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Texas Franchise Tax Update: Texas Supreme Court Allows Revenue Exclusion and Remands Cost of Goods Sold Subtraction for Oil Rig Repair Company

On April 3, 2020, the Texas Supreme Court issued its opinion in Hegar v. Gulf Copper & Manufacturing Corporation in which it found the oil rig repair company could reduce its revenue by the payments it made to hourly subcontractors but limited its COGS subtraction to the costs incurred as a producer of goods.1 The Supreme Court determined that Gulf Copper did not qualify as a “deemed” owner of goods and remanded the case to the trial court to determine how much Gulf Copper could subtract as an “actual” owner of goods.

Gulf Copper inspects, repairs, and upgrades offshore drilling rigs for rig owners and drilling contractors who use the rigs to drill offshore oil and gas wells. Each rig must be custom-modified or rebuilt so that it can be used to drill well(s) efficiently, safely, and legally in particular areas. Gulf Copper manufactures component parts which it installs on the rigs. To perform its work, Gulf Copper hires subcontractors to supplement its employee workforce.

The Comptroller audited Gulf Copper’s Report Year 2009 Texas franchise tax report and alleged that Gulf Copper had improperly excluded $80 million in payments to subcontractors from total revenue. The Comptroller also alleged that Gulf Copper improperly claimed a cost-of-goods-sold subtraction for various costs not specifically listed in Tex. Tax Code § 171.1012. The Comptroller allowed Gulf Copper to subtract the initial costs of fabricating the rig’s component parts, but denied Gulf Copper the COGS subtraction for the costs incurred in completing the component part and installing it on the rig.

Revenue Exclusion

In calculating its franchise tax liability, Gulf Copper excluded its payments to subcontractors from total revenue under Tex. Tax Code § 171.1011(g)(3). For Report Year 2009, subsection (g)(3) provided:

(g) A taxable entity shall exclude from its total revenue . . . 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.

The Comptroller argued that Gulf Copper’s subcontractor payments did not qualify for two reasons. First, the Comptroller argued that none of the work that Gulf Copper’s subcontractors did was “in connection with” the construction of real property improvements. Second, the Comptroller claimed that Gulf Copper’s payments to subcontractors were not “mandated by contract to be distributed to other entities.” Slip op. at 6. The Texas Supreme Court rejected both of these arguments.

Surveying dictionary definitions for the phrase “in connection with,” and the statutory context of the term, the Court found that the phrase “in connection with” “requires more than a remote, tangential relationship to the requisite design, construction, remodeling, or repair of real-property improvements.” Slip op. at 10. Nevertheless, the Court found that Gulf Copper’s work surveying, repairing, and upgrading rigs was “in connection with” the drilling of oil wells.

The Court rejected the Comptroller’s assertion that there must be a “physical, temporal, or contractual proximity” between the work performed and the real property improvement project. Slip op. at 10. The Texas Supreme Court found that the “in connection with” requirement was satisfied based on the trial court finding that “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.” Slip op. at 10–11. The Texas Supreme Court found Gulf Copper’s work “in connection with” specific real property improvement projects because it was a necessary component of enabling the rigs to drill specific wells. Slip op. at 11.

The Texas Supreme Court likewise rejected the Comptroller’s argument that Gulf Copper’s payments to subcontractors did not satisfy the requirement in subsection Tex. Tax Code § 171.1011(g)(3), which required that such payments be “flow-through funds that are mandated by contract to be distributed to other entities.” During the period at issue, Gulf Copper made payments to subcontractors and billed its customers for the subcontractors’ work under two different billing arrangements. Under the first “hourly” arrangement, Gulf Copper charged its customers hourly rates that were approximately fifteen to twenty percent more than Gulf Copper anticipated its subcontractor costs would be. Slip op. at 11–12. Under the second “cost-plus” arrangement, the customer was required to pay Gulf Copper for its cost of paying subcontractors plus a specified percentage that was typically also fifteen to twenty percent higher than Gulf Copper paid its subcontractors. Slip op. at 12.

The Comptroller argued that only the “cost-plus” billing arrangement met the requirement that the payments were contractually mandated to flow through to other entities. The Comptroller argued that the “cost-plus” arrangements with customers allocated exactly how much of the customer’s payment would go to Gulf Copper and how much would go to Gulf Copper’s subcontractors, while the “hourly” arrangement left Gulf Copper free to use the customer’s payment for purposes other than paying subcontractors. Slip op. at 12.

The Texas Supreme Court rejected this argument, finding that it “rests on the faulty premise that under subsection 171.1011(g), the only contract that can mandate the distribution of funds to other entities is the taxable entity’s contract with its customer.” Slip op. at 12. The Court found that Gulf Copper’s contract with a subcontractor is “no less a contract” than that with its customer. Slip op. at 12. Since Gulf Copper’s contracts with its subcontractors required payment to “other entities” (i.e., the subcontractors), the Court found that the “mandated by contract” requirement was satisfied for payments Gulf Copper received under both the “hourly” and the “cost-plus” customer billing arrangements. The Court found that the phrase “mandated by contract” did not require “language designating specific funds to be passed through the taxable entity on their way from the customer to the subcontractor,” but merely required some contractual obligation that prevents the taxable entity from retaining the funds. Slip op. at 14. The Supreme Court also found that Gulf Copper’s use of accrual method accounting to book subcontractor costs in tandem with receiving customer payments supported the characterization of these receipts as flow-through funds. Slip op. at 15.

The Texas Legislature amended Tex. Tax Code § 171.1011(g) for later years to exclude from revenue “flow-through funds that are mandated by contract or subcontract to be distributed to other entities.” (emphasis added). The Texas Supreme Court’s holding in Gulf Copper, and the Texas Legislature’s amendment to the statute, create a broad basis for exclusion of subcontractor payments since virtually all contracts with subcontractors require payment. This provides significant franchise tax savings, not just for Gulf Copper, but throughout the oilfield services and construction industries.

