Introduction

In Sunstate Equipment Co. v. Hegar, the Court denied the cost of goods sold (COGS) subtraction for the heavy equipment rental company’s costs to deliver and pick-up equipment. In Hegar v. American Multi-Cinema, Inc., the Court denied the COGS subtraction for AMC’s film exhibition costs. While AMC ultimately lost, as we explain below, the Court’s rejection of an argument that the Legislature can “clarify” prior law and thereby give it retroactive effect may undermine the Comptroller’s position in other cases.

Sunstate Equipment Co. v. Hegar

On April 3, 2020, the Texas Supreme Court published its opinion in Sunstate Equipment Co., LLC v. Hegar1 denying Sunstate a COGS subtraction for the costs Sunstate incurred to deliver and later pick-up the heavy construction equipment that Sunstate had rented to its customers for use at construction sites.

Background. Sunstate rents out heavy construction and industrial equipment to its customers. This includes equipment such as forklifts and earth-moving machinery. Most of Sunstate’s customers were subcontractors doing construction work and Sunstate typically delivered the rented equipment to its customer’s construction site. Sunstate owned and maintained a fleet of delivery vehicles capable of transporting the equipment to a construction jobsite and it hired employees to deliver, set-up and pick-up the equipment once the rental period was over. Sunstate incurred costs in connection with the acquisition and use of the equipment, as well as costs to deliver the equipment to constructions sites and to pick it up when its rental customers finish using it:

- labor costs for employees driving the delivery vehicles

- depreciation of delivery vehicles

- property taxes on delivery vehicles

- insurance for the delivery vehicles and drivers

- fuel for the delivery vehicles

- costs to repair and maintain the delivery vehicles

When Sunstate prepared its Texas franchise tax report, Sunstate included in its COGS subtraction its costs of acquisition and use (fuel, maintenance, etc.), as well as its costs of delivering and picking up the equipment before and after rentals. The Comptroller audited Sunstate. The auditor allowed the costs associated with the equipment’s acquisition and use but disallowed the delivery and pick-up costs.2

COGS Not an Exemption. At the outset, the Court addressed a lingering issue: Is the COGS subtraction the equivalent of an exemption requiring strict construction against taxpayers? The Comptroller argued that the COGS subtraction was a deduction tantamount to an exemption and the Court should, therefore, “strictly construe [the COGS statute] against the taxpayer.”3 The Court noted that exemptions are strictly construed against taxpayers because “they are the antithesis of equality and uniformity and because they place a greater burden on other taxpaying businesses and individuals.”4 The Court refused to treat the COGS subtraction as a tax exemption, reasoning that the franchise tax is a tax imposed on margin (i.e., taxable margin is the tax base) and the COGS subtraction is part of the taxable margin calculation. The COGS subtraction does not exempt taxable amounts from taxation. Instead, the subtraction is used to determine how much is taxable in the first place.5

Delivery & Pick-up Costs. The Court then turned to whether or not Sunstate’s delivery and pick-up costs qualified as COGS. The Court examined and rejected two arguments Sunstate had advanced. The first argument arose under the industry-specific provision for rental companies, such as Sunstate. This provision, found in Tex. Tax Code § 171.1012(k-1), states:

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:

. . .

(2) a heavy construction equipment rental or leasing company.

The Court found this provision allowed rental companies to subtract only the same types of costs as are allowed to businesses who sell the equipment, rather than rent it out.6 Specifically, the Court stated that the phrase “in relation to” in subsection (k-1) refers to the same sorts of direct and indirect costs listed in subsections (c) and (d).7

The Court rejected pleas from Sunstate to consider “differences in a company’s business model” and allow Sunstate to subtract “any cost associated with how it realizes income.”8 The Court also rejected Sunstate’s argument that pickup and delivery costs were “direct costs of acquiring” the equipment, finding that only the initial acquisition of goods is covered by the COGS subtraction, not the re-acquisition from a rental customer.9 Moreover, the Court found that the pickup and delivery costs were specifically excluded from COGS because the statute specifically disallows rehandling and distribution costs.10

Next, the Court rejected Sunstate’s alternative argument that it could subtract the costs because of Sunstate’s connection with real property improvement projects.11 Under Tex. Tax Code § 171.1012(i):

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.

Sunstate argued that it furnished labor to real property projects because its workers delivered the heavy equipment to construction sites where contractors used it to improve real property. Thus, Sunstate argued, the costs it incurred were those of furnishing of labor and materials to its customers’ construction projects.12 While the Court acknowledged that “Sunstate certainly provides construction equipment that is ultimately used on real property,” the Court refused to extend subsection (i) to Sunstate because it was a step removed from the actual real property improvement project.13 Rather than furnishing labor and materials to projects for real property improvements, the Court found that Sunstate “furnishes labor to fulfill its own obligations under its rental agreements.”14

Hegar v. American Multi-Cinema, Inc.

On April 3, 2020, the Texas Supreme Court issued its opinion in Hegar v. American Multi-Cinema, Inc.15 holding that a movie theater may not subtract film exhibition costs as COGS when calculating its taxable margin. The Court reasoned that “film exhibitions are not tangible personal property that is sold” and, thus, the exhibition costs did not qualify.16 The case has limited application because the Legislature later added a provision to the statute that allows movie theaters to subtract their costs of exhibition.

