Texas Comptroller Raises More Questions After Denying Taxpayer a Cost of Goods Sold Deduction

At a glance

• The main takeaway: In a decision that raised more questions on the concept of ownership, the Texas Comptroller concluded that a taxpayer was not permitted to include labor costs for repairing customer-owned helicopter parts in its costs of goods sold deduction.
• Assess the impact: The rules for unique tax regimes, like the Texas franchise tax, are often complex and lead to a greater risk of compliance errors since familiar concepts found in traditional income tax states may not apply.
• Take the next step: Let Aprio’s State and Local Tax (SALT) team advise you on the Texas franchise tax as well as other tax regimes imposed at the state and local level.

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The full story

In a recent decision issued by the Texas Comptroller (Decision No. 116,007), a taxpayer who engaged in the business of providing aircraft instrument, avionics, and accessory services was denied the ability to claim the cost of goods sold (COGS) deduction in determining its franchise tax liability. Specifically, the Comptroller concluded that the taxpayer was not able to deduct labor costs related to repairing customer-owned helicopter parts because the COGS deduction is only permitted for eligible cost of goods sold related to goods that are owned by the taxpayer.

Understanding Texas’ franchise tax

Before delving into the Comptroller’s ruling, a brief description of Texas’ franchise tax is warranted as it involves a unique tax regime. Most states impose a net income tax on businesses, and there are also a few states that impose gross receipts tax on businesses. However, Texas’ franchise tax is somewhat of a hybrid and can generally be described as a modified gross receipts tax whereby the tax base (i.e., the taxpayer’s taxable margin) consists of total revenue less some limited deductions. A taxpayer’s taxable margin is generally the lesser of 70% of total revenue, total revenue less compensation, or total revenue less COGS. Not all taxpayers are eligible to use the COGS deduction. 

For example, most service providers are not permitted to claim the COGS deduction. However, if a taxpayer has sales that contain elements of both a sale of goods and a service, the taxpayer may utilize the COGS deduction in connection with the sale of the goods. In terms of eligible COGS expenses that can be claimed, a taxpayer can generally deduct all direct costs of acquiring or producing goods, including labor costs.

A closer look at the decision

As part of its business, the taxpayer in the Comptroller’s decision received defective helicopter parts from customers. The taxpayer would send its customers replacement parts, and it would then repair the defective parts and place them into its inventory. The taxpayer included in its COGS deduction the labor costs to repair these defective parts. However, the Comptroller concluded that such labor costs were not allowed as part of the COGS deduction because the repair labor on customer-owned aircraft parts is not a cost to produce parts that the taxpayer sold. 

The decision lacks any detailed analysis on how the Comptroller concluded that the parts were not owned by the taxpayer. As noted above, the taxpayer’s inventory of helicopter parts was partially derived from defective parts received from customers that it then repaired and placed into its inventory. Thus, at some point those defective parts presumably became property of the taxpayer, or did they?

The Comptroller clearly concluded that the labor to repair parts was not deductible because the taxpayer did not own the parts. However, on the issue of “ownership” of goods, the decision merely stated that 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.”  In addition to the lack of ownership, the decision appeared to be partly based on the fact that the taxpayer did not “produce” the goods, but instead only performed repairs on “already-completed” parts.

The bottom line

This decision is somewhat limited to taxpayers that are engaged in certain types of business activities. However, the case does raise questions regarding the concept of the ownership of goods that a taxpayer sells and the relevant facts and circumstances that the Comptroller considers in determining if and when a taxpayer is deemed to own certain items. Indeed, the ruling includes a conclusion that seems rather straightforward but at the same time perplexing.

The decision states that the taxpayer’s “repair labor on customer-owned aircraft parts is not a cost to produce the associated parts that it sells.” It’s somewhat unclear from this statement why the Comptroller concluded that the return parts were still owned by the customer when the taxpayers had provided a replacement part to the customer. The language also places importance on the Comptroller’s opinion that the taxpayer was deemed not to “produce” the parts that it sold. This is somewhat difficult to reconcile with the accompany language in the decision providing that “taxpayers may subtract as cost of goods sold those adequately documented costs. . . incurred in repairing damaged or defective parts that taxpayer owns and sells in the regular course of business.” One piece of clarity that taxpayers can take from this ruling is that repair labor performed on items the taxpayers does not own and will never own (e.g., customer-owned parts repaired by a taxpayer that are subsequently returned to the customer) is not an allowable COGS deduction. 

Aprio’s SALT team has extensive experience advising clients on the Texas franchise tax as well as other unique tax regimes imposed at the state and local level. The rules of these unique tax regimes are often more complex and confusing, and the more familiar concepts found in the traditional income tax states may not apply, thus leading to a greater risk of compliance errors. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.