Gulf Copper Decision Defines Scope of Real Estate Industry Revenue Exclusion and COGS Calculation

The Texas Court of Appeals resolved two important issues under the Texas franchise tax in Hegar v. Gulf Copper & Manufacturing Corporation, No. 03-16-00250-CV (Tex. App.—Austin August 11, 2017, no pet. h.). First, the Court ruled that the revenue exclusion for payments to subcontractors in the real estate industry is not confined to the narrow circumstances where the parties share fees on a percentage basis. In doing so, the Court held that the repair of an offshore rig to be used to drill a particular well was a qualifying activity. Second, the Court explained the proper calculation for the cost of goods sold deduction after rejecting both methods offered by the parties.

Gulf Copper & Manufacturing Corporation inspects, repairs, and upgrades rigs for offshore drilling. Its work includes manufacturing and installing large, steel components on the rigs. Once repaired, the rigs are sent offshore to drill particular wells. In preparing its Texas franchise tax report, Gulf Copper excluded its subcontractor payments to hourly workers and claimed a COGS deduction for its internal costs. The Comptroller audited Gulf Copper and denied both its revenue exclusion for payments to hourly subcontractors and that portion of its COGS deduction relating to the repair of offshore rigs. Gulf Copper brought suit, which culminated in a published opinion issued by the Texas Court of Appeals on August 11, 2017.

a. Revenue Exclusion for Real Estate Subcontractors

The Court allowed Gulf Copper to exclude the entirety of its payments to subcontractors as flow-through funds. The first issue was whether Gulf Copper made the payments “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 Tex. Tax Code § 171.1011(g)(3).

The Comptroller contended that the work was too far removed to be performed “in connection with” any actual or proposed construction of improvements on real property, and was therefore too removed or attenuated from any actual or proposed construction site to qualify for the revenue exclusion. The Court stated that the proper inquiry is whether the activities performed by the subcontractors have “a reasonable connection to the construction of oil wells, which we have held, and the parties do not dispute, are improvements to real property.” The Court noted 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.” The Court held that these activities were reasonably connected to the construction of that oil well, so the portion of this work done by Gulf Copper’s subcontractors met the revenue exclusion’s requirement that work be performed “in connection with” construction of an improvement on real property.

The second issue was whether the statute required either a fee-sharing or cost-plus subcontract. Gulf Copper’s subcontracts did not: they provided for payment on an hourly basis. The Court rejected the Comptroller’s position that any particular form of subcontract was required, relying upon the plain text of the statute and the holding in Titan Transportation, LP v. Combs. In doing so, the Court invalidated the Comptroller’s attempt to limit the holding of Titan Transportation in a Tax Policy Division memorandum that limited the exclusion to only contracts that met these conditions:

"[I]f the taxable entity has a contract with its customer providing that a subcontractor may be used and requiring payment to the subcontractor, or by a written contract between the taxable entity and the subcontractor where the payment is based on the funds paid to the taxable entity by the taxable entity’s customers. For example, the contract between the taxable entity and the subcontractor require payment based on a percentage of the funds the taxable entity receives from its customer." See STAR System Document No. 201606856L (June 30, 2016).

The Court’s ruling in Gulf Copper overturns this narrow interpretation and therefore contractors may claim the exclusion and avoid double-taxation without the fear of audit assessments on this issue.

b. Cost of Goods Sold for Oil Rig Repairs

The Court held that Gulf Copper must calculate its COGS deduction on a cost-by-cost basis, examining each category of deductions in relation to the qualifying activities. Gulf Copper both fabricated replacement parts and installed them on its customers’ oil rigs. The parties did not dispute the costs of fabrications, only the costs of repair. The Court held that the repair of oil rigs to be used to drill particular wells constituted a qualifying activity under Texas Tax Code § 171.1012(i), which states:

"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 costs of goods sold."

The Court remanded the case back to the trial court for further development of the costs incurred in repairing oil rigs that were going to be used for drilling particular wells. In its analysis, the Court rejected both of the calculation methods offered by the parties.

Jimmy Martens and Danielle Ahlrich of Martens, Todd, Leonard & Ahlrich represented Gulf Copper at trial and in connection with this appeal. For more information, please email either of them at jmartens@textaxlaw.com or dahlrich@textaxlaw.com or call (512) 542-9898.