 to 20 percent upcharge.
On appeal the State agrees, as it did at trial, that the amounts paid to the “outside
specialty” subcontractors constitute flow-through funds mandated by contract to be distributed to
other entities and may be included in the (g)(3) revenue exclusion. With respect to payments to the
“labor” subcontractors, however, the State maintains that because Gulf Copper’s contracts with its
customers do not “mandate that their payments flow through Gulf Copper to the subcontractors
providing the regular labor” those payments do not qualify for the (g)(3) revenue exclusion.
The State’s position is contrary to the plain language of the statute and to this Court’s
previous holding in Titan Transportation. The statute requires Gulf Copper to exclude from its total
revenue calculation certain flow-through funds that were mandated by contract to be distributed to
other entities. See Tex. Tax Code § 171.1011(g). As this Court held in Titan Transportation, the
“mandate” may be contained in either a contract with the customer or in a contract with the
subcontractor. See Titan Transp., 433 S.W.3d at 641. An agreement between Gulf Copper and a
“labor” subcontractor constitutes a contract. The evidence and exhibits admitted at trial, including
contracts with the “labor” subcontractors who supplied the individuals performing the regular
labor, establish that Gulf Copper was obligated by those contracts to pay the “labor” subcontractors
for that labor.16 Thus, Gulf Copper was contractually obligated to pass on to the “labor”
16
For example, Gulf Copper’s Master Service Agreement with Maxum Industries, LLC, a
“labor” subcontractor, contains the following provision:
[Gulf Copper] shall pay [Maxum Industries, LLC], subject to [Gulf Copper’s]
14
subcontractors—other entities of the type referenced in the statute—a fixed portion of the customer’s
$54 per hour per worker payment, typically between $35 and $38 per hour per worker. Gulf Copper’s
contracts with its “labor” subcontractors satisfy “the statutory requirement that qualifying payments
be contractually mandated to someone other than the taxpayer.” Id.17
The Comptroller also maintains that the $79,405,230 in subcontractor payments
do not qualify for the (g)(3) revenue exclusion because the work done in exchange for those
payments was too remote or attenuated to constitute the provision of “services, labor, or materials
in connection with the actual or proposed design, construction, remodeling, remediation, or repair
of improvements on real property.” Tex. Tax Code § 171.1011(g)(3). Specifically, the Comptroller
argues that, although Gulf Copper’s work on the rigs adds value to the rigs, that work does not itself
add value to any actual or proposed construction of oil wells, which it concedes are improvements
on real property. The Comptroller points out that Gulf Copper does not have contracts with and is
not liable to the exploration and production companies that actually drill the oil wells and does not
verification that [Maxum Industries, LLC] has complied with all terms and conditions
of this Agreement and any applicable Purchase Order. In the event [Gulf Copper]
should dispute any part of an invoice, undisputed portions thereof shall be paid;
and upon resolution of all disputed items, a supplemental invoice will be submitted
to [Gulf Copper] for payment.
An email exchange between principals from Gulf Copper and Maxum Industries, LLC provides the
hourly rates Gulf Copper was to pay for welders, fitters, superintendents, and leadmen, ranging from
$36.50 to $37.50 per hour.
17
As this Court noted in Titan Transportation, “an evident purpose of the (g)(3) revenue
exclusion is to prevent double taxation of funds that are not truly gain or income to the taxpayer.”
Titan Transp., LP v. Combs, 433 S.W.3d 625, 641 (Tex. App.—Austin 2014, pet. denied). That
purpose is served when, as here, the taxpayer excludes from its revenue the portion of payments
received that it must pass on to another entity.
15
perform any work on the oil wells themselves. According to the Comptroller, the fact that Gulf
Copper is “two steps removed” from the construction of the improvement on real property itself (the
oil well) precludes it from falling within the “logical limit” the Legislature intended to impose on
the phrase “in connection with” used in the statute.
This Court has previously described the phrase “in connection with” as one “of
intentional breadth,” but not without “logical limit.” Titan Transp., 433 S.W.3d at 637. The Court
delineated the contours of the “in connection with” requirement as follows:
As used in former section 171.1011(g)(3), the phrase “in connection with” can only
be read as requiring some reasonable nexus between the services, labor, and materials
for which the taxpayer pays a subcontractor and “the actual or proposed design,
construction, remodeling, or repair of improvements on real property or the location
of boundaries of real property.” [] Given its context, the only plausible interpretation
of the “in connection with” language employed in the (g)(3) revenue exclusion is that
there must be a reasonable—i.e., more than tangential or incidental—relationship
between the activities delineated in the statute and the services, labor, or materials
for which the subcontractors receive payment. . . . The critical inquiry [] is whether
the services, labor, or materials provided have a reasonable connection to
construction, remodeling, design, or repair work on real property.
Id. at 638-39. The inquiry, then, is whether the activities performed by the subcontractors for Gulf
Copper have a reasonable connection to the construction of oil wells, which we have held, and the
parties do not dispute, are improvements on real property. See Newpark Res., 422 S.W.3d at 53
(drilling of oil and gas well is “project for construction and improvement of real property”).
The evidence at trial showed that the workers supplied to Gulf Copper by the “labor”
subcontractors performed essentially the same activities as Gulf Copper’s employees in its
yards. Thus, those workers were engaged in activities that resulted in the offshore drilling rigs’
16
(1) obtaining and maintaining the certification requirements imposed by marine classification
societies, (2) complying with regulations, both state and federal, applicable to offshore drilling rigs
and their operations, and (3) meeting the requirements imposed by contracts entered into between
exploration and production companies and the drilling rigs’ owners related to specific drilling
projects. In our view, it is evident that doing work on offshore drilling rigs—equipment that is
undisputedly integral to drilling offshore wells—that renders them able to perform the drilling
services required to drill a particular oil well is an activity that is reasonably connected to the
construction of that oil well. Thus, at least part of the work done by the subcontractors plainly meets
the (g)(3) revenue exclusion’s requirement that it be “in connection with” construction of an
improvement on real property.
Whether performing work that makes a rig compliant with general requirements
imposed by marine classification societies or with state and federal regulations generally applicable
to offshore drilling rigs and their operations presents a closer question. Arguably, readying an
offshore drilling rig for use on offshore drilling projects generally might not be sufficiently related
to the “actual or proposed” construction of an improvement to real property to meet the (g)(3)
revenue exclusion requirement. Likewise, it could be argued that a drilling rig’s compliance with
rules and regulations that permit it to operate offshore generally is incidental or tangential to the
“actual or proposed” construction of a particular offshore well. We need not, however, address
such arguments here because the Comptroller’s position is that all subcontractor payments were
for work too attenuated to qualify for the (g)(3) revenue exclusion by virtue of the work being
“two steps” away from the actual drilling of oil wells. The State made no distinctions among the
17
subcontractors’ various activities but rather took the position that, as a matter of law, Gulf Copper
was not entitled to take the (g)(3) revenue exclusion at all. Thus, the State has failed to preserve the
argument that while Gulf Copper may have been permitted to claim a (g)(3) revenue exclusion for
some of its subcontractor payments, other subcontractor payments were for work too attenuated to
an actual or proposed project to qualify. On this record, there is sufficient evidence to support the
trial court’s conclusion that Gulf Copper was entitled to include the $79,405,230 in payments to
subcontractors as flow-through funds falling within the (g)(3) revenue exclusion.
Having concluded that the subcontractor payments qualified for the (g)(3) revenue
exclusion, we turn now to Gulf Copper’s calculation of its COGS deduction to determine whether
the trial court’s finding that Gulf Copper was entitled to claim a COGS deduction of $72,711,734
when calculating its margin for franchise tax purposes was supported by factually sufficient evidence.
Gulf Copper’s Calculation of the COGS Deduction
The COGS deduction is calculated in accordance with Texas Tax Code section
171.1012. See Tex. Tax Code § 171.1012 (determination of cost of goods sold). Section 171.1012
defines “goods” to mean “real or tangible personal property sold in the ordinary course of business
of a taxable entity” and provides that “tangible personal property” does not include services. Id.
§171.1012(a)(1), (3)(B)(iii). Section 171.1012 provides that an entity may take a COGS deduction
for “all direct costs of acquiring or producing the goods,” including labor costs, “costs of materials
that are an integral part of” the goods, “handling costs, including costs attributable to processing,
assembling, repackaging, and inbound transportation costs,” storage costs, and costs of renting,
leasing, maintaining, and repairing equipment, facilities, or real property directly used for production
18
of the goods. Id. § 171.1012(c).18 A taxable entity may also take a COGS deduction for post-
production direct costs, including storage and handling provided for by subsection (c), and for
indirect or administrative overhead costs allocable to the acquisition or production of goods, up to
four percent of the entity’s total indirect or administrative overhead costs. Id. § 171.1012(d), (f).19
Specifically excluded from COGS eligibility are the cost of renting or leasing equipment, facilities,
or real property not used for the production of “goods,” “selling costs, including employee expenses
related to sales,” “distribution costs, including outbound transportation costs,” and rehandling costs.
Id. § 171.1012(e). Also excluded are advertising costs, idle facility expenses, bidding costs, interest,
income taxes, strike expenses, officer compensation, and compensation paid to undocumented
workers. Id.
A COGS deduction is generally available only to the taxable entity that owns
the “goods” in question. Id. § 171.1012(i). The Legislature has, however, “extended access to the
deduction in limited circumstances.” See Hegar v. Sunstate Equip. Co., No. 03-15-00738-CV,
18
Subsection (c) also includes the cost of materials consumed in producing the goods;
depreciation, depletion, and amortization associated with and necessary to the production of the
goods; research and design activities directly related to the production of the goods; geophysical
costs to locate mineral-producing property; taxes paid for materials or services that are direct
production costs; the cost of producing or acquiring electricity sold; and “a contribution to a
partnership in which the taxable entity owns an interest that is used to fund activities, the costs of
which would otherwise be treated as cost of goods sold of the partnership, but only to the extent that
those costs are related to goods distributed to the taxable entity as goods-in-kind in the ordinary
course of production activities rather than being sold.” Tex. Tax Code § 171.1012(c).
