Texas high court issues three franchise tax opinions on COGS Deduction

Apr 08, 2020
Apr 08, 2020
0 min. read

On April 3, 2020, the Texas Supreme Court issued three opinions addressing the Texas franchise tax cost of goods sold deduction. The franchise tax is imposed on taxable entities doing business in Texas. Generally, businesses can determine the tax by calculating the lesser of: 70% of total revenue, total revenue minus the compensation deduction or total revenue minus the cost of goods sold deduction. Texas Tax Code section 171.1012 sets forth what costs can be included in the cost of goods sold deduction.

In Sunstate Equipment Co. LLC v Hegar (No. 17-0444), the Supreme Court held that a heavy equipment rental company could not subtract delivery and pick-up costs of its equipment as cost of goods sold. The taxpayer subtracted the labor and related costs associated with delivering and retrieving heavy equipment to its customers. Citing sections 171.1012(k-1) and 171.1012(i), the court noted that the cost of goods sold subtraction for heavy equipment rental companies was limited to costs associated with the acquisition or production of equipment that is rented. The court held that the taxpayer’s delivery and pick up costs were not eligible for a cost of goods sold subtraction under any other provision. 

In Hegar v. American Multi-Cinema Inc. (No. 17-0464), the Supreme Court held that a movie theater company could not subtract film exhibition costs from revenue as a cost of goods sold, according to the tax code as it existed for the tax years at issue. The taxpayer claimed costs for acquiring films and the costs associated with operating the theaters. The court noted that section 171.1012, as it existed for the tax years at issue, limited the cost of goods sold deduction to ‘all direct costs of acquiring or producing the goods,’ including costs of labor, certain materials, handling, storage, depreciation, rent, repairs and maintenance, research and development, and acquisition and production taxes. The “goods” must be real or tangible personal property. In this case, the court held that the film exhibitions were neither real nor tangible personal property and the costs at issue were thus ineligible for the deduction.

In Hegar v. Gulf Copper & Manufacturing Corp. (No. 17-0894), the Supreme Court held that an oil rig service company was not entitled to a cost of goods sold subtraction for repairs, surveys and upgrades to offshore rigs which were performed in the taxpayer’s shipyards and dry docks. The court noted that in this case, the statute required the costs to be for the improvement of real property and the requisite labor or material must be furnished to or included directly into the real property. The court concluded that the taxpayer’s labor and materials were directed toward preparing equipment for later use on real property. In a separate issue, the court held that the taxpayer properly excluded subcontractor payments from its revenue which negated a Texas Comptroller’s long-standing policy related to the revenue exclusion.


These three cases represent ongoing issues between taxpayers and the Texas Comptroller of Pubic Accounts over the availability of the cost of goods sold deduction for franchise tax purposes. As evidence by these cases, the subtraction is an issue for various industries and different business transactions. A number of cases are still pending on cost of goods sold issues and taxpayers should be aware of the highly nuanced and often ambiguous analysis required to calculate the deduction. Texas franchise tax taxpayers should consult with their tax adviser for additional information on calculating the tax. 

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