In Letter Ruling 201307727L (July 16, 2013), the Texas Comptroller of Public Accounts (“Comptroller”) explained revisions to Rule 3.588, which provides a cost of goods sold (COGS) deduction for labor costs for the Texas franchise tax. These revisions alter the definition of labor costs and service costs. In whole, the changes expand the COGS deduction for taxpayers by having the franchise tax more closely conform to the Internal Revenue Code.
Previously, the Comptroller allowed a COGS deduction for only direct labor costs, which are “wages and benefits paid to individuals who physically produced or acquired good.” The revised rule now includes “indirect labor costs, or labor costs, other than service costs, that can be directly attributed to production or resale activities.” [emphasis added] An example of indirect labor costs are costs for production supervisors and project managers. The new rule specifically references Treasury Regulation Sections 1.263A-1(e) and 1.460-5, which define costs that are subject to capitalization and allocation, as costs applicable to the Texas COGS deduction. The ruling aptly notes that a taxpayer does not have to capitalize these costs for federal purposes to receive the benefit at the state level.
The new rule (Rule 3.588(b)(9)) also defined a new term—service costs:
Indirect costs and administrative overhead costs that can be identified specifically with a service department or function, or that directly benefit or are incurred by reason of a service department or function. For purposes of this section, a service department includes personnel (including costs of recruiting, hiring, relocating, assigning, and maintaining personnel records or employees); accounting (including accounts payable, disbursements, and payroll functions); data processing; security; legal; general financial planning and management; and other similar departments or functions.
The ruling points out that service costs that are “demonstrably allocable to the acquisition or production of goods are includable in the COGS deduction” but are subject to a 4-percent cap. On the other hand, direct and indirect labor costs are not subject to the cap. The cap is a departure from the federal approach, which has no limitation. Lastly, if a cost is both a “service cost” and an “indirect labor cost,” the taxpayer must categorize that cost as a “service cost,” which is subject to the cap.
This ruling may reduce Texas franchise tax liability for certain taxpayers.
The views expressed in this article are those of the authors and do not necessarily reflect the position or policy of Berkeley Research Group, LLC.
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