On Friday, April 3 the Texas Supreme Court issued three decisions addressing the availability and scope of the cost of goods sold, or “COGS,” deduction.
Hegar v. American Multi-Cinema Inc.
The first, and most anticipated, decision is Hegar v. American Multi-Cinema, Inc.1 This case concerned whether AMC, the movie-theater chain, was eligible to deduct COGS for its costs of exhibiting films.
For context, the COGS statute, § 171.1012 of the Texas Tax Code, allows taxpayers to deduct all direct costs of acquiring or producing goods. “Goods” is defined as real or tangible personal property sold in the ordinary course of business.2 “Tangible personal property” is defined, in turn, as personal property that is perceptible to the senses, and as films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and similar property that is intended to be mass-distributed.3 The Supreme Court referred to these two definitions of tangible personal property, respectively, as the “perceptibility prong” and the “film prong.”4
Before the case reached the Supreme Court, Texas’s Third Court of Appeals held that AMC was entitled to deduct COGS pursuant to the perceptibility prong. It later issued a substitute opinion holding instead that AMC was entitled to deduct COGS pursuant to the film prong. The Court of Appeals determined that AMC was entitled to deduct all of its auditorium costs, including costs associated with projectors, speakers, amplifiers, screens, lighting, and chairs, because the costs were necessary to create a “unique audio and visual experience.”
The Supreme Court reversed, holding that AMC was not eligible to deduct COGS in the years at issue because the reference to “films” in the definition of tangible personal property does not extend to the exhibition of films. Specifically, the court determined that AMC exhibited, but did not sell, films.
To determine whether AMC “sold” films, the court looked to Texas case law, as well as common dictionary definitions, and concluded that for a sale to take place, a transfer of title or property is required.5 The court reasoned that although the film itself is tangible personal property, AMC’s exhibition of the film is not. AMC transfers to its patrons an intangible right to see a film, but does not transfer “property with a physical or demonstrable—that is, tangible” form.6
The Supreme Court also rejected arguments AMC made, based on two subsections of the COGS statute, that its distribution of films was sufficient even if it did not sell films. First, AMC relied on subsection (o), which states that a taxpayer may deduct COGS if its principal business activity is film or television production or broadcasting or the distribution of tangible personal property described by the film prong.7 The court rejected this argument, concluding that the reference to “distribution” in subsection (o) requires a “precise,” industry-specific meaning. In the film industry, the court reasoned, AMC is not a distributor that finances productions, like Disney or Lionsgate, but an “exhibitor” that projects the films in theaters.8 The court thus determined that AMC did not distribute films for purposes of subsection (o).
Second, AMC argued that subsection (t), a newer subsection enacted in 2013—after the years at issue—expressly provided a COGS deduction for movie theaters. The court rejected this argument as well, concluding that although the addition of subsection (t) was styled as a “clarification” of existing law, the 2013 legislature did not have the power to clarify the intent of the prior legislature that enacted the original COGS statute. Although the court determined that subsection (t) could not be applied retroactively to the years at issue, it noted that nothing in its decision would preclude AMC from deducting COGS in years when subsection (t) was effective.9
Hegar v. Gulf Copper & Manufacturing Corp.
The next case, Hegar v. Gulf Copper & Manufacturing Corp.,10 addresses whether Gulf Copper is entitled to deduct COGS for its costs to survey, repair, and upgrade offshore oil-and-gas rigs for rig owners and drilling contractors.
Gulf Copper involves a subsection of the COGS statute not addressed in AMC—subsection (i). That subsection states that although a taxpayer may typically deduct COGS only if it owns the goods being sold, a taxpayer will be considered to own labor and materials it furnishes to a project for the construction, improvement, remodeling, repair, or industrial maintenance of real property.11 The parties agreed that the drilling of an oil well constitutes a qualifying real property improvement project under subsection (i), but disputed whether Gulf Copper’s work constitutes furnishing labor or materials to such a project.
The Supreme Court determined that Gulf Copper did not qualify under subsection (i). Specifically, the court concluded that Gulf Copper did not furnish labor or materials to a real property construction project—e.g., the drilling of an oil well—because it furnished labor and materials to oil rigs that were not currently in active use, and to its own projects of fulfilling repair contracts. The court concluded that to qualify under subsection (i), “the requisite labor or materials must be furnished to or incorporated into the real property itself.”12
Although the court denied Gulf Copper’s COGS deduction, it allowed an exclusion from total revenue for amounts Gulf Copper paid to subcontractors performing the repair work, pursuant to § 171.1011(g)(3) of the Texas Tax Code. That provision allows an exclusion for flow-through funds for subcontracting payments for services, labor, or materials provided in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property.
Though similar to subsection (i) of the COGS statute, the court found this provision to be broader because it includes services, labor, and materials provided “in connection with” construction projects, and because it includes both actual and “proposed” projects. The court determined that Gulf Copper qualified for this flow-through provision because its work enables oil rigs to meet certification requirements of specific drilling projects.13
Sunstate Equipment Co., LLC v. Hegar
Unlike AMC and Gulf Copper, the third case, Sunstate Equipment Co., LLC v. Hegar,14 addresses the question of which costs a taxpayer may deduct, rather than the threshold question of whether the taxpayer is entitled to a COGS deduction at all. Sunstate Equipment also addresses yet another subsection of the COGS statute—subsection (k-1), which allows a “heavy construction equipment rental or leasing company” to deduct COGS notwithstanding the general requirement that goods be “sold.”15
The parties agreed that Sunstate Equipment, a heavy-construction-equipment rental company, qualified for COGS pursuant to subsection (k-1), but disagreed as to whether Sunstate Equipment could deduct costs incurred to deliver and pick up equipment to and from construction sites.
The court stated that subsection (k-1) only determines whether Sunstate Equipment may deduct COGS, and to determine which costs may be deducted, one must look to the same COGS provisions that apply to other taxpayers—i.e., the general requirement that the costs be direct costs of acquiring or producing goods.16
The court determined that Sunstate Equipment’s delivery and pick-up costs were not acquisition costs. Although picking up rented equipment could be seen as acquiring or reacquiring the property it already owned, the court reasoned that the deduction is only for the initial acquisition of property.17 The court also determined that delivery and pick-up costs were not production costs. Although “production” is defined broadly to include construction, installation, manufacture, development, mining, extraction, improvement, creation, raising, and growth, the court noted that the definition does not include delivery.18
Further, the court noted that subsection (e) of the COGS statute, which enumerates several non-deductible costs, such as distribution costs and rehandling costs, supported its decision. The court thus concluded that a taxpayer may not deduct costs associated with transporting goods for sale or goods it has already sold.19
1 No. 17-0464 (Tex. Apr. 3, 2020).
2 Tex. Tax Code § 171.1012(a)(1).
3 Tex. Tax Code § 171.1012(a)(3)(A)(i), (ii).
4 No. 17-0464, at 5.
5 Id. at 9.
6 Id. at 16.
7 Tex. Tax Code § 171.1012(o).
8 No. 17-0464, at 11.
9 Id. at 15.
10 No. 17-0894 (Tex. Apr. 3, 2020).
11 Tex. Tax Code § 171.1012(i).
12 Id. at 21.
13 Id. at 10.
14 No. 17-0444 (Tex. Apr. 3, 2020).
15 Tex. Tax Code § 171.1012(k-1)(2).
16 No. 17-0444, at 11.
17 Id. at 18–19.
18 Tex. Tax Code § 171.1012(a)(2); No. 17-0444, at 20.