19
Subsection (d) also includes insurance for facilities or equipment directly used to produce
the goods; insurance on the produced goods; deterioration, obsolescence, spoilage, and abandonment
of the goods; pre-production direct costs for property held for future production, including storage
and handling provided for by subsection (c); utilities directly used in producing the goods; quality
control costs; and licensing or franchise costs. Id. § 171.1012(d).
19
2017 WL 279602, at *3 (Tex. App.—Austin Jan. 20, 2017, pet. filed) (mem. op.). Relevant to this
case is that “an entity furnishing labor or materials to a project for the construction, improvement,
remodeling, repair, or industrial maintenance . . . of real property is considered to be an owner of that
labor and materials and may include the costs, as allowed by [section 171.1012], in the cost of goods
sold.” Id. “The analytic framework for determining whether a particular ‘labor cost’ is includable
as a cost of goods sold under subsection 171.1012(i) [] requires determining whether the particular
activity is an essential and direct component of the ‘project for the construction . . . of real property.’”
CGG Veritas, 2016 WL 1039054, at *3 (citing Newpark Res., 422 S.W.3d at 56). This Court adopted
this analytic framework to address the circumstance that (1) the terms “labor” and “service” are not
defined in the statute, (2) “services” are specifically excluded from the definition of “tangible
personal property,” (3) “labor” and “services” are not mutually exclusive, and (4) certain labor
expenses associated with activities that might also be described as a “service” fall within the wide
range of labor expenses that section 171.1012(i) permits a taxable entity that furnishes labor to a
project for construction or improvement of real property to deduct. See Newpark Res., 422 S.W.3d at
55-57; see also CGG Veritas, 2016 WL 1039054, at *3. Thus, provided the activity is “an essential
and direct component” of the project for construction or improvement of real property, the associated
costs may, through application of subsection 171.1012(i), be included in the COGS deduction even
if the activity might be in the nature of a “service.” See Newpark Res., 422 S.W.3d at 56 (trial court
could reasonably have concluded that removal and disposal of waste material was labor furnished
to project for construction of oil and gas well based on trial testimony that this activity was essential
to continue drilling of oil and gas well).
20
In calculating its COGS deduction, Gulf Copper did not engage in a cost-by-cost
analysis of each expense to determine whether it fit into one of the categories of costs the statute
provides may properly be included in the calculation of cost of goods sold, see Tex. Tax Code
§ 171.1012(c), (d), (f), nor did it employ the analytic framework described above to determine
whether its particular activities that involved furnishing labor to a project for construction or
improvement of real property (as opposed to its activities that produced “goods”) were “an essential
and direct component” of a particular project, see id. § 171.1012(i). Rather, Gulf Copper took the
position that it is a taxable entity “eligible” to take a COGS deduction both because it is the owner
of goods (i.e., tangible personal property sold in the ordinary course of its business) and because it
furnishes labor and materials for the construction or improvement of real property. Then, relying
on subsection 171.1012(h), which provides that “[a] taxable entity shall determine its cost of goods
sold, except as otherwise provided by this section, in accordance with the methods used on the
federal income tax return on which the report under this chapter is based,” id. § 171.1012(h),
Gulf Copper used as a “starting point” for its COGS calculation the trial balance (a summary of
all transactions for the accounting year) that it used to prepare its federal income tax return. Gulf
Copper explained: “When Gulf Copper applied its federal income tax methods to its transactional
data (revenues generated and costs incurred), the result represented Gulf Copper’s COGS for federal
income tax purposes. [] For federal income tax purposes, Gulf Copper qualifies a [sic] producer of
goods and, thus, must calculate its federal COGS pursuant to the accounting method imposed
by Internal Revenue Code Section 236A.”20 From the dollar amount of the COGS deduction it
20
Gulf Copper states that “it appears our Legislature used the corresponding treasury
regulation (C.F.R. § 1.236A-1) as an outline to draft the COGS statute.”
21
calculated for federal income tax purposes, Gulf Copper excluded costs that it determined constituted
costs expressly excluded from the state COGS deduction by subsections 171.1012(e) and (f). Id.
§ 171.1012(e) (list of costs in relation to taxable entity’s goods that may not be included in COGS
calculation); (f) (taxable entity may include only four percent of taxable entity’s total indirect or
administrative overhead costs in COGS calculation). Gulf Copper stated that it:
did not parse the costs associated with its integrated business activities because doing
so would violate (1) its federal income tax methods; (2) the economic realities of
Gulf Copper’s business (i.e., it takes all of the activities and their associated costs to
generate the taxable revenue); (3) its accounting system (which captures a host of
financial data necessary to operate the business but does not segregate its single
integrated activity–rig repair–and its costs into component steps; (4) its combined
group status; and (5) the Legislature’s goal of taxing margin (because diluting Gulf
Copper’s ability to deduct its costs generates a tax on revenue).
Thus, Gulf Copper’s failure to examine, on an item-by-item basis, whether a cost could properly be
included in the COGS calculation under the Texas Tax Code was based on (1) its belief that it was
required by section 171.1012(h) to start with its federal COGS calculation and (2) the logistical
difficulties, given its business model and its accounting systems, of performing that task.
We first consider whether Texas Tax Code subsection 171.1012(h) directs a taxable
entity to use its federal income tax COGS deduction as the starting point for its calculation of the
Texas franchise tax COGS deduction.21 Texas Tax Code subsection 171.1012(h) provides:
21
This presents a question of statutory construction that we review de novo. See State v.
Shumake, 199 S.W.3d 279, 284 (Tex. 2006). Our primary objective in construing statutes is to give
effect to the Legislature’s intent and, ordinarily, “‘the truest manifestation’ of what lawmakers intended
is what they enacted.” First Am. Title Ins. Co. v. Combs, 258 S.W.3d 627, 632 (Tex. 2008) (quoting
Alex Sheshunoff Mgmt. Servs. L.P. v. Johnson, 209 S.W.3d 644, 651-52 (Tex. 2006)). The language
emerging from the legislative process “constitutes the law, and when a statute’s words are
22
A taxable entity shall determine its cost of goods sold, except as otherwise provided
by [section 171.1012], in accordance with the methods used on the federal income
tax return on which the report under this chapter is based. This subsection does not
affect the type or category of cost of goods sold that may be subtracted under [section
171.1012].
Tex. Tax Code § 171.1012(h). Contrary to Gulf Copper’s assertion, this provision does not constitute
a directive to use the amount of the taxable entity’s federal income tax COGS deduction as a starting
point for calculating its state franchise tax COGS deduction and to thereby avoid considering
whether each particular cost corresponds to a subtraction from total revenue permitted by section
171.1012. The text of this subsection plainly states that it “does not affect the type or category of
cost of goods sold that may be subtracted” under section 171.1012. Id. (emphasis added).
Thus, the plain language of subsection (h) confirms that a taxable entity is permitted
to include in the calculation of its COGS deduction only the types of expenses outlined in
subsections 171.1012(c), (d), and (f). Indeed, these subsections are prefaced by subsection (b),
which expressly provides that “a taxable entity that elects to subtract cost of goods sold for the
purpose of computing its taxable margin shall determine the amount of that cost of goods sold as
unambiguous and yield but one interpretation, ‘the judge’s inquiry is at an end.’” Combs v. Roark
Amusement & Vending, L.P., 422 S.W.3d 632, 635 (Tex. 2013) (quoting Johnson, 209 S.W.3d
at 651-52)). We give an unambiguous statute its plain meaning without resorting to rules of
construction or extrinsic aids. Id.; see also Texas Lottery Comm’n v. First State Bank of DeQueen,
325 S.W.3d 628, 635, 637 (Tex. 2010) (branding such reliance “improper” because “[w]hen a
statute’s language is clear and unambiguous, it is inappropriate to resort to rules of construction or
extrinsic aids to construe the language”). Rules of construction such as agency deference and strict
construction of tax statutes against the taxing authority are employed only when a statute is ambiguous.
See TracFone Wireless, Inc. v. Commission on State Emergency Commc’ns, 397 S.W.3d 173, 182
(Tex. 2013) (“The reach of an ambiguous tax statute must be construed “strictly against the taxing
authority and liberally for the taxpayer.” (emphasis added) (quoting Morris v. Houston Indep. Sch.
Dist., 388 S.W.3d 310, 313 (Tex. 2012) (per curiam))).
23
provided by this section.” Id. § 171.1012(b) (emphases added). If the Legislature intended for a
taxable entity to calculate its state franchise tax COGS deduction by simply subtracting certain
expenses from its federal income tax COGS deduction it would not have needed to include the
detailed and extensive description of the costs eligible for inclusion in the state COGS deduction
that are found in subsections 171.1012(c), (d), and (f). See id. § 171.1012(c), (d), (f). Gulf Copper’s
interpretation of subsection (h) would essentially render subsections (c) and (d) superfluous. While
Gulf Copper’s interpretation of subsection (h) may have appeal when that subsection is viewed in
isolation, well settled rules of statutory interpretation require us to “examine the entire act to glean
its meaning” and “to presume that ‘the entire statute is intended to be effective.’” Meritor Auto., Inc.
v. Ruan Leasing Co., 44 S.W.3d 86, 90 (Tex. 2001) (quoting Tex. Gov’t Code § 311.021(2)). And
we may not interpret a statute in a way that renders any part of it meaningless. Crosstex Energy
Servs., L.P. v. Pro Plus, Inc., 430 S.W.3d 384, 390 (Tex. 2014).
