Texas: Expanded definition of “goods” for COGS

Texas: Expanded definition of “goods” for COGS

A Texas state appellate court held that a taxpayer could include costs associated with exhibiting films in calculating its costs of goods sold (COGS) deduction for the franchise (margin) tax years at issue (2008 and 2009).

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The case is: American Multi-Cinema, Inc. v. Hegar, No. 03-14-09397-CV (Tex. App. April 30, 2015)

 

Read the 19-page decision [PDF 124 KB]

KPMG observation

Although the case before the Texas Third Court of Appeals concerned movie theaters, the holding may have much broader implications. In fact, shortly after the decision was released, the Comptroller’s Office suggested it could lead to billions of dollars in franchise tax—and sales and use tax—refund claims.

Background

The taxpayer, a multistate movie theater, included its costs of exhibiting films and other content (exhibition costs) in its COGS deduction for the tax years at issue. The Comptroller adjusted the taxpayer’s COGS deduction on the basis that the taxpayer was not selling tangible personal property when it sold tickets to movies and was, therefore, not entitled to deduct its exhibition costs as COGS.

The taxpayer paid the additional franchise taxes under protest and initiated a judicial proceeding.

At trial, in support of its position that its products were “goods,” the taxpayer called witnesses who explained the extensive production steps that the taxpayer took from the time it received a film from a movie studio to the time the movie was shown to theater patrons. The Comptroller, in turn, argued that the taxpayer’s customers did not purchase “goods” when they bought the right to see a movie in the theater.

In a two-phase case, the trial court concluded that the taxpayer was entitled to deduct a portion of its exhibition costs as COGS. Both the taxpayer and the Comptroller subsequently appealed. The Comptroller appealed the trial court’s finding that the exhibition costs could be deducted as COGS. The taxpayer, on the other hand, disagreed with the trial court’s finding that only 13.42% of its disputed costs could be deducted.

Legislative background

Under Texas law as in effect for the tax years at issue,* taxable “margin” was the lesser of:

  • 70% of total revenue, or
  • Total revenue minus either (1) COGS or (2) compensation and benefits.

*The 2013 Texas legislature passed legislation providing that for franchise tax reports due on or after January 1, 2014, movie theaters that elect to deduct COGS may deduct certain costs associated with the acquisition, production, exhibition or use of a film or motion picture, including expenses for the right to use the film or motion picture.

The statute provides that a company could deduct “all direct costs of acquiring or producing goods,” and up to 4% of other “indirect or administrative overhead costs.” Generally, only entities that own and sell real or tangible personal property may elect to deduct COGS.

Accordingly, Texas franchise taxpayers may elect to deduct COGS or compensation in determining taxable margin. COGS includes “all direct costs of acquiring or producing the goods.”

The term “goods” is defined as “real or tangible personal property sold in the ordinary course of business of a taxable entity.”

“Tangible personal property” is further defined as:

  • Personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner
  • Films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and other similar property embodying words, ideas, concepts, images, or sound, without regard to the means or methods of distribution or the medium in which the property is embodied, for which, as costs are incurred in producing the property, it is intended or is reasonably likely that any medium in which the property is embodied will be mass-distributed by the creator or any one or more third parties in a form that is not substantially altered

Tangible personal property does not include intangible property or services.

Appeals court’s decision

Before the state appeals court, the Comptroller argued that exhibiting films does not constitute a “good” because the taxpayer did not sell tangible personal property but sold intangible property or a movie-viewing service.

The appeals court—which appeared to find the taxpayer’s witnesses persuasive—rejected the Comptroller’s assertions. In the appeals court’s view, the taxpayer presented evidence, including witness testimony on the steps and processes used to go from the film received from the distributor to that shown on the screen in the theater, to support its position that its film products fell within the statutory definition of “tangible personal property.”

The taxpayer’s witnesses described the films as a “tangible product visible to the sight and sound – perceptible to sound,” and as “creative content that is consumed.” These descriptions, the court observed, fit within the common meaning of “personal property” and the statutory definition of “tangible personal property,” that specifically included films “without regard to the means or methods of distribution of the medium in which the property is embodied….” As such, the court held in the taxpayer’s favor on the first issue.

Having determined that the taxpayer was eligible for the COGS deduction, the court next addressed the taxpayer’s appeal of the trial court’s finding that only the taxpayer’s costs associated with the square footage housing the speakers and screens in its auditoriums—rather than the costs associated with the square footage of the auditorium as a whole—qualified as COGS.

The taxpayer argued that the trial court erred when it gave deference to the Comptroller’s interpretation of the relevant statute. The taxpayer further contended that it had conclusively proven that costs associated with the entire auditorium were direct costs of producing the films that the taxpayer sold to its customers.

After agreeing with the taxpayer that the Comptroller’s interpretation was not entitled to deference, the appeals court concluded that the taxpayer had established that the costs associated with the square footage of its auditoriums were the direct costs of producing its product and that the Comptroller had failed to produce evidence to the contrary.

In particular, the taxpayer argued that the entire auditorium and the balancing of various sound and other effects among components in all parts of the auditorium were necessary to providing the complete product to the consumer. In rendering this decision, the court again seemed to find the taxpayer’s witnesses —and their testimony as to the creation and improvement of a film product in the auditorium—to be persuasive.

KPMG observation

The court’s decision is seen as having two potentially significant franchise tax outcomes.

  • First, by broadly defining “goods” and “tangible personal property” to include all things that are “perceptible to the senses,” the decision appears to expand the types of expenses that may be deducted as COGS—and perhaps the types of taxpayers that may qualify to take the COGS deduction. Notably, the taxpayer’s product did not fit squarely into common definitions of intangible property or services (which are specifically excluded from the statutory definition of tangible personal property). Thus, it is believed that the holding could apply to taxpayers in other industries that likewise sell products perceptible to the senses that are not “services” or “intangible property.”
  • Second, by allowing the taxpayer to deduct costs associated with its entire auditorium, rather than just the square footage housing the speakers, sound equipment and screen, the court appeared to magnify the amount of expenses associated with producing goods that can be included in COGS.In addition to potential franchise tax refunds, the Comptroller also issued a statement that the decision may affect sales and use tax collections. An appeal is expected, given that the Comptroller Glenn Hegar was recently quoted as saying that the appeals court’s decision “really turns two of the major funding streams for the state of Texas on its head.”
In addition to potential franchise tax refunds, the Comptroller also issued a statement that the decision may affect sales and use tax collections. An appeal is expected, given that the Comptroller Glenn Hegar was recently quoted as saying that the appeals court’s decision “really turns two of the major funding streams for the state of Texas on its head.”
 
For more information, contact a tax professional with KPMG’s State and Local Tax practice:
Doug Maziur | +1 (713) 319-3866 | dmaziur@kpmg.com
Lori Wiseman | +1 (214) 840-6041 | lwiseman@kpmg.com
Jason Greenlee | + 1 (214) 840-8079 | jgreenlee@kpmg.com

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