Corporate Close-Up: Another Texas Taxpayer Loses Bid to Strike Down Narrow Interpretation of Cost of Goods Sold Deduction

“Another One Bites the Dust” might be an appropriate theme song for those arguing that their labor costs qualify for the cost of goods sold deduction (COGS) in Texas. The latest failed claim involved an auto dealership’s labor costs from installing auto parts in customer-owned vehicles. A Texas appellate court recently overturned a lower court decision for the taxpayer and opted against striking down a regulation that narrows the definition of “installation” for purposes of qualifying for the deduction.

The Texas Franchise Tax stands out as a unique system in the field of state taxes. In place of a system that bases a corporate income tax on federal taxable income for corporations, Texas calculates tax based on certain specific items of income that constitute total revenue, and then taxpayers can choose from four different computations to achieve the lowest tax burden based on taxable margin. In the Autohaus case, the controversy surrounded the COGS method and what costs the taxpayer could deduct to determine its taxable margin.

The case turned on whether the taxpayer, an automotive dealership, was allowed to subtract the costs of labor from installing auto parts in customer-owned vehicles from total revenue as part of its COGS deduction. In the district court, Autohaus successfully argued that the definition applied by the Texas Comptroller from Tex. Admin. Code tit. 34, § 3.588(b)(7) was an unconstitutional extra-statutory limitation on the definition of “installation” as described in Tex. Tax Code Ann. § 171.1012(a)(2). The statute defines “production” for the purposes of determining COGS to include “construction, installation, manufacture, development, mining, extraction, improvement, creation, raising, or growth.” The district court agreed that the regulation impermissibly narrowed the definition of installation costs that could be subtracted as part of the COGS deduction and that Autohaus should have been allowed to include these labor costs in COGS under the statutory definition.

However, the Texas Court of Appeals reached a different conclusion in Autohaus LP v. Hegar, No. 03-15-00427-CV (Tex. Ct. App. 2017) as reported in the Daily Tax Report by Che Odom. On appeal, the court found that the language of the statute was unambiguous when defining installation. Based on the context of the statute, the court found that the definition of installation needed to be narrowly interpreted to only include installation of parts during the process of actually producing tangible property for sale. Since the parts were being installed in customer owned vehicles, the installation could not have been in the context of production of goods as written in the statute. As explained by Steve Moore, a partner in Jackson Walker LLP’s Austin office, “In Autohaus, the Austin Court of Appeals confirms that the cost of goods sold deduction in Section 171.1012 of the Texas Tax Code is only available with respect to goods that the taxpayer ‘owns,’ and that labor charges to install a product into a customer-owned good are ‘services’ and are not included in the cost of goods sold deduction.”

A wrinkle to this ruling is that the court did not address the constitutionality of the language of the regulation that differed from the statute. The court reasoned that because the plain language of the statute on which it based its ruling was unambiguous, it did not need to address the question of whether the regulation should be struck down as an extra-statutory limitation on the definition.

Even further, the Court of Appeals ruled that the district court didn’t even have the authority to make a judgment on the constitutionality of the rule in the context of this challenge. “The Autohaus case also stands for the position that the scope of the Texas Uniform Declaratory Judgments Act does not include a challenge to the validity of a Texas Comptroller rule in a tax suit brought under Chapter 112 of the Texas Tax Code,” according to Moore.

This case is the latest ruling out of Texas to hold that specific labor costs cannot be included in the COGS deduction if they are not directly involved in the production of goods. Similarly, in Texas Comptroller's Decision, Hearing No. 111,107 in September 2016, the Texas Comptroller ruled that labor costs paid to employees and independent contractors for the design and building of computer software for customers could not be included in COGS because the taxpayer did not own the property it was delivering to customers. In September 2014, the comptroller ruled in Texas Comptroller's Decision, Hearing No. 108,959 that labor costs for the taxpayer, a dispatcher of cement-mixing trucks, must be split into two categories. The first, labor costs from the production of cement, could be included in the COGS deduction as direct costs of production. The second, related to labor costs from transportation that occurred after the sale of the cement, could not be included in COGS.

As more taxpayers seek to take advantage of favorable treatment of certain costs in the Texas Tax Code, more controversy is soon to come. For now, Texas will continue to apply the statutes narrowly when determining which labor costs are directly related to production.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Should Texas continue to narrowly define labor costs in the context of production for cost of goods sold?

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