The Texas Court of Appeals for the Third Appellate District recently upheld a trial court's determination that a movie theater was entitled to take a cost of goods sold (COGS) deduction in computing its margin for the Revised Texas Franchise Tax (RTFT).1 The ruling potentially expands the application of the COGS deduction to certain service providers that were not previously thought to be eligible to claim the COGS deduction.
Procedural History and Background
The taxpayer, which operates a movie theater business and primarily exhibits motion pictures and other content to customers, claimed a COGS deduction on its 2008 and 2009 RTFT reports. The COGS deduction consisted of motion picture licensing fees and other expenses associated with the commercial display of motion pictures, including facility rent and depreciation. Upon audit, the Texas Comptroller disallowed the COGS deduction, arguing that the taxpayer either provided a service or sold intangible property. The taxpayer paid the assessment under protest and filed suit in district court.
The parties agreed to a bifurcated bench trial. In phase one of the trial, the issue before the trial court was whether the taxpayer's product amounted to a "good" under Tex. Tax Code Ann. Sec. 171.1012(a)(1), or whether the taxpayer provided a service or an intangible product. The trial court held that the taxpayer's product amounted to a "good" under the definition of a good under Tex. Tax Code Ann. Sec. 171.1012(a)(1) and therefore, the taxpayer was entitled to claim a COGS deduction. Having concluded that the taxpayer was entitled to claim a COGS deduction, phase two of the trial centered on the costs associated with acquiring or producing the goods eligible for the COGS deduction. The Comptroller and the taxpayer reached an agreement delineating the majority of exhibition costs eligible for the COGS deduction. However, the parties did not agree to the treatment of certain costs such as facility-related rent and depreciation eligible for the COGS deduction. The taxpayer argued that the entire amount of square footage in the auditorium qualified for the COGS deduction, while the Comptroller argued that the square footage should be limited to the square footage involving the speakers and screens within the auditorium that produced the images that were perceptible to the senses. The trial court sided with the Comptroller and limited the deduction to the square footage associated with the speakers and the screen. The Comptroller appealed the trial court's decision with respect to the court's findings associated with phase one of the trial, and the taxpayer appealed the trial court's findings with respect to phase two of the trial.
Third Appellate Court's Decision
In appealing the trial court's ruling in phase one, the Comptroller asserted that the trial court erred in finding that the taxpayer produces tangible personal property. The Comptroller argued that exhibiting a film does not constitute a "good" because the taxpayer does not sell tangible personal property. Rather, the taxpayer sells either intangible property or a film-watching service, and therefore, is precluded from taking the deduction under Tex. Tax Code Ann. Sec. 171.1012(a)(3)(B).
The Court of Appeals found that the trial court's determination that the taxpayer's product satisfied the legislature's definition of tangible personal property was supported by the weight of the evidence. According to the Court, the legislature crafted a very specific definition of the term "tangible personal property" and defined that term to include personal property that can be "seen" or "that is perceptible to the senses in any other manner." The Court found this definition to be unambiguous and that the taxpayer's product satisfied this definition since the movie screening could be seen and was otherwise perceptible to the senses.
The Comptroller argued that the taxpayer was not a film producer or distributor, and did not sell the film. Rather, the taxpayer sold the right to watch the film, which was more akin to a license. The Court of Appeals dismissed the Comptroller's argument, holding that the definition of "tangible personal property" did not have a "take-home requirement." Therefore, the Court upheld the trial court's determination that it was entitled to claim the COGS deduction for all costs associated with acquiring or producing this "good."
As for the conclusions reached in phase two of the trial court's ruling, the Court reversed the trial court's findings of fact denying the inclusion of certain costs in the COGS deduction as not supported by the evidence. The Court found that the taxpayer introduced evidence that the entire "auditorium is integral to the visual and acoustic production" and that it uses the entire auditorium space for production. Rejecting the Comptroller's assertion that the auditorium should be classified as "consumption space" instead of "production space," the Court noted that the Comptroller did not introduce any evidence rebutting the taxpayer's assertions, and that the trial court's denial of certain costs that were stipulated by the parties prior to the trial was not supported by the evidence.
Commentary
While American Multi-Cinema concerned a taxpayer in the business of screening motion pictures, the Court's decision potentially expands the availability of the COGS deduction to other taxpayers that might have previously been considered service providers or sellers of intangible property. For example, an accounting firm that historically has viewed itself as a service provider may consider taking the position that it is entitled to a COGS deduction, arguing it produces audit reports and tax returns that meet the definition of "tangible personal property" under Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A)(i) since the end products can be seen, weighed, felt, measured, and are perceptible to the senses.
Other perceived "service providers" to which this decision, if upheld, may apply include operators of sporting events, performing arts and other forms of visual and aural entertainment and telecommunications. Similarly, the expansion of direct costs qualifying for the COGS deduction could apply to restaurants and other businesses that currently qualify for the COGS deduction.