Under well established rules of statutory interpretation, the proper interpretation of
subsection 171.1012(h) is that it speaks to the specific accounting methods the taxable entity uses
in determining the amount of its cost of goods sold and mandates that the taxable entity use the same
accounting method it used when preparing its federal tax return.22 A review of the statute as a whole
22
An entity’s chosen accounting method dictates how the entity’s transactions are recorded
in its financial books. For example, an entity using the cash-basis accounting method records its
expenses in its accounts when it actually pays the cash and books revenues when it actually receives
payment. An entity using the accrual accounting method records revenue when the transaction is
completed—e.g., when the work specified in a contract between the entity and its customer is
completed—instead of when it actually receives payment. The entity handles expenses in the same
manner by recording them when they have been incurred rather than when payment is actually made.
See E. McGruder Faris, Jr., Accounting for Lawyers 75-84 (3d ed. 1975). The cash method and the
accrual method are two of the methods a taxpayer may use to compute its taxable income for federal
24
confirms this conclusion. Subsection 171.1012(b) requires that a taxable entity that elects to subtract
cost of goods sold for the purpose of computing its taxable margin “determine the amount of that
cost of goods sold as provided by [section 171.1012],” whereas subsection (h) requires that a taxable
entity “determine its cost of goods sold [] in accordance with the methods used on the federal income
tax return.” Cf. Tex. Tax Code § 171.1012(b), with id. § 171.1012(h). Thus, subsection 171.1012(b)
addresses how to calculate the amount of the COGS deduction while subsection (h) clarifies that
the taxable entity must use the same accounting method—either cash basis or accrual—when
determining whether a particular COGS-deduction-eligible expense should be included in that tax
year’s COGS calculation.23
We also observe that by using its federal income tax COGS deduction as the “starting
point,” Gulf Copper offered insufficient evidence that the expenses included in that calculation
actually correspond to the types and categories of expenses permitted to be included in the
calculation of a taxable entity’s state franchise tax COGS deduction pursuant to section 171.1012.
To the extent the federal COGS calculation includes expenses that are not eligible for the state
COGS deduction, such as costs that do not qualify under the state statute as direct costs of “acquiring
tax purposes. See 26 U.S.C. § 446(c) (taxpayer may compute taxable income under cash receipts and
disbursement method, accrual method, any other method permitted by statute, or any combination
of foregoing methods permitted under regulations prescribed by Secretary of Treasury).
23
The main difference between accrual and cash basis accounting is the timing of when
revenue and expenses are recognized. Under the cash method, the taxable entity generally deducts
expenses in the tax year in which it actually paid them. Under the accrual method, expenses may
be deducted when they are incurred. See 26 C.F.R. § 1.466-1 (general rule for methods of
accounting). Thus, an expense that might be recognized and included in the COGS deduction
calculation in a particular tax year when using the accrual accounting method might not qualify for
inclusion in the same tax year when using the cash basis accounting method.
25
or producing” the “goods,” the result of using that calculation as a starting point is the overinclusion
of expenses in the calculation of the COGS deduction for state franchise tax purposes. Gulf Copper’s
method for calculating its state COGS deduction fails to provide evidence that the expenses included
in its starting point (the federal COGS deduction) are deductions that are also permitted to be
included in the calculation of the COGS deduction under the state statute.
Also unpersuasive is Gulf Copper’s argument that its interpretation permits it to
avoid the “incredibly burdensome” task of identifying which of the expenses of its integrated business
activities actually constitute a cost of “acquiring or producing” a “good” such that it is eligible to be
included in the calculation of its COGS deduction. Our interpretation of the Texas Tax Code is
not guided by the accounting systems used by taxable entities. Cf. Combs v. Roark Amusement &
Vending, L.P., 422 S.W.3d 632, 637 (Tex. 2013) (statutory determinations in tax disputes should
reflect economic realities of transactions at issue). The supreme court has explained that it has never
suggested that, “in the guise of considering the economic realities or essence of the transaction,
courts were authorized to impose an entirely new requirement” that is not found in the language of
the tax statute. Combs v. Health Care Servs. Corp., 401 S.W.3d 623, 627 n.8 (Tex. 2013). Rather,
we must take the Legislature “at its word and giv[e] the statute its plain meaning.” Id. at 627. A
taxable entity is offered three alternative methods for determining its margin under the Texas franchise
tax statute: (1) 70% of total revenue from the entity’s total business; (2) subtracting from total
revenue the costs of goods sold as determined under section 171.1012; or (3) subtracting from total
revenue compensation as determined under section 171.1013. See Tex. Tax Code § 171.101(a).
Gulf Copper’s choice was to subtract from its calculation of total revenue its COGS deduction. The
26
burden on Gulf Copper of calculating the proper amount of that deduction may be an indication that
one of the different methods of determining its taxable margin is the better choice. The burden on
the entity making the calculation cannot dictate the applicability or the amount of the deduction
allowed; we must enforce the statute as written.
The plain language of section 171.1012 confirms that calculating the COGS deduction
for Texas franchise tax purposes requires a cost-by-cost analysis to determine whether the cost fits
one of the types and categories eligible for inclusion in the calculation. “[T]he Cost of Goods Sold
includes ‘all direct costs of acquiring or producing goods,’ some indirect costs like insurance, utilities,
and quality control, and up to 4% of other ‘indirect or administrative overhead costs.’” In re Nestle
USA, 387 S.W.3d at 615 (citations omitted). Because Gulf Copper’s calculation of its COGS
deduction did not conform to the statute, we reverse the trial court’s finding that for report year
2009, Gulf Copper incurred expenses eligible to be included in the cost of goods sold subtraction
in the amount of $152,116,96424 as lacking factually sufficient evidentiary support.25 We also
reverse the finding that “[t]he categories, classifications, locations and amounts of the costs eligible
to be included in the cost of goods subtraction are accurately stated in Exhibit 56.”
24
This number assumes that the subcontractor payments are not excluded from total revenue
but, instead, are included in the COGS deduction.
25
Although the State did not frame its appellate issue as a factual sufficiency challenge, the
Comptroller has acknowledged that Gulf Copper is entitled to take a COGS deduction of some
amount. The State requested that, in the event this Court does not accept the Comptroller’s method
of calculating Gulf Copper’s COGS deduction, we remand the case to the trial court for further
proceedings to determine Gulf Copper’s COGS deduction by application of a proper interpretation
of section 171.1012 to the evidence before the trial court.
27
Our analysis of the COGS deduction issue does not end here, however, because the
State likewise presented the trial court with a flawed view of what qualifies for inclusion in Gulf
Copper’s calculation of its COGS deduction, as explained below.
The Comptroller’s Calculation of Gulf Copper’s COGS Deduction
The Comptroller performed its own calculation of Gulf Copper’s COGS deduction
as follows. First, the Comptroller determined that Gulf Copper had no expenses that qualified for
the COGS deduction by virtue of subsection 171.1012(i). That is, it concluded that none of Gulf
Copper’s costs were associated with labor and materials “furnished to a project for the construction,
improvement, remodeling, repair, or industrial maintenance of real property.” See Tex. Tax Code
§ 171.1012(i). Thus, the Comptroller did not consider whether any of Gulf Copper’s costs were for
labor and materials furnished to a qualifying project or were associated with activities that might
otherwise be viewed as “services” but might nevertheless be eligible for inclusion in the COGS
deduction calculation because they were an “essential and direct component of the ‘project for
construction . . . of real property.’” See id.; CGG Veritas, 2016 WL 1039054, at *3; Newpark Res.,
422 S.W.3d at 56. Next, the Comptroller determined that only activities involving “fabrication” of
items sold to Gulf Copper’s customers should be included in the COGS calculation. Because Gulf
Copper’s accounting records did not differentiate between the costs of what the Comptroller deemed
to be “fabrication” and what it deemed to be simply “installation” or other non-production related
activities,26 the Comptroller decided to use Gulf Copper’s labor records as a proxy for all of its costs
26
The Legislature recently amended the definition of “production” contained in Texas Tax
Code section 171.1012(a). See Act of May 19, 2017, 85th Leg., R.S., ch. 377, § 1, 2017 Tex.
28
and asked Gulf Copper to review its labor costs to come up with a percentage to apply to each of
Gulf Copper’s facilities that would represent the percentage of its costs that were related to
“fabrication.” The Comptroller assigned the following percentages for each of Gulf Copper’s
facilities: (1) 50% at Port Arthur, (2) 50% at Galveston, and (3) 5% at Corpus Christi. The
Comptroller then reviewed each type of Gulf Copper’s expenses for each facility and, if the
Comptroller concluded that the type of expense was one that was generally eligible for inclusion in
the COGS calculation it allowed it on the percentage basis assigned to the facility where the activity
generating the expense occurred. For example, the Comptroller allowed 50% of the labor costs
associated with the Port Arthur facility because labor is identified in subsection 171.1012(c) as a cost
of goods sold, but only to the extent it is a direct cost of acquiring or producing a good. Having
determined that 50% of the Port Arthur yard activities were “fabrication,” the Comptroller
determined that 50% of the labor costs at that facility were a direct cost of producing a good. The
Comptroller analyzed all of Gulf Copper’s expenses in this general manner unless it was apparent
that the expense was entirely related to producing goods, such as cost of materials. The Comptroller
Sess. Law Serv. ch. 377 (to be codified as an amendment to Tex. Tax Code § 171.1012(a)(2)).
The amendment provides that, effective September 1, 2017, “‘production’ means construction,
manufacture, development, mining, extraction, improvement, creation, raising, or growth.” Id. The
pre-amendment definition provides that production “includes construction, installation, manufacture,
development, mining, extraction, improvement, creation, raising, or growth.” The amended version
replaces the word “includes” with the word “means” and eliminates “installation” from the
definition of “production.” The Legislature’s note to the amendment states that the amendment “is
a clarification of existing law and does not imply that Section 171.1012, Tax Code, before the
amendment made by this Act may be construed as inconsistent with Section 171.1012, Tax
Code, as amended by this Act.” Act of May 19, 2017, 85th Leg., R.S., ch. 377, § 2, 2107 Tex. Sess.