Legislative “Clarification.” The American Multi-Cinema opinion is a nominal win for the Comptroller because its application is limited by the Legislature’s later amendment to the COGS statute that allowed for the subtraction of exhibition costs, such as those at issue in the AMC case. While the amendment was labeled a “clarification of existing law,” the Court rejected it as a basis for retroactively applying the amendment. We discuss the reasons at the end of this analysis.

However, it’s important to observe this at the outset because the Court’s rejection of an argument that the Legislature can “clarify” prior law and thereby give it retroactive effect may undermine the Comptroller’s position in other cases. For the 2019 legislative session, the Comptroller convinced the Legislature to substantively amend sales tax statutes and label the amendments as “clarifications” of existing law so that he could retroactively tax Texas businesses.17 The Comptroller’s position that subsequent amendments are “clarifications” may be less tenable given the Texas Supreme Court’s deference to the intent of a prior legislature.

Background. AMC is a national movie theater chain, with several theaters in Texas. It sells tickets to patrons to watch movies that it rented from film distributors. Movie tickets provide a revocable license to watch a specific movie at a specific time. AMC exhibited the movies by running the film through projectors that displayed the movie’s video and audio on screens and through speakers located in the movie theaters’ auditoriums. AMC incurred costs of exhibition, which related to costs associated with the auditoriums and their components.

When preparing its franchise tax reports for years 2008 and 2009, AMC subtracted, as COGS, the costs it incurred to exhibit films.18

The Comptroller audited AMC’s franchise tax reports and disallowed AMC’s costs for film exhibitions, alleging that the costs did not qualify. AMC filed a tax protest lawsuit challenging the Comptroller’s position. Ultimately, the Texas Supreme Court held that AMC could not subtract its exhibition costs as COGS, thus ruling in favor of the Comptroller.19 It did so under the following analysis:

COGS Requirements. In order to include costs in its COGS subtraction, a taxable entity must clear several statutory hurdles:

1. The costs must relate to “goods,” which can be real or tangible personal property;

2. The goods must be “sold” in the ordinary course of the taxable entity’s business; and

3. The taxable entity must “own” the goods.20

The Court’s analysis hinged on the second requirement.

The Court determined that AMC did not “sell” goods. The Court defined the term “sold” according to its ordinary meaning and consistent with Texas cases and dictionary definitions.21 Specifically, the Court stated “to constitute a sale of property, the title to, or property in, the thing, must pass from the seller to the buyer.”22 This “passage” constitutes a transfer, which the Court defined as “any mode of disposing of or parting with an asset or an interest in an asset.”23 Under these definitions, the Court determined that AMC’s movie ticket sales did not constitute a “sale” of goods and that transferring a film’s creative content alone will not suffice.24

Next, the Court held that the lower court had erred in supporting its analysis in favor of AMC by reference to a 2013 amendment to the COGS statute enacted after the report years at issue.25 The amendment expressly allows movie theaters to subtract exhibition costs as COGS:

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.26

While AMC argued this was a mere “clarification” of existing law, the Texas Supreme Court found that “even if the Legislature amends a statute ‘to clarify what it believe[s] to be existing law, we cannot attribute the intent of [the amending] Legislature to that of [an earlier] Legislature, which initially promulgated [the statute].”27 Instead, the Court found it must construe the statute as it existed in the tax years at issue.

1. No. 17-0444, slip op. (Tex. Apr. 3, 2020), available at https://www.txcourts.gov/media/1446331/170444.pdf.

2. Slip op. at 2.

3. Slip op. at 4.

4. Slip op. at 4 (quoting Bullock v. Nat’l Bancshares Corp., 584 S.W.2d 268, 272 (Tex. 1979)).

5. Slip op. at 4–5.

6. Slip op. at 12.

7. Slip op. at 13.

8. Slip op. at 14.

9. Slip op. at 18–19.

10. Slip op. at 20–21; Tex. Tax Code § 171.1012(e)(3), (6).

11. Slip op. at 24.

12. Slip op. at 25.

13. Slip op. at 28–29.

14. Slip op. at 29.

15. No. 17-0464, slip op. (Tex. Apr. 3, 2020), available at https://www.txcourts.gov/media/1446332/170464.pdf.

16. Slip op. at 2, 7.

17. See, e.g., S.B. 1525, 86th Leg., R.S. (Tx. 2019).

18. Slip op. at 3.

19. Slip op. at 3.

20. Tex. Tax Code § 171.1012(a)(1), (i).

21. Slip op. at 9.

22. Slip op. at 9 (quoting Cobb v. Tufts, 2 Willson 141, 141 (Tex. Ct. App. 1888)).

23. Slip op. at 9 (quoting Transfer, Black’s Law Dictionary (11th ed. 2019)).

24. Slip op. at 16.

25. Slip op. at 6, 13.

26. Tex. Tax Code § 171.1012(t).

27. Slip op. at 14 (quoting In re C.O.S., 988 S.W.2d 760, 764 (Tex. 1999)).

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.