Texas Rules that Service Provider May Use Cost of Goods Sold Deduction

A Texas company providing seismic data to oil and gas exploratory companies was able to claim a COGS deduction because their services were an essential component of a project for the construction of real property.

By Jess Johannesen, SALT manager

If your company files a Texas franchise tax return, you may be aware of the unique rules that govern the calculation of the franchise tax, which is based on the taxpayer’s taxable margin. The margin is basically computed by taking the taxpayer’s gross revenue and applying one of four deductions, one of which is the cost of goods sold (“COGS”). [1] This deduction is generally available only to those taxpayers that sell real and/or tangible personal property in the ordinary course of business. [2]

However, on March 9, 2016, the Texas Court of Appeals issued a memorandum opinion upholding a service provider’s use of the COGS deduction. [3] The taxpayer was a “fully-integrated geoseismic” company that acquired seismic data and processed the data to generate images of the subsurface of the earth. The taxpayer’s customers were companies that explore for and produce oil and gas, and the images that the taxpayer generated were used by its customers in their efforts to search for and produce oil and gas from onshore and offshore locations. In computing its Texas franchise tax, the taxpayer claimed the COGS deduction. However, the Texas comptroller denied this deduction because the state characterized the taxpayer as a service provider.

The taxpayer contested the comptroller’s position by pointing to a provision of the franchise tax law which states that “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…in the computation of cost of goods sold. [4] The taxpayer argued that since oil and gas wells are considered real property, it was entitled to use the COGS deduction.

During trial, the Texas Court of Appeals considered whether the taxpayer “furnished labor or materials to a project for the construction…of real property,” as the taxpayer would then be entitled to the COGS deduction. [5] It looked at whether this particular activity is an essential and direct component of a project for the construction of real property. Based on the evidence presented, the Court agreed with the taxpayer and allowed use of the COGS deduction.

This case highlights a subtle rule within the Texas franchise tax that allows a service provider to claim the COGS deduction due to the fact that the labor it provided was an essential and direct component of a project for the construction of real property. Taxpayers that may qualify should evaluate whether they are entitled to use of the COGS deduction and, if so, whether that provides a greater benefit. In addition, refund opportunities may be available for prior years. Aprio has experience assisting taxpayers with Texas franchise tax computations and can work with your company to ensure that you are benefiting from the deductions that you are entitled to claim.

Contact Jess Johannesen, SALT manager, at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the April 2016 SALT Newsletter. To view the newsletter, click here.

[1] The other three are (i) compensation, (ii) 30 percent of gross revenue and (iii) $1 million (the $1 million option was not available until 2014).

[2] Tex. Tax Code Ann. §171.1012(a)(1).

[3] Hegar v. CCG Veritas Services (U.S.), Inc., No. 03-14-00713-CV (Tex. Ct. App.), 03/09/2016.

[4] Tex. Tax. Code Ann. §171.1012(i). The taxpayer also argued alternatively that it sells “goods” because the definition of “tangible personal property” includes sound recordings, images or sounds, which the taxpayer intended to be mass-distributed and sold to as many customers as possible. The Court never addressed this argument since it agreed that the taxpayer could use the COGS deduction based on its initial argument.

[5] Tex. Tax. Code Ann. §171.1012(i).

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