Law Serv. ch. 377.
29
did not allow any of the costs incurred by Sabine Surveyors because it determined that this entity
performed only services.27
The trial court concluded that “[t]he limitations imposed by the Comptroller upon
Gulf Copper’s cost of goods sold calculation violate Tex. Tax Code § 171.1012.” We agree. The
Comptroller’s calculation of Gulf Copper’s COGS deduction is inconsonant with section 171.1012
in two ways. First, we do not agree with the Comptroller that none of Gulf Copper’s expenses
qualify for inclusion in its COGS calculation by virtue of subsection 171.1012(i). For example, Gulf
Copper presented evidence at trial that, to some extent, Gulf Copper’s employees provided labor
and materials to projects for improvement of real property (drilling oil wells). The Comptroller was
obligated to consider to what extent the activities of Gulf Copper’s employees were essential and
direct components of those specific projects. See CGG Veritas, 2016 WL 1039054, at *3. Sabine
Surveyors also performed activities that, while constituting activities that might be described as a
“service,” are an “essential and direct component” of a project for construction of real property.
Such activities include conducting surveys of rigs in order to ensure compliance with requirements
specific to a particular drilling project. Other of Sabine Surveyors’ activities, such as performing
vessel surveys for underwriters, might be so attenuated that the costs of those activities would not
constitute the cost of furnishing labor and materials to a project. Sabine Surveyors’ costs should
have been analyzed on a cost-by-cost basis to determine which of those costs met the requirement
that they be integral, essential, and direct components of the offshore drilling process and which
27
Implicit in the 0% assigned to Sabine Surveyors is the Comptroller’s determination that
none of its costs could be included in Gulf Copper’s COGS calculation by virtue of subsection
171.1012(i).
30
might be “too far removed from the construction, improvement, remodeling, repair, or industrial
maintenance of real property to qualify for the cost-of-goods-sold deduction under section
171.1012(i).” Newpark Res., 422 S.W.3d at 57.
Second, the Comptroller did not calculate the COGS deduction using a cost-by-cost
analysis but, rather, developed percentages that it then applied to disallow and remove certain costs
from the COGS deduction. This methodology is contrary to the cost-by-cost analysis required to
determine whether a certain cost fits into a type or category identified in section 171.1012. The
Comptroller’s percentages were derived by using labor costs as a proxy for other costs and,
consequently, there is an insufficient basis for the Comptroller’s allocation of costs as deductible
direct costs of producing goods.
Applying a proper construction of section 171.1012, the trial court’s findings that
Gulf Copper was entitled to include the entire $152,116,964 amount of its costs in the calculation
of its COGS deduction is erroneous as a matter of law. Gulf Copper did, however, present some
evidence, and the Comptroller does not dispute, that it was entitled to take a COGS deduction and
exclude from its taxable margin a significant amount of its costs. The trial court correctly found that
the limitations the Comptroller placed on Gulf Copper’s cost of goods sold calculation were contrary
to section 171.1012 for the reasons stated above. The Comptroller’s calculation may not serve as
the basis for determining Gulf Copper’s taxable margin or, consequently, the amount of any refund
to which it may be entitled. Further proceedings are therefore required to correctly calculate Gulf
Copper’s COGS deduction.
31
CONCLUSION
For the reasons stated in this opinion, we conclude that, on this record, Gulf Copper
was entitled to include the entire $79,405,230 of subcontractor payments in its (g)(3) revenue
exclusion. We also conclude that (1) factually insufficient evidence supports the trial court’s
finding that Gulf Copper was entitled to include the entire $152,116,964 of its costs in its COGS
deduction and (2) the Comptroller’s calculation of that deduction is incorrect as a matter of law.
Consequently, we reverse the trial court’s judgment ordering the State to pay Gulf Copper the full
amount it paid under protest and remand the cause to the trial court for further proceedings to
determine the exact amount of refund to which Gulf Copper is entitled.
__________________________________________
Scott K. Field, Justice
Before Chief Justice Rose, Justices Field and Bourland
Reversed and Remanded
Filed: August 11, 2017
32
TEXAS COURT OF APPEALS, THIRD DISTRICT, AT AUSTIN
JUDGMENT RENDERED AUGUST 11, 2017
NO. 03-16-00250-CV
Glenn Hegar, Comptroller of Public Accounts of the State of Texas; and
Ken Paxton, Attorney General of the State of Texas, Appellants
v.
Gulf Copper and Manufacturing Corporation, Appellee
APPEAL FROM THE 201ST DISTRICT COURT OF TRAVIS COUNTY
BEFORE CHIEF JUSTICE ROSE, JUSTICES FIELD AND BOURLAND
REVERSED AND REMANDED -- OPINION BY JUSTICE FIELD
This is an appeal from the judgment signed by the trial court on February 22, 2016. Having
reviewed the record and the parties’ arguments, the Court holds that there was reversible error in
the judgment. Therefore, the Court reverses the trial court’s judgment and remands the case to
the trial court for further proceedings. Each party shall pay the costs of appeal incurred by that
party, both in this Court and the court below.
APPENDIX D-1
§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
KeyCite Yellow Flag - Negative Treatment
Proposed Legislation
Vernon's Texas Statutes and Codes Annotated
Tax Code (Refs & Annos)
Title 2. State Taxation (Refs & Annos)
Subtitle F. Franchise Tax (Refs & Annos)
Chapter 171. Franchise Tax (Refs & Annos)
Subchapter C. Determination of Taxable Margin; Allocation and Apportionment
V.T.C.A., Tax Code § 171.1011
§ 171.1011. Determination of Total Revenue from Entire Business
Effective: January 1, 2014
Currentness
(a) In this section, a reference to an Internal Revenue Service form includes a variant of the form. For example, a reference
to Form 1120 includes Forms 1120-A, 1120-S, and other variants of Form 1120. A reference to an Internal Revenue
Service form also includes any subsequent form with a different number or designation that substantially provides the
same information as the original form.
(b) In this section, a reference to an amount reportable as income on a line number on an Internal Revenue Service
form is the amount entered to the extent the amount entered complies with federal income tax law and includes the
corresponding amount entered on a variant of the form, or a subsequent form, with a different line number to the extent
the amount entered complies with federal income tax law.
(c) Except as provided by this section, and subject to Section 171.1014, for the purpose of computing its taxable margin
under Section 171.101, the total revenue of a taxable entity is:
(1) for a taxable entity treated for federal income tax purposes as a corporation, an amount computed by:
(A) adding:
(i) the amount reportable as income on line 1c, Internal Revenue Service Form 1120;
(ii) the amounts reportable as income on lines 4 through 10, Internal Revenue Service Form 1120; and
(iii) any total revenue reported by a lower tier entity as includable in the taxable entity's total revenue under
Section 171.1015(b); and
(B) subtracting:
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§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(i) bad debt expensed for federal income tax purposes that corresponds to items of gross receipts included in
Subsection (c)(1)(A) for the current reporting period or a past reporting period;
(ii) to the extent included in Subsection (c)(1)(A), foreign royalties and foreign dividends, including amounts
determined under Section 78 or Sections 951-964, Internal Revenue Code;
(iii) to the extent included in Subsection (c)(1)(A), net distributive income from a taxable entity treated as a
partnership or as an S corporation for federal income tax purposes;
(iv) allowable deductions from Internal Revenue Service Form 1120, Schedule C, to the extent the relating
dividend income is included in total revenue;
(v) to the extent included in Subsection (c)(1)(A), items of income attributable to an entity that is a disregarded
entity for federal income tax purposes; and
(vi) to the extent included in Subsection (c)(1)(A), other amounts authorized by this section;
(2) for a taxable entity treated for federal income tax purposes as a partnership, an amount computed by:
(A) adding:
(i) the amount reportable as income on line 1c, Internal Revenue Service Form 1065;
(ii) the amounts reportable as income on lines 4, 6, and 7, Internal Revenue Service Form 1065;
(iii) the amounts reportable as income on lines 3a and 5 through 11, Internal Revenue Service Form 1065, Schedule
K;
(iv) the amounts reportable as income on line 17, Internal Revenue Service Form 8825;
(v) the amounts reportable as income on line 11, plus line 2 or line 45, Internal Revenue Service Form 1040,
Schedule F; and
(vi) any total revenue reported by a lower tier entity as includable in the taxable entity's total revenue under
Section 171.1015(b); and
(B) subtracting:
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§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(i) bad debt expensed for federal income tax purposes that corresponds to items of gross receipts included in
Subsection (c)(2)(A) for the current reporting period or a past reporting period;
(ii) to the extent included in Subsection (c)(2)(A), foreign royalties and foreign dividends, including amounts
determined under Section 78 or Sections 951-964, Internal Revenue Code;
(iii) to the extent included in Subsection (c)(2)(A), net distributive income from a taxable entity treated as a
partnership or as an S corporation for federal income tax purposes;
(iv) to the extent included in Subsection (c)(2)(A), items of income attributable to an entity that is a disregarded
entity for federal income tax purposes; and
(v) to the extent included in Subsection (c)(2)(A), other amounts authorized by this section; or
(3) for a taxable entity other than a taxable entity treated for federal income tax purposes as a corporation or
partnership, an amount determined in a manner substantially equivalent to the amount for Subdivision (1) or (2)
determined by rules that the comptroller shall adopt.
(d) Subject to Section 171.1014, a taxable entity that is part of a federal consolidated group shall compute its total revenue
under Subsection (c) as if it had filed a separate return for federal income tax purposes.
(e) A taxable entity that owns an interest in a passive entity shall exclude from the taxable entity's total revenue the
taxable entity's share of the net income of the passive entity, but only to the extent the net income of the passive entity
was generated by the margin of any other taxable entity.
