In Gulf Copper & Manufacturing Corp. v. Hegar, a Texas district court awarded full relief to Gulf Copper, upholding its position on both the Revenue Exclusion for Real Property Subcontractors and Cost of Goods Sold Deduction. The court rejected the Comptroller’s arguments that a fee-sharing contract was required in order to exclude revenues paid to subcontractors and that Gulf Copper’s activities were too far removed from real property activities. The court also allowed the full Cost of Goods Sold deduction claimed by Gulf Copper, which included costs incurred to remove defective portions of customers’ offshore oil rigs and to install the new components.
Gulf Copper is primarily engaged in the business of repair and upgrade of offshore drilling rigs. For example, Gulf Copper’s customers bring damaged rigs to one of Gulf Copper’s facilities located along the Texas coast. Gulf Copper moves the rigs onto its dry dock facilities and makes note of the damaged, corroded portions. Gulf Copper then manufactures replacement steel components. It then cuts out the defective portions of the rigs, and welds on the newly-manufactured components.
Gulf Copper performs this work using both employees and subcontractors. During 2008, Gulf Copper paid its subcontractors $79 million for their services and incurred an additional almost $70 million in employee labor, materials, supplies, and other costs associated with its operations.
Texas Franchise Tax
The Texas franchise tax is imposed on a business’s gross profits (or margin). Margin, under Gulf Copper’s circumstances, mean its federal income tax revenues less its revenue exclusions and its costs of goods sold.
Revenue Exclusion for Real Property Activities
Texas law allows taxpayers to exclude (remove) from revenue amounts paid to subcontractors in connection with real property activities. The provision reads, in relevant part:
(g) A taxable entity shall exclude from its total revenue . . . only the following flow-through funds that are mandated by contract or subcontract to be distributed to other entities: . . .
(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.
Under this provision, Gulf Copper reduced its revenue by $79 million. The Texas Comptroller denied the exclusion alleging that only percentage-based fee sharing contracts qualify for this exclusion. The Texas Comptroller also argued that rig repair work wasn’t sufficiently connected to a real estate activity to qualify.
Gulf Copper alleged that, under Titan Transportation L.P. v. Combs, 433 S.W.3d 625 (Tex. App.-Austin, Mar. 14 2014, pet. denied), no particular form of contract was required. Gulf Copper also presented evidence to establish that the rigs, once repaired, would be used to drill oil wells and that the drilling of oil wells constituted qualifying real property activities under Texas law. This enabled the court to find in favor of Gulf Copper on the revenue exclusion.
Cost of Goods Sold Deduction
Gulf Copper also alleged that it was entitled to include its $70 million of internal costs in its cost of goods sold deduction. These costs consisted of employee labor, rent, welding equipment, and other costs associated with manufacturing and installing the replacement components on its customers’ rigs. The Texas Comptroller disagreed, arguing that Gulf Copper could only include the costs incurred in manufacturing the replacement components and not the costs incurred to remove defective portions and to install the new ones. The Texas Comptroller contended that the costs associated with removing defective rig components and installing the new ones were costs incurred for services, not for the production of goods.
Gulf Copper argued that the clear language of the statute allowed it to deduct the entire $70 million of its costs. Gulf Copper presented the court with a statutory analysis inapposite of the position advanced by the Texas Comptroller. The court allowed Gulf Copper’s full cost of goods sold deduction.
Pursuant to the Texas Comptroller’s request, the court has entered findings of fact and conclusions of law. Such a request signals the Comptroller’s intent to appeal.