Cost of Goods Sold Subtraction

The Supreme Court also analyzed the costs that taxpayers may subtract as costs of goods sold (COGS) under Tex. Tax Code § 171.1012. Section 171.1012 requires that a taxable entity own and sell “goods” to qualify for the COGS subtraction. Tex. Tax Code § 171.1012(i). The statute also provides laundry lists of costs that are explicitly included in the COGS subtraction, costs that are specifically excluded, and costs that are included but limited to four percent of the costs incurred. Tex. Tax Code § 171.1012(c)–(f).

The Comptroller conceded that certain costs were properly included in Gulf Copper’s COGS subtraction. For example, Gulf Copper manufactures steel plates that it installs on the hulls of rigs to repair corroded hulls. The Comptroller agreed that these steel plates are “goods” under Tex. Tax Code § 171.1012 and that Gulf Copper is entitled to subtract some of the costs it incurred in manufacturing. Slip op. at 17.

The Comptroller argued, however, that Gulf Copper was prohibited from subtracting costs not specifically listed in the COGS statute as qualifying for subtraction. Gulf Copper argued that it qualified as a “deemed” owner of goods under Tex. Tax Code § 171.1012(i) and was entitled to include various other costs, such as the cost of painting existing rig hulls, in its COGS subtraction. Slip op. at 18. Section 171.1012(i) provides:

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 in this section, in the computation of cost of goods sold.

In analyzing this language, the Texas Supreme Court noted that it “differs in significant respects” from the real property revenue exclusion discussed above. Slip op. at 19. The Court reasoned that the COGS subtraction language is narrower than the corresponding revenue exclusion language, because the revenue exclusion “includes ‘design,’ which occurs off-site, and is not limited to actual ‘design, construction, remodeling, or repair’ but also includes ‘proposed design, construction, remodeling or repair.’” Slip op. at 19 (emphasis in slip op.) (quoting Tex. Tax Code § 171.1011(g)(3)). The Court also found that the revenue exclusion language “in connection with” is an “expanding term” while the COGS subtraction language “furnishing . . . to” is “restricting language.” Slip op. at 20.

The Court held that, “under section 171.1012(i), the requisite labor or materials must be furnished to or incorporated into the real property itself.” Slip op. at 21. Therefore, the Court found that Gulf Copper’s labor and materials were not “directed toward real property, but toward preparing equipment for later use on real property.” Slip op. at 20. In other words, the labor and materials were furnished to a project for inspecting, repairing and upgrading a drilling rig, not for drilling an offshore well.

Gulf Copper also argued that its costs were independently allowed under Tex. Tax Code § 171.1012(c)–(f) notwithstanding their relationship to real property improvement projects. Gulf Copper argued that, since its work to inspect, repair, and upgrade rigs is part of an integrated project involving production and acquisition of goods, all related project costs were subtractable. Slip op. at 22. Gulf Copper also argued that all of its activities are acts of production in preparation to drill an offshore well.

The Supreme Court refused to analyze the COGS subtraction on an integrated-project basis, finding instead that, even if the project involved some allowable costs, Gulf Copper was required to show that each of its costs independently qualified under section 171.1012. Slip op. at 22.

To support its COGS analysis, Gulf Copper pointed to a provision in the COGS statute that piggybacks off federal income tax COGS rules. Tex. Tax Code § 171.1012(h) provides:

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 costs of goods sold that may be subtracted under this section.

Gulf Copper interpreted subsection (h) to mean that the starting point for calculating its COGS subtraction was the amount reported on federal tax returns under Internal Revenue Code Section 263A, which governs which costs must be capitalized and which are included in inventory and tracks section 171.1012’s statutory listing of costs allowed for COGS. Slip op. at 24. The Court found that the language restricting subsection (h) from “affect[ing] the type or category of [COGS] that may be subtracted” meant that federal methods do not determine the COGS calculation unless “there are gaps in the Texas statute,” such as whether a cash or accrual method of accounting should be used. Slip op. at 25. The Supreme Court decoupled the analysis of whether an entity qualified for the COGS subtraction from the mathematical calculation of the amount of that subtraction:

Accordingly, whether a particular cost may be included in the COGS subtraction is not dependent on whether a taxable entity engages in some qualifying activities but rather on whether that cost independently meets the requirements of section 171.1012.

Slip op. at 25.

The Court also dismissed Gulf Copper’s argument that analyzing each individual cost separately would be practically unworkable for Gulf Copper by suggesting that a taxable entity could forego the COGS subtraction entirely and elect to calculate margin as 70% of total revenue. Slip op. at 25.

The Texas Supreme Court then remanded the case to the trial court to determine, on a cost-by-cost basis, which of Gulf Copper’s costs were independently eligible for the COGS subtraction. Slip op. at 26.

1. No. 17-0894, slip op. (Tex. Apr. 3, 2020), available at https://www.txcourts.gov/media/1446333/170894.pdf.

About Martens, Todd, Leonard & Ahlrich

Martens, Todd, Leonard & Ahlrich is a trial and appellate law firm headquartered in Austin, Texas. It handles only Texas tax cases, specifically those involving the Texas sales tax and Texas franchise tax. The firm’s attorneys have handled cases all the way through the Texas Supreme Court and U.S. Supreme Court. They speak and write frequently on a variety of Texas sales tax and franchise tax topics and have published articles in publications such as the Journal of State Taxation, the Texas Bar Journal, the Texas Lawyer, and the Texas Tech Administrative Law Journal. For more information, please visit texastaxlaw.com.