(f) A taxable entity shall exclude from its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or
(c)(3), flow-through funds that are mandated by law or fiduciary duty to be distributed to other entities, including taxes
collected from a third party by the taxable entity and remitted by the taxable entity to a taxing authority.
(g) A taxable entity shall exclude from its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or
(c)(3), only the following flow-through funds that are mandated by contract or subcontract to be distributed to other
entities:
(1) sales commissions to nonemployees, including split-fee real estate commissions;
(2) the tax basis as determined under the Internal Revenue Code of securities underwritten; and
(3) subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide
services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation,
or repair of improvements on real property or the location of the boundaries of real property.
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§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(g-1) A taxable entity that is a lending institution shall exclude from its total revenue, to the extent included under
Subsection (c)(1)(A), (c)(2)(A), or (c)(3), proceeds from the principal repayment of loans.
(g-2) A taxable entity shall exclude from its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A),
or (c)(3), the tax basis as determined under the Internal Revenue Code of securities and loans sold.
(g-3) A taxable entity that provides legal services shall exclude from its total revenue:
(1) to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), the following flow-through funds that are
mandated by law, contract, or fiduciary duty to be distributed to the claimant by the claimant's attorney or to other
entities on behalf of a claimant by the claimant's attorney:
(A) damages due the claimant;
(B) funds subject to a lien or other contractual obligation arising out of the representation, other than fees owed
to the attorney;
(C) funds subject to a subrogation interest or other third-party contractual claim; and
(D) fees paid an attorney in the matter who is not a member, partner, shareholder, or employee of the taxable entity;
(2) to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), reimbursement of the taxable entity's expenses
incurred in prosecuting a claimant's matter that are specific to the matter and that are not general operating expenses;
and
(3) $500 per pro bono services case handled by the attorney, but only if the attorney maintains records of the pro
bono services for auditing purposes in accordance with the manner in which those services are reported to the State
Bar of Texas.
(g-4) A taxable entity that is a pharmacy cooperative shall exclude from its total revenue, to the extent included
under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), flow-through funds from rebates from pharmacy wholesalers that are
distributed to the pharmacy cooperative's shareholders. A taxable entity that provides a pharmacy network shall exclude
from its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), reimbursements, pursuant
to contractual agreements, for payments to pharmacies in the pharmacy network.
(g-5) A taxable entity that is a qualified live event promotion company shall exclude from its total revenue, to the extent
included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), a payment made to an artist in connection with the provision
of a live entertainment event or live event promotion services.
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§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(g-6) A taxable entity that is a qualified destination management company as defined by Section 151.0565 shall exclude
from its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), payments made to other
persons to provide services, labor, or materials in connection with the provision of destination management services as
defined by Section 151.0565.

(g-7) A taxable entity that is a qualified courier and logistics company shall exclude from its total revenue, to the
extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), subcontracting payments made by the taxable entity
to nonemployee agents for the performance of delivery services on behalf of the taxable entity. For purposes of this
subsection, “qualified courier and logistics company” means a taxable entity that:
(1) receives at least 80 percent of the taxable entity's annual total revenue from its entire business from a combination
of at least two of the following courier and logistics services:
(A) expedited same-day delivery of an envelope, package, parcel, roll of architectural drawings, box, or pallet;
(B) temporary storage and delivery of the property of another entity, including an envelope, package, parcel, roll
of architectural drawings, box, or pallet; and
(C) brokerage of same-day or expedited courier and logistics services to be completed by a person or entity under
a contract that includes a contractual obligation by the taxable entity to make payments to the person or entity
for those services;
(2) during the period on which margin is based, is registered as a motor carrier under Chapter 643, Transportation
Code, and if the taxable entity operates on an interstate basis, is registered as a motor carrier or broker under the
unified carrier registration system, as defined by Section 643.001, Transportation Code, during that period;
(3) maintains an automobile liability insurance policy covering individuals operating vehicles owned, hired, or
otherwise used in the taxable entity's business, with a combined single limit for each occurrence of at least $1 million;
(4) maintains at least $25,000 of cargo insurance;
(5) maintains a permanent nonresidential office from which the courier and logistics services are provided or arranged;
(6) has at least five full-time employees during the period on which margin is based;
(7) is not doing business as a livery service, floral delivery service, motor coach service, taxicab service, building supply
delivery service, water supply service, fuel or energy supply service, restaurant supply service, commercial moving and
storage company, or overnight delivery service; and
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§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(8) is not delivering items that the taxable entity or an affiliated entity sold.

(g-7) A taxable entity that is a qualified courier and logistics company shall exclude from its total revenue, to the
extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), subcontracting payments made by the taxable entity
to nonemployee agents for the performance of delivery services on behalf of the taxable entity. For purposes of this
subsection, “qualified courier and logistics company” means a taxable entity that:
(1) receives at least 80 percent of the taxable entity's annual total revenue from its entire business from a combination
of at least two of the following courier and logistics services:
(A) expedited same-day delivery of an envelope, package, parcel, roll of architectural drawings, box, or pallet;
(B) temporary storage and delivery of the property of another entity, including an envelope, package, parcel, roll
of architectural drawings, box, or pallet; and
(C) brokerage of same-day or expedited courier and logistics services to be completed by a person or entity under
a contract that includes a contractual obligation by the taxable entity to make payments to the person or entity
for those services;
(2) during the period on which margin is based, is registered as a motor carrier under Chapter 643, Transportation
Code, and if the taxable entity operates on an interstate basis, is registered as a motor carrier or broker under the
motor vehicle registration system established under 49 U.S.C. Section 14504a or a similar federal registration program
that replaces that system during that period;
(3) maintains an automobile liability insurance policy covering individuals operating vehicles owned, hired, or
otherwise used in the taxable entity's business, with a combined single limit for each occurrence of at least $1 million;
(4) maintains at least $25,000 of cargo insurance;
(5) maintains a permanent nonresidential office from which the courier and logistics services are provided or arranged;
(6) has at least five full-time employees during the period on which margin is based;
(7) is not doing business as a livery service, floral delivery service, motor coach service, taxicab service, building supply
delivery service, water supply service, fuel or energy supply service, restaurant supply service, commercial moving and
storage company, or overnight delivery service; and
(8) is not delivering items that the taxable entity or an affiliated entity sold.
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§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(g-8) A taxable entity that is primarily engaged in the business of transporting aggregates shall exclude from its total
revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), subcontracting payments made by the
taxable entity to independent contractors for the performance of delivery services on behalf of the taxable entity. In this
subsection, “aggregates” means any commonly recognized construction material removed or extracted from the earth,
including dimension stone, crushed and broken limestone, crushed and broken granite, other crushed and broken stone,
construction sand and gravel, industrial sand, dirt, soil, cementitious material, and caliche.
(g-10) A taxable entity that is primarily engaged in the business of transporting barite shall exclude from its total revenue,
to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), subcontracting payments made by the taxable
entity to nonemployee agents for the performance of transportation services on behalf of the taxable entity. For purposes
of this subsection, “barite” means barium sulfate (BaSO4), a mineral used as a weighing agent in oil and gas exploration.
(g-11) A taxable entity that is primarily engaged in the business of performing landman services shall exclude from its
total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), subcontracting payments made by
the taxable entity to nonemployees for the performance of landman services on behalf of the taxable entity. In this
subsection, “landman services” means:
(1) performing title searches for the purpose of determining ownership of or curing title defects related to oil, gas, or
other related mineral or petroleum interests;
(2) negotiating the acquisition or divestiture of mineral rights for the purpose of the exploration, development, or
production of oil, gas, or other related mineral or petroleum interests; or
(3) negotiating or managing the negotiation of contracts or other agreements related to the ownership of mineral
interests for the exploration, exploitation, disposition, development, or production of oil, gas, or other related mineral
or petroleum interests.
(h) If the taxable entity belongs to an affiliated group, the taxable entity may not exclude payments described by
Subsection (f), (g), (g-1), (g-2), (g-3), or (g-4) that are made to entities that are members of the affiliated group.
(i) Except as provided by Subsection (g), a payment made under an ordinary contract for the provision of services in the
regular course of business may not be excluded.
(j) Any amount excluded under this section may not be included in the determination of cost of goods sold under Section
171.1012 or the determination of compensation under Section 171.1013.
(k) A taxable entity that is a professional employer organization shall exclude from its total revenue payments received
from a client for wages, payroll taxes on those wages, employee benefits, and workers' compensation benefits for the
covered employees of the client.
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§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(l) For purposes of Subsection (g)(1):
(1) “Sales commission” means:
(A) any form of compensation paid to a person for engaging in an act for which a license is required by Chapter
1101, Occupations Code; or
(B) compensation paid to a sales representative by a principal in an amount that is based on the amount or level of
certain orders for or sales of the principal's product and that the principal is required to report on Internal Revenue
Service Form 1099-MISC.
(2) “Principal” means a person who:
(A) manufactures, produces, imports, distributes, or acts as an independent agent for the distribution of a product
for sale;
(B) uses a sales representative to solicit orders for the product; and
(C) compensates the sales representative wholly or partly by sales commission.
(m) A taxable entity shall exclude from its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or
(c)(3), dividends and interest received from federal obligations.
(m-1) A taxable entity that is a management company shall exclude from its total revenue reimbursements of specified
costs incurred in its conduct of the active trade or business of a managed entity, including “wages and cash compensation”
as determined under Sections 171.1013(a) and (b).