Meeting the definition of "tangible personal property" is important for COGS purposes because the definition of "goods" for which the COGS deduction may apply only includes "real or tangible personal property sold in the ordinary course of business of a taxable entity."2 In turn, the definition of "tangible personal property" for purposes of the COGS deduction specifically excludes: (i) intangible property; and (ii) services.3 Interestingly, the Court of Appeals only briefly considered this issue as it related to the taxpayer in American Multi-Cinema, specifically whether film viewing is a good that is intangible property or a service (both terms undefined by the Texas Tax Code). In Newpark Resources,4 the Court went to great lengths in addressing and resolving the overlapping definitions of the terms "service" and "labor." In American Multi-Cinema, however, the Court noted the "conflict" and summarily resolved that conflict in favor of the taxpayer. The analysis is of interest not in defining motion picture films as tangible personal property (given, particularly, the Tex. Tax Code Ann. Sec. 171.1012(a)(3)(A)(ii) definition of the term) but more in identifying the costs of "production" that may be includible in COGS.
Notably absent from American Multi-Cinema is the mantra that "to promote uniformity and equality in taxation, [courts] construe tax exemptions--and provisions tantamount to tax exemptions--strictly against the taxpayer and in favor of the taxing authority."5 It is also of interest that the auditorium costs were not considered in the light of excluded "distribution costs, including outbound transportation costs."6
The Comptroller's announced intention of seeking a rehearing of the case and/or of appealing to the Texas Supreme Court7 will be followed closely. It should be noted that those procedures ultimately were unsuccessful in the Newpark Resources and Titan Transportation cases.8
Envisioning that numerous types of businesses, even those that primarily engage in the sale of services and intangibles, will consider the Court's decision as an invitation to markedly expand the availability and scope of the COGS deduction, the Comptroller estimates an annual revenue loss of $1.5 billion and cumulative refunds to exceed $6 billion if the Court's decision ultimately stands.9 The Comptroller has already filed a motion for an en banc rehearing before the Third District, and this motion will be considered before any appeal is made to the Texas Supreme Court. The Comptroller's other potential remedy is through legislative action. The 84th Texas Legislature appears to have adjourned without any actions as a result of American Multi-Cinema or of the Comptroller's warning of potential revenue losses.
While a full consideration of the Texas sales and use tax implications of this case is beyond the scope of this alert, these issues deserve some mention and preliminary consideration. This is especially important due to the distinctions between taxable services, which are listed in Tex. Tax Code Ann. Sec. 151.0101, non-taxable services, which are not defined (but presumably are services not enumerated in the list of taxable services), and sales of tangible personal property. The potential impact from a sales tax perspective may be felt by taxpayers that are solely focused on obtaining RTFT refunds, as well as taxpayers that want to proactively seek sales and use tax refunds based on the rationale in American Multi- Cinema.
Taxpayers advancing the argument for RTFT purposes that was accepted in American Multi-Cinema should be particularly careful. Specifically, a taxpayer that previously considered itself a service provider for RTFT purposes but now seeks to claim that it is a producer of tangible personal property may unwittingly subject itself to sales tax liability for failing to collect and remit sales tax on the "tangible personal property" it now purportedly produces. That said, a taxpayer challenged by the Comptroller on this point could counter that it is manufacturing tangible personal property, and therefore, treat most of the activities in the production process as exempt.10 The Comptroller made both of these points in his briefing sheet filed with the Texas Legislature in response to American Multi-Cinema.
Likewise, taxpayers that decide to proactively pursue sales tax refunds based on American Multi-Cinema if the Comptroller loses an appeal to the Texas Supreme Court should think about how the Comptroller might respond. The opportunities for non-taxable service providers such as lawyers and accountants to claim an exemption for the tangible personal property that they purchase that is transferred to customers, or used in producing property that is transferred to customers, may be limited and more than offset by the likely assessment by the Comptroller of uncollected sales tax on sales of tangible personal property. It should be noted that if a transaction is treated as a sale of tangible personal property instead of a taxable service, the general requirement that a "transfer of title (to) or possession (of)" the property must take place in order for a sale to have occurred11 potentially may be a mitigating factor to both the taxability and the refund positions.
Footnotes
1 American Multi-Cinema, Inc. v. Hegar, Texas Court of Appeals, Third District, Austin, No. 03-14-00397-CV, April 30, 2015.
2 TEX. TAX CODE ANN. § 171.1012(a)(1).
3 TEX. TAX CODE ANN. § 171.1012(a)(3)(B).
4 Combs v. Newpark Resources, Inc., 422 S.W.3d 46 (Tex. Ct. App. 2013).
5 Texas Utilities Electric Co. v. Sharp, 962 S.W.2d 723 (Tex. Ct. App. 1998), petition for review denied (citation omitted).
6 TEX. TAX CODE ANN. § 171.1012(e)(3).
7 E-mail Update, Texas Taxpayers & Research Association, May 7, 2015 (citing Texas Comptroller's briefing sheet filed with the Texas Legislature in response to American Multi-Cinema).
8 Titan Transportation, Inc. v. Combs, 433 S.W.3d 625 (Tex. Ct. App. 2014), petition for review denied, May 1, 2015.
9 E-mail Update, Texas Taxpayers & Research Association, May 7, 2015 (citing Texas Comptroller's briefing sheet filed with the Texas Legislature in response to American Multi-Cinema).
10 Sales and use tax manufacturing exemptions are provided by TEX. TAX CODE ANN. § 151.318.
11 TEX. TAX CODE ANN. § 151.005(1).
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