United States: Texas Comptroller Limits Telecommunications Company’s COGS Deduction

The Texas Comptroller of Public Accounts recently upheld a decision by the Administrative Law Judge (ALJ) to limit a telecommunications company's cost of goods sold (COGS) deduction for purposes of the Revised Texas Franchise Tax (RTFT) to those costs incurred in purchasing certain telephone equipment that was sold to its customers in the regular course of business.¹ On the report filed, the taxpayer had sought to include in its COGS deduction, a deduction for costs associated with the telecommunications products provided to its customers. The ALJ determined that the telecommunications products sold by the taxpayer were services and therefore, inclusion of costs related to those services was improper.

Background

The taxpayer, a telecommunications company that received substantially all of its revenue from the sale of certain "telecommunications products" such as local and long distance telephone, Internet access and video telecommunications products, also derived a minimal amount of revenue from the sale of "telephone equipment," such as multi-line telephones and headsets. On its 2008 report, the taxpayer claimed a COGS deduction for costs associated with both the sale of its telephone equipment and its telecommunications products. A desk audit was performed, whereby the Comptroller disallowed the entire COGS deduction based on the overall determination that the taxpayer sold services and not tangible personal property. Therefore, the Comptroller determined that the taxpayer was required to compute its taxable margin based on 70 percent of its total revenues.

The taxpayer requested a redetermination, and the matter was assigned to the State Office of Administrative Hearings. At the hearing, the Comptroller conceded that those costs associated with the purchase of telephone equipment were deductible, but those costs associated with the sale of the taxpayer's telecommunications products were not. Since the total COGS deduction after the change would still have been less than 30 percent of the taxpayer's revenues, the Comptroller determined that the use of the 70 percent methodology was proper and therefore, denied the taxpayer's refund claim. The ALJ recommended that the audit assessment be affirmed, and the Comptroller subsequently adopted the ALJ's recommendation.

Computation of Revised Texas Franchise Tax

The RTFT, for reports due on or after January 1, 2008, is imposed on a combined unitary basis.² The tax base is generally total revenues reported for federal income tax purposes less the highest of three potential deductions: (i) 30 percent of total revenue; (ii) compensation; or (iii) COGS.³

Taxpayer's Telecommunications Products Were Services

The taxpayer argued that the telecommunications products it sold consisted of voice and data transmissions in the form of electronic signals, dial tones, busy signals, ring tones, digital addresses, and electricity to power the system, all of which can be measured, felt, and perceived by the senses.⁴ Therefore, the taxpayer argued that it was entitled to deduct those costs under the statute allowing a subtraction of COGS.⁵ In the alternative, the taxpayer argued that even if the Comptroller determined that the telecommunications products were services, it was nevertheless entitled to deduct such costs under the Comptroller's rule regarding "mixed transactions."⁶

The ALJ rejected both of the taxpayer's arguments, reasoning that the telecommunications products provided by the taxpayer were the sale of services and not the sale of tangible personal property. The ALJ never directly addressed the taxpayer's contention that the sale of its telecommunications products was the sale of tangible personal property, due to the fact that the dial tones, electronic signals, busy signals, and other similar items could be perceived by the senses. The ALJ found that the term "service" is not defined in the franchise tax statutes. Under the Code of Construction Act, a word or phrase that is not defined by statute shall be construed according to its ordinary meaning, but if the word or phrase has acquired a technical or particular meeting, then it should be construed accordingly.⁷ Therefore, the ALJ looked to how such sales were treated for sales and use tax purposes and the Standard Industrial Classification (SIC) Code the taxpayer used in identifying its business activity.

The ALJ found that the telecommunications products sold by the taxpayer were treated as the sale of services for sales and use tax, which it found to be instructive for RTFT purposes since the term "service" is not defined in the RTFT statutes.⁸ Furthermore, the ALJ was persuaded by the fact that the taxpayer used SIC Code 4813, a classification found within Division E of the SIC Manual which applies to establishments that furnish services,⁹ to describe its business activities.

The ALJ also rejected the taxpayer's contention that it was entitled to a deduction under the "mixed transactions" rule promulgated by the Comptroller. That rule states that if a transaction contains elements of both a sale of tangible personal property and the sale of services, the taxpayer is allowed to claim a COGS deduction in relation to the tangible personal property sold.¹⁰ The ALJ stated that the taxpayer's argument that it was entitled to a deduction under the "mixed transactions" rule was based on the taxpayer's misapprehension of the rule. According to the taxpayer, the RTFT provisions do not require that the "goods" must ultimately be sold as tangible personal property in order to claim the COGS deduction. Rather, the mixed services rule allows for a taxpayer to take the deduction only in relation to the tangible personal property sold. Since the ALJ determined that the telecommunications products were services and not tangible personal property, the taxpayer was precluded from taking a deduction for those costs.