(n) Except as provided by Subsection (o), a taxable entity that is a health care provider shall exclude from its total revenue:
(1) to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), the total amount of payments the health care
provider received:
(A) under the Medicaid program, Medicare program, Indigent Health Care and Treatment Act (Chapter 61, Health
and Safety Code), and Children's Health Insurance Program (CHIP);
(B) for professional services provided in relation to a workers' compensation claim under Title 5, Labor Code; 1 and
(C) for professional services provided to a beneficiary rendered under the TRICARE military health system; and
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 8
§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(2) the actual cost to the health care provider for any uncompensated care provided, but only if the provider maintains
records of the uncompensated care for auditing purposes and, if the provider later receives payment for all or part of
that care, the provider adjusts the amount excluded for the tax year in which the payment is received.
(n-1) The comptroller shall adopt rules governing:
(1) the computation of the actual cost to a health care provider of any uncompensated care provided under Subsection
(n)(2); and
(2) the audit requirements related to the computation of those costs.
(o) A health care provider that is a health care institution shall exclude from its total revenue 50 percent of the amounts
described by Subsection (n).
(p) In this section:
(1) “Federal obligations” means:
(A) stocks and other direct obligations of, and obligations unconditionally guaranteed by, the United States
government and United States government agencies; and
(B) direct obligations of a United States government-sponsored agency.
(2) “Health care institution” means:
(A) an ambulatory surgical center;
(B) an assisted living facility licensed under Chapter 247, Health and Safety Code;
(C) an emergency medical services provider;
(D) a home and community support services agency;
(E) a hospice;
(F) a hospital;
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 9
§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(G) a hospital system;
(H) an intermediate care facility for the mentally retarded or a home and community-based services waiver program
for persons with mental retardation adopted in accordance with Section 1915(c) of the federal Social Security Act
(42 U.S.C. Section 1396n);
(I) a birthing center;
(J) a nursing home;
(K) an end stage renal disease facility licensed under Section 251.011, Health and Safety Code; or
(L) a pharmacy.
(3) “Health care provider” means a taxable entity that participates in the Medicaid program, Medicare program,
Children's Health Insurance Program (CHIP), state workers' compensation program, or TRICARE military health
system as a provider of health care services.
(4) “Obligation” means any bond, debenture, security, mortgage-backed security, pass-through certificate, or other
evidence of indebtedness of the issuing entity. The term does not include a deposit, a repurchase agreement, a loan, a
lease, a participation in a loan or pool of loans, a loan collateralized by an obligation of a United States government
agency, or a loan guaranteed by a United States government agency.
(4-a) “Pro bono services” means the direct provision of legal services to the poor, without an expectation of
compensation.
(4-b) Repealed by Acts 2007, 80th Leg., ch. 1282, § 37(2).
(5) “United States government” means any department or ministry of the federal government, including a federal
reserve bank. The term does not include a state or local government, a commercial enterprise owned wholly or partly
by the United States government, or a local governmental entity or commercial enterprise whose obligations are
guaranteed by the United States government.
(6) “United States government agency” means an instrumentality of the United States government whose obligations
are fully and explicitly guaranteed as to the timely payment of principal and interest by the full faith and credit of
the United States government. The term includes the Government National Mortgage Association, the Department
of Veterans Affairs, the Federal Housing Administration, the Farmers Home Administration, the Export-Import
Bank, the Overseas Private Investment Corporation, the Commodity Credit Corporation, the Small Business
Administration, and any successor agency.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 10
§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(7) “United States government-sponsored agency” means an agency originally established or chartered by the United
States government to serve public purposes specified by the United States Congress but whose obligations are not
explicitly guaranteed by the full faith and credit of the United States government. The term includes the Federal Home
Loan Mortgage Corporation, the Federal National Mortgage Association, the Farm Credit System, the Federal Home
Loan Bank System, the Student Loan Marketing Association, and any successor agency.
(8) “Vaccine” means a preparation or suspension of dead, live attenuated, or live fully virulent viruses or bacteria, or
of antigenic proteins derived from them, used to prevent, ameliorate, or treat an infectious disease.
(q) A taxable entity shall exclude from its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or
(c)(3), all revenue received that is directly derived from the operation of a facility that is:
(1) located on property owned or leased by the federal government; and
(2) managed or operated primarily to house members of the armed forces of the United States.
(r) A taxable entity shall exclude, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), total revenue
received from oil or gas produced, during the dates certified by the comptroller pursuant to Subsection (s), from:
(1) an oil well designated by the Railroad Commission of Texas or similar authority of another state whose production
averages less than 10 barrels a day over a 90-day period; and
(2) a gas well designated by the Railroad Commission of Texas or similar authority of another state whose production
averages less than 250 mcf a day over a 90-day period.
(s) The comptroller shall certify dates during which the monthly average closing price of West Texas Intermediate crude
oil is below $40 per barrel and the average closing price of gas is below $5 per MMBtu, as recorded on the New York
Mercantile Exchange (NYMEX).
(t) The comptroller shall adopt rules as necessary to accomplish the legislative intent prescribed by this section.
(u) A taxable entity shall exclude from its total revenue the actual cost paid by the taxable entity for a vaccine.
(v) A taxable entity primarily engaged in the business of transporting goods by waterways that does not subtract cost of
goods sold in computing its taxable margin shall exclude from its total revenue direct costs of providing transportation
services by intrastate or interstate waterways to the same extent that a taxable entity that sells in the ordinary course of
business real or tangible personal property would be authorized by Section 171.1012 to subtract those costs as costs of
goods sold in computing its taxable margin, notwithstanding Section 171.1012(e)(3).
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 11
§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(w-1) A taxable entity primarily engaged in the business of providing services as an agricultural aircraft operation, as
defined by 14 C.F.R. Section 137.3, shall exclude from its total revenue the cost of labor, equipment, fuel, and materials
used in providing those services.
(x) A taxable entity that is registered as a motor carrier under Chapter 643, Transportation Code, shall exclude from
its total revenue, to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), flow-through revenue derived
from taxes and fees.
Credits
Added by Acts 2006, 79th Leg., 3rd C.S., ch. 1, § 5, eff. Jan. 1, 2008. Amended by Acts 2007, 80th Leg., ch. 1282, §§ 12,
13, 37(2), eff. Jan. 1, 2008; Acts 2009, 81st Leg., ch. 1360, § 3(a), eff. Jan. 1, 2010; Acts 2011, 82nd Leg., 1st C.S., ch. 4
(S.B. 1), § 45.03, eff. Jan. 1, 2012; Acts 2013, 83rd Leg., ch. 117 (S.B. 1286), § 25, eff. Sept. 1, 2013; Acts 2013, 83rd Leg.,
ch. 1006 (H.B. 2451), § 1, eff. Jan. 1, 2014; Acts 2013, 83rd Leg., ch. 1034 (H.B. 2766), § 1, eff. Jan. 1, 2014; Acts 2013,
83rd Leg., ch. 1232 (H.B. 500), §§ 7, 8, eff. Jan. 1, 2014; Acts 2017, 85th Leg., ch. 703 (H.B. 3254), § 1, eff. Jan. 1, 2018.
Notes of Decisions (9)
Footnotes
1 V.T.C.A., Labor Code § 401.001 et seq.
V. T. C. A., Tax Code § 171.1011, TX TAX § 171.1011
Current through the end of the 2017 Regular and First Called Sessions of the 85th Legislature
End of Document © 2017 Thomson Reuters. No claim to original U.S. Government Works.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 12
APPENDIX D-2
§ 171.1012. Determination of Cost of Goods Sold, TX TAX § 171.1012
KeyCite Yellow Flag - Negative Treatment
Proposed Legislation
Vernon's Texas Statutes and Codes Annotated
Tax Code (Refs & Annos)
Title 2. State Taxation (Refs & Annos)
Subtitle F. Franchise Tax (Refs & Annos)
Chapter 171. Franchise Tax (Refs & Annos)
Subchapter C. Determination of Taxable Margin; Allocation and Apportionment
V.T.C.A., Tax Code § 171.1012
§ 171.1012. Determination of Cost of Goods Sold
Effective: September 1, 2017
Currentness
(a) In this section:
(1) “Goods” means real or tangible personal property sold in the ordinary course of business of a taxable entity.
(2) “Production” means construction, manufacture, development, mining, extraction, improvement, creation, raising,
or growth.
(3)(A) “Tangible personal property” means:
(i) personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in
any other manner;
(ii) films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and other
similar property embodying words, ideas, concepts, images, or sound, without regard to the means or methods of
distribution or the medium in which the property is embodied, for which, as costs are incurred in producing the
property, it is intended or is reasonably likely that any medium in which the property is embodied will be mass-
distributed by the creator or any one or more third parties in a form that is not substantially altered; and
(iii) a computer program, as defined by Section 151.0031.
(B) “Tangible personal property” does not include:
(i) intangible property; or
(ii) services.
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§ 171.1012. Determination of Cost of Goods Sold, TX TAX § 171.1012
(b) Subject to Section 171.1014, a taxable entity that elects to subtract cost of goods sold for the purpose of computing
its taxable margin shall determine the amount of that cost of goods sold as provided by this section.
(c) The cost of goods sold includes all direct costs of acquiring or producing the goods, including:
(1) labor costs;
(2) cost of materials that are an integral part of specific property produced;
(3) cost of materials that are consumed in the ordinary course of performing production activities;
(4) handling costs, including costs attributable to processing, assembling, repackaging, and inbound transportation
costs;
(5) storage costs, including the costs of carrying, storing, or warehousing property, subject to Subsection (e);
(6) depreciation, depletion, and amortization, reported on the federal income tax return on which the report under this
chapter is based, to the extent associated with and necessary for the production of goods, including recovery described
by Section 197, Internal Revenue Code;
(7) the cost of renting or leasing equipment, facilities, or real property directly used for the production of the goods,
including pollution control equipment and intangible drilling and dry hole costs;
(8) the cost of repairing and maintaining equipment, facilities, or real property directly used for the production of the
goods, including pollution control devices;
(9) costs attributable to research, experimental, engineering, and design activities directly related to the production of
the goods, including all research or experimental expenditures described by Section 174, Internal Revenue Code;
(10) geological and geophysical costs incurred to identify and locate property that has the potential to produce
minerals;
(11) taxes paid in relation to acquiring or producing any material, or taxes paid in relation to services that are a direct
cost of production;
(12) the cost of producing or acquiring electricity sold; and
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 2
§ 171.1012. Determination of Cost of Goods Sold, TX TAX § 171.1012
(13) a contribution to a partnership in which the taxable entity owns an interest that is used to fund activities, the costs
of which would otherwise be treated as cost of goods sold of the partnership, but only to the extent that those costs
are related to goods distributed to the taxable entity as goods-in-kind in the ordinary course of production activities
rather than being sold.
