United States

Texas: Taxpayer Allowed to Deduct Subcontractor Payments in Calculating Taxable Margin; COGS Computation Should Not Start With Federal COGS

Aug 21, 2017
From KPMG TaxWatch

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Recently, a Texas appeals court addressed whether a taxpayer qualified for an exclusion from total revenue and whether it properly computed its COGS deduction. The taxpayer was primarily engaged in the business of surveying, manufacturing, upgrading, and repairing offshore drilling rigs. To compute franchise tax liability, a taxpayer must first determine its total revenue. Total revenue is generally defined with reference to certain line items on the taxpayer’s federal income tax return. In computing total revenue, certain exclusions are allowed, including exclusions for certain types of flow-through payments. At issue in the case was a statutory exclusion in effect for the tax year at issue for certain subcontracting payments mandated by contract that were “handled by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, or repair of improvements on real property or the location of the boundaries of real property.” The taxpayer filed its franchise tax return for the year at issue deducting from total revenue payments made to subcontractors for labor. Following an audit, the Texas Comptroller determined that the taxpayer could not exclude the subcontractor payments from total revenue, but that certain of the labor costs could be deducted as COGS. The Comptroller also pared down the taxpayer’s original COGS deduction. The end result was that the taxpayer was assessed additional tax and interest. After a trial court ruled in favor of the taxpayer on the subcontractor and COGS issues, the Comptroller appealed to the Texas Court of Appeals.

Before the appeals court, the Comptroller argued that amounts the taxpayer paid over to subcontractors for labor expenses could not be excluded from total revenue because the taxpayer’s written customer contracts did not specifically mandate that the payments for labor be distributed to the subcontractors providing the labor. The court rejected this argument, observing that the Comptroller’s interpretation was contrary to the plain language of the statute and the court’s holding in Titan Transportation. As the court held in Titan Transportation, the “mandate” for payment distribution may be contained in either a contract with the customer or in a contract with the subcontractor. The exhibits admitted at trial established that the taxpayer was obligated by contracts with its subcontractors to pay for the labor. The Comptroller also argued that the labor the subcontractors performed on the rigs was “two steps away” from the actual or proposed construction of improvements on real property. Specifically, the taxpayer performed work on offshore drilling rigs, rather than work on oil wells, which all parties agreed were improvements to real property. The court again rejected this argument and held that at least certain of the labor costs for work on offshore drilling rigs—equipment that was undisputedly integral to drilling offshore wells—was reasonably connected to the construction of oil wells. Because the Comptroller had taken an all or nothing position on the subcontractor costs and had failed to preserve the argument that some of the costs did not qualify, the taxpayer was entitled to exclude all of the subcontractor labor costs from total revenues. The appeals court next held that the trial court erred when it upheld the taxpayer’s original COGS deduction and ruled that the Comptroller’s calculation of the taxpayer’s COGs was incorrect. Although the case was ultimately remanded for additional findings on the COGS issue, the court held the taxpayer’s use of the federal COGS calculation as a starting point for calculating the Texas COGS deduction did not provide sufficient evidence to support the claimed deduction. In the court’s view, Texas law mandates that the COGS deduction be computed on an item-by-item basis. And, if this mandate was too difficult, the court observed that the taxpayer could elect to use another method to compute taxable margin (i.e., deducting compensation or simply paying tax on 70 percent of total revenue). For more information about Gulf Copper and Manufacturing Corp. v. Hegar, please contact Doug Maziur at 713-319-3866.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.