The ALJ summarily denied the taxpayer's alternative contention that the RTFT violated the Texas and U.S. Constitutions, on the grounds that the Comptroller and the ALJ do not have the power to determine that a statute is unconstitutional.

Commentary

In reaching its conclusion, the ALJ found the sales tax treatment of the taxpayer's telecommunications products to be highly persuasive in determining that the telecommunications products were not sales of tangible personal property. Implicit in the ALJ's reasoning was that if the telecommunications products at issue were services for sales tax purposes, then a consistent treatment of those same products should be applied for RTFT purposes.¹¹ It is also noteworthy that the ALJ looked to the SIC Code for guidance in determining whether the taxpayer was a service provider,¹² which code had ordinarily only been used for determining whether a taxpayer qualified for the 0.5 percent rate as a wholesaler or retailer.¹³ A trend has begun to develop whereby the Comptroller relies on the taxpayer's SIC Code not just for purposes of determining the 0.5 percent rate but also to determine whether a taxpayer is entitled to deduct COGS in determining its margin. The reliance on the SIC Code suggests that all taxpayers – not just retailers or wholesalers – should take care in selecting the SIC and North American Industry Code System (NAICS) Codes to be used on their federal and state returns. The ALJ's decision aligns with the view that the essence of the transaction between the taxpayer and its customers is for the provision of telecommunications services and any tangible personal property provided with the service (e.g. busy signals and dial tones) is incidental to the service being provided. While this may be the Texas Comptroller's approach, telecommunications providers have successfully argued in other states that the provision of telecommunications services qualifies for an exemption because it is part of the manufacturing or production process.¹⁴ Despite the ALJ's decision, one would expect that challenges to the taxability of telecommunication services and bundled items will continue, both in Texas and in other states.

Footnotes

1 Decision, Hearing No. 102,735, Texas Comptroller of Public Accounts, Oct. 24, 2012, released Jan. 2013.

2 TEX. TAX. CODE ANN. § 171.1014(a).

3 TEX. TAX. CODE ANN. § 171.101.

4 TEXAS TAX CODE ANN. § 171.1012(a)(3)(A)(i) defines "tangible personal property" as "personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any manner."

5 TEX. TAX. CODE ANN. § 171.1012(b).

6 34 TEXAS ADMIN. CODE § 3.588(c)(7). The mixed transaction rule recognizes that certain transactions contain both an element of the sale of tangible personal property and the sale of a service and allows for a deduction to the extent of the tangible personal property sold.

7 TEXAS GOV'T CODE ANN. § 311.01.

8 Citing GTE Southwest, Inc. v. Combs, Tex. Court of Appeals, 3rd Dist., Austin, No. 03-08-00561-CV, June 3, 2010, pet. rev. denied, Tex. Supreme Court, No. 10-0629, Oct. 1, 2010, Jan. 14, 2011.

9 Specifically, SIC 4813 captures establishments primarily engaged in furnishing telephone voice and data communications except radiotelephone and telephone answering services. For the SIC Manual, see http://www.osha.gov/pls/imis/sic_manual.html.

10 34 TEXAS ADMIN. CODE § 3.588(c)(7) (emphasis added).

11 TEXAS TAX CODE ANN. § 151.0101(a)(6) defines "telecommunications services" as a taxable service.

12 Another recent decision, involving a taxpayer that sold and installed automobile parts, also heavily relied on the SIC Code. Decision Hearing Nos. 105,553, 105,554, 105,555, Texas Comptroller of Public Accounts, Oct. 2, 2012, released Nov. 2012.

13 The RTFT generally is imposed at a rate of 1 percent of taxable margin, but a 0.5 percent tax rate applies to taxpayers that are "primarily engaged in retail or wholesale trade." TEX. TAX CODE ANN. § 171.002(a), (b).

14 Sprint Spectrum LP v. Commissioner of Revenue, 676 N.W.2d 656 (Minn. 2004); Southwestern Bell Telephone Co. v. Director of Revenue, 78 S.W.3d 763 (Mo. 2002); Southwestern Bell Telephone Co. v. Director of Revenue, 182 S.W.3d 226, 230 (Mo. 2005).

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