(d) In addition to the amounts includable under Subsection (c), the cost of goods sold includes the following costs in
relation to the taxable entity's goods:
(1) deterioration of the goods;
(2) obsolescence of the goods;
(3) spoilage and abandonment, including the costs of rework labor, reclamation, and scrap;
(4) if the property is held for future production, preproduction direct costs allocable to the property, including costs
of purchasing the goods and of storage and handling the goods, as provided by Subsections (c)(4) and (c)(5);
(5) postproduction direct costs allocable to the property, including storage and handling costs, as provided by
Subsections (c)(4) and (c)(5);
(6) the cost of insurance on a plant or a facility, machinery, equipment, or materials directly used in the production
of the goods;
(7) the cost of insurance on the produced goods;
(8) the cost of utilities, including electricity, gas, and water, directly used in the production of the goods;
(9) the costs of quality control, including replacement of defective components pursuant to standard warranty policies,
inspection directly allocable to the production of the goods, and repairs and maintenance of goods; and
(10) licensing or franchise costs, including fees incurred in securing the contractual right to use a trademark, corporate
plan, manufacturing procedure, special recipe, or other similar right directly associated with the goods produced.
(e) The cost of goods sold does not include the following costs in relation to the taxable entity's goods:
(1) the cost of renting or leasing equipment, facilities, or real property that is not used for the production of the goods;
(2) selling costs, including employee expenses related to sales;
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§ 171.1012. Determination of Cost of Goods Sold, TX TAX § 171.1012
(3) distribution costs, including outbound transportation costs;
(4) advertising costs;
(5) idle facility expense;
(6) rehandling costs;
(7) bidding costs, which are the costs incurred in the solicitation of contracts ultimately awarded to the taxable entity;
(8) unsuccessful bidding costs, which are the costs incurred in the solicitation of contracts not awarded to the taxable
entity;
(9) interest, including interest on debt incurred or continued during the production period to finance the production
of the goods;
(10) income taxes, including local, state, federal, and foreign income taxes, and franchise taxes that are assessed on
the taxable entity based on income;
(11) strike expenses, including costs associated with hiring employees to replace striking personnel, but not including
the wages of the replacement personnel, costs of security, and legal fees associated with settling strikes;
(12) officers' compensation;
(13) costs of operation of a facility that is:
(A) located on property owned or leased by the federal government; and
(B) managed or operated primarily to house members of the armed forces of the United States; and
(14) any compensation paid to an undocumented worker used for the production of goods. As used in this subdivision:
(A) “undocumented worker” means a person who is not lawfully entitled to be present and employed in the United
States; and
(B) “goods” includes the husbandry of animals, the growing and harvesting of crops, and the severance of timber
from realty.
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§ 171.1012. Determination of Cost of Goods Sold, TX TAX § 171.1012
(f) A taxable entity may subtract as a cost of goods sold indirect or administrative overhead costs, including all mixed
service costs, such as security services, legal services, data processing services, accounting services, personnel operations,
and general financial planning and financial management costs, that it can demonstrate are allocable to the acquisition
or production of goods, except that the amount subtracted may not exceed four percent of the taxable entity's total
indirect or administrative overhead costs, including all mixed service costs. Any costs excluded under Subsection (e) may
not be subtracted under this subsection.
(g) A taxable entity that is allowed a subtraction by this section for a cost of goods sold and that is subject to Section
263A, 460, or 471, Internal Revenue Code, may capitalize that cost in the same manner and to the same extent that the
taxable entity capitalized that cost on its federal income tax return or may expense those costs, except for costs excluded
under Subsection (e), or in accordance with Subsections (c), (d), and (f). If the taxable entity elects to capitalize costs,
it must capitalize each cost allowed under this section that it capitalized on its federal income tax return. If the taxable
entity later elects to begin expensing a cost that may be allowed under this section as a cost of goods sold, the entity may
not deduct any cost in ending inventory from a previous report. If the taxable entity elects to expense a cost of goods
sold that may be allowed under this section, a cost incurred before the first day of the period on which the report is based
may not be subtracted as a cost of goods sold. If the taxable entity elects to expense a cost of goods sold and later elects
to capitalize that cost of goods sold, a cost expensed on a previous report may not be capitalized.
(h) A taxable entity shall determine its cost of goods sold, except as otherwise provided by this section, in accordance
with the methods used on the federal income tax return on which the report under this chapter is based. This subsection
does not affect the type or category of cost of goods sold that may be subtracted under this section.
(i) A taxable entity may make a subtraction under this section in relation to the cost of goods sold only if that entity
owns the goods. The determination of whether a taxable entity is an owner is based on all of the facts and circumstances,
including the various benefits and burdens of ownership vested with the taxable entity. A taxable entity furnishing labor
or materials to a project for the construction, improvement, remodeling, repair, or industrial maintenance (as the term
“maintenance” is defined in 34 T.A.C. Section 3.357) of real property is considered to be an owner of that labor or
materials and may include the costs, as allowed by this section, in the computation of cost of goods sold. Solely for
purposes of this section, a taxable entity shall be treated as the owner of goods being manufactured or produced by the
entity under a contract with the federal government, including any subcontracts that support a contract with the federal
government, notwithstanding that the Federal Acquisition Regulation may require that title or risk of loss with respect to
those goods be transferred to the federal government before the manufacture or production of those goods is complete.
(j) A taxable entity may not make a subtraction under this section for cost of goods sold to the extent the cost of goods
sold was funded by partner contributions and deducted under Subsection (c)(13).
(k) Notwithstanding any other provision of this section, if the taxable entity is a lending institution that offers loans
to the public and elects to subtract cost of goods sold, the entity, other than an entity primarily engaged in an activity
described by category 5932 of the 1987 Standard Industrial Classification Manual published by the federal Office of
Management and Budget, may subtract as a cost of goods sold an amount equal to interest expense. For purposes of this
subsection, an entity engaged in lending to unrelated parties solely for agricultural production offers loans to the public.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 5
§ 171.1012. Determination of Cost of Goods Sold, TX TAX § 171.1012
(k-1) Notwithstanding any other provision of this section, the following taxable entities may subtract as a cost of goods
sold 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:
(1) a motor vehicle rental or leasing company that remits a tax on gross receipts imposed under Section 152.026;
(2) a heavy construction equipment rental or leasing company; and
(3) a railcar rolling stock rental or leasing company.
(k-2) This subsection applies only to a pipeline entity: (1) that owns or leases and operates the pipeline by which the
product is transported for others and only to that portion of the product to which the entity does not own title; and
(2) that is primarily engaged in gathering, storing, transporting, or processing crude oil, including finished petroleum
products, natural gas, condensate, and natural gas liquids, except for a refinery installation that manufactures finished
petroleum products from crude oil. Notwithstanding Subsection (e)(3) or (i), a pipeline entity providing services for
others related to the product that the pipeline does not own and to which this subsection applies may subtract as a cost
of goods sold its depreciation, operations, and maintenance costs allowed by this section related to the services provided.
(k-3) For purposes of Subsection (k-2), “processing” means the physical or mechanical removal, separation, or treatment
of crude oil, including finished petroleum products, natural gas, condensate, and natural gas liquids after those materials
are produced from the earth. The term does not include the chemical or biological transformation of those materials.
(l) Notwithstanding any other provision of this section, a payment made by one member of an affiliated group to another
member of that affiliated group not included in the combined group may be subtracted as a cost of goods sold only if
it is a transaction made at arm's length.
(m) In this section, “arm's length” means the standard of conduct under which entities that are not related parties and
that have substantially equal bargaining power, each acting in its own interest, would negotiate or carry out a particular
transaction.
(n) In this section, “related party” means a person, corporation, or other entity, including an entity that is treated as a
pass-through or disregarded entity for purposes of federal taxation, whether the person, corporation, or entity is subject
to the tax under this chapter or not, in which one person, corporation, or entity, or set of related persons, corporations,
or entities, directly or indirectly owns or controls a controlling interest in another entity.
(o) If a taxable entity, including a taxable entity with respect to which cost of goods sold is determined pursuant to Section
171.1014(e)(1), whose principal business activity is film or television production or broadcasting or the distribution of
tangible personal property described by Subsection (a)(3)(A)(ii), or any combination of these activities, elects to subtract
cost of goods sold, the cost of goods sold for the taxable entity shall be the costs described in this section in relation to
the property and include depreciation, amortization, and other expenses directly related to the acquisition, production,
or use of the property, including expenses for the right to broadcast or use the property.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 6
§ 171.1012. Determination of Cost of Goods Sold, TX TAX § 171.1012
(p) to (s) [Blank].
(t) If a taxable entity that is a movie theater elects to subtract cost of goods sold, the cost of goods sold for the taxable
entity shall be the costs described by this section in relation to the acquisition, production, exhibition, or use of a film or
motion picture, including expenses for the right to use the film or motion picture.
Credits
Added by Acts 2006, 79th Leg., 3rd C.S., ch. 1, § 5, eff. Jan. 1, 2008. Amended by Acts 2007, 80th Leg., ch. 1282, §§ 14,
15, eff. Jan. 1, 2008; Acts 2013, 83rd Leg., ch. 1232 (H.B. 500), § 9, eff. Jan. 1, 2014; Acts 2013, 83rd Leg., ch. 1232 (H.B.
500), § 10(a), eff. Sept. 1, 2013; Acts 2017, 85th Leg., ch. 377 (H.B. 4002), § 1, eff. Sept. 1, 2017.
Notes of Decisions (12)
V. T. C. A., Tax Code § 171.1012, TX TAX § 171.1012
Current through the end of the 2017 Regular and First Called Sessions of the 85th Legislature
End of Document © 2017 Thomson Reuters. No claim to original U.S. Government Works.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 7
APPENDIX D-3
§ 53.001. Definitions, TX PROPERTY § 53.001
KeyCite Yellow Flag - Negative Treatment
Proposed Legislation
Vernon's Texas Statutes and Codes Annotated
Property Code (Refs & Annos)
Title 5. Exempt Property and Liens
Subtitle B. Liens
Chapter 53. Mechanic's, Contractor's, or Materialman's Lien (Refs & Annos)
Subchapter A. General Provisions
V.T.C.A., Property Code § 53.001
§ 53.001. Definitions
Currentness
In this chapter:
(1) “Contract price” means the cost to the owner for any part of construction or repair performed under an original
contract.
(2) “Improvement” includes:
(A) abutting sidewalks and streets and utilities in or on those sidewalks and streets;
(B) clearing, grubbing, draining, or fencing of land;
(C) wells, cisterns, tanks, reservoirs, or artificial lakes or pools made for supplying or storing water;
(D) pumps, siphons, and windmills or other machinery or apparatuses used for raising water for stock, domestic
use, or irrigation; and
(E) planting orchard trees, grubbing out orchards and replacing trees, and pruning of orchard trees.
(3) “Labor” means labor used in the direct prosecution of the work.
(4) “Material” means all or part of:
(A) the material, machinery, fixtures, or tools incorporated into the work, consumed in the direct prosecution of
the work, or ordered and delivered for incorporation or consumption;
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 1
§ 53.001. Definitions, TX PROPERTY § 53.001
(B) rent at a reasonable rate and actual running repairs at a reasonable cost for construction equipment used or
reasonably required and delivered for use in the direct prosecution of the work at the site of the construction or
repair; or
(C) power, water, fuel, and lubricants consumed or ordered and delivered for consumption in the direct prosecution
of the work.
(5) “Mechanic's lien” means the lien provided by this chapter.
(6) “Original contract” means an agreement to which an owner is a party either directly or by implication of law.
(7) “Original contractor” means a person contracting with an owner either directly or through the owner's agent.
(8) “Residence” means a single-family house, duplex, triplex, or quadruplex or a unit in a multiunit structure used
for residential purposes that is:
(A) owned by one or more adult persons; and
(B) used or intended to be used as a dwelling by one of the owners.
(9) “Residential construction contract” means a contract between an owner and a contractor in which the contractor
agrees to construct or repair the owner's residence, including improvements appurtenant to the residence.
(10) “Residential construction project” means a project for the construction or repair of a new or existing residence,
including improvements appurtenant to the residence, as provided by a residential construction contract.
(11) “Retainage” means an amount representing part of a contract payment that is not required to be paid to the
claimant within the month following the month in which labor is performed, material is furnished, or specially
fabricated material is delivered. The term does not include retainage under Subchapter E. 1
(12) “Specially fabricated material” means material fabricated for use as a component of the construction or repair
so as to be reasonably unsuitable for use elsewhere.
(13) “Subcontractor” means a person who has furnished labor or materials to fulfill an obligation to an original
contractor or to a subcontractor to perform all or part of the work required by an original contract.
(14) “Work” means any part of construction or repair performed under an original contract.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 2
§ 53.001. Definitions, TX PROPERTY § 53.001
(15) “Completion” of an original contract means the actual completion of the work, including any extras or change
orders reasonably required or contemplated under the original contract, other than warranty work or replacement or
repair of the work performed under the contract.
Credits
Acts 1983, 68th Leg., p. 3533, ch. 576, § 1, eff. Jan. 1, 1984. Amended by Acts 1997, 75th Leg., ch. 526, § 2, eff. Sept. 1,
1997; Acts 1999, 76th Leg., ch. 889, § 1, eff. Sept. 1, 1999.
Editors' Notes
REVISOR'S NOTE
2014 Main Volume
(1) The revised law omits the source law provision that materials qualify as specially fabricated even if not
delivered because the provision is unnecessary as part of the definition. The provision has the substantive
effect of making the mechanic's lien attach even if the material is not delivered, and that is expressly provided
for in Section 53.021(b).
(2) The revised law adds the definition of “mechanic's lien” for drafting convenience.
Notes of Decisions (47)
Footnotes
1 V.T.C.A., Property Code § 53.101 et seq.
V. T. C. A., Property Code § 53.001, TX PROPERTY § 53.001
Current through the end of the 2017 Regular and First Called Sessions of the 85th Legislature
End of Document © 2017 Thomson Reuters. No claim to original U.S. Government Works.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 3
APPENDIX D-4
§ 53.021. Persons Entitled to Lien, TX PROPERTY § 53.021
KeyCite Yellow Flag - Negative Treatment
Proposed Legislation
Vernon's Texas Statutes and Codes Annotated
Property Code (Refs & Annos)
Title 5. Exempt Property and Liens
Subtitle B. Liens
Chapter 53. Mechanic's, Contractor's, or Materialman's Lien (Refs & Annos)
Subchapter B. Persons Entitled to Lien; Subject Property (Refs & Annos)
V.T.C.A., Property Code § 53.021
§ 53.021. Persons Entitled to Lien
Effective: September 1, 2003
Currentness
(a) A person has a lien if:
(1) the person labors, specially fabricates material, or furnishes labor or materials for construction or repair in this
state of:
(A) a house, building, or improvement;
(B) a levee or embankment to be erected for the reclamation of overflow land along a river or creek; or
(C) a railroad; and
(2) the person labors, specially fabricates the material, or furnishes the labor or materials under or by virtue of a
contract with the owner or the owner's agent, trustee, receiver, contractor, or subcontractor.
(b) A person who specially fabricates material has a lien even if the material is not delivered.
(c) An architect, engineer, or surveyor who prepares a plan or plat under or by virtue of a written contract with the
owner or the owner's agent, trustee, or receiver in connection with the actual or proposed design, construction, or repair
of improvements on real property or the location of the boundaries of real property has a lien on the property.
(d) A person who provides labor, plant material, or other supplies for the installation of landscaping for a house, building,
or improvement, including the construction of a retention pond, retaining wall, berm, irrigation system, fountain, or
other similar installation, under or by virtue of a written contract with the owner or the owner's agent, contractor,
subcontractor, trustee, or receiver has a lien on the property.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 1
§ 53.021. Persons Entitled to Lien, TX PROPERTY § 53.021
(e) A person who performs labor as part of, or who furnishes labor or materials for, the demolition of a structure on real
property under or by virtue of a written contract with the owner of the property or the owner's agent, trustee, receiver,
contractor, or subcontractor has a lien on the property.
Credits
Acts 1983, 68th Leg., p. 3535, ch. 576, § 1, eff. Jan. 1, 1984. Amended by Acts 1989, 71st Leg., ch. 395, § 1, eff. Sept. 1,
1989; Acts 1989, 71st Leg., ch. 1138, § 1, eff. Sept. 1, 1989; Acts 1991, 72nd Leg., ch. 16, § 16.01, eff. Aug. 26, 1991; Acts
1995, 74th Leg., ch. 851, §§ 1, 6, eff. Sept. 1, 1995; Acts 1999, 76th Leg., ch. 896, § 1, eff. Sept. 1, 1999; Acts 2003, 78th
Leg., ch. 410, § 1, eff. Sept. 1, 2003; Acts 2011, 82nd Leg., ch. 271 (H.B. 1456), § 1, eff. Jan. 1, 2012.
Editors' Notes
REVISOR'S NOTE
2014 Main Volume
The revised law omits the references to a “firm” and a “corporation” because those entities are included in
the definition of “person” under the Code Construction Act (V.A.C.S. Article 5429b-2).
Notes of Decisions (143)
V. T. C. A., Property Code § 53.021, TX PROPERTY § 53.021
Current through the end of the 2017 Regular and First Called Sessions of the 85th Legislature
End of Document © 2017 Thomson Reuters. No claim to original U.S. Government Works.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 2
APPENDIX D-5
§ 53.023. Payment Secured by Lien, TX PROPERTY § 53.023
KeyCite Yellow Flag - Negative Treatment
Proposed Legislation
Vernon's Texas Statutes and Codes Annotated
Property Code (Refs & Annos)
Title 5. Exempt Property and Liens
Subtitle B. Liens
Chapter 53. Mechanic's, Contractor's, or Materialman's Lien (Refs & Annos)
Subchapter B. Persons Entitled to Lien; Subject Property (Refs & Annos)
V.T.C.A., Property Code § 53.023
§ 53.023. Payment Secured by Lien
Currentness
The lien secures payment for:
(1) the labor done or material furnished for the construction or repair;
(2) the specially fabricated material, even if the material has not been delivered or incorporated into the construction
or repair, less its fair salvage value; or
(3) the preparation of a plan or plat by an architect, engineer, or surveyor in accordance with Section 53.021(c).
Credits
Acts 1983, 68th Leg., p. 3536, ch. 576, § 1, eff. Jan. 1, 1984. Amended by Acts 1995, 74th Leg., ch. 851, § 2, eff. Sept.
1, 1995.
Notes of Decisions (3)
V. T. C. A., Property Code § 53.023, TX PROPERTY § 53.023
Current through the end of the 2017 Regular and First Called Sessions of the 85th Legislature
End of Document © 2017 Thomson Reuters. No claim to original U.S. Government Works.
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 1