Last week, the Texas Third District Court of Appeals (Austin) issued an opinion that could expand the types of businesses that qualify for the cost-of-goods-sold deduction for Texas franchise tax purposes. This decision is of particular importance to taxpayers previously categorized as providers of services and intangible property and may have ramifications beyond the Texas franchise tax.
The Texas franchise tax allows a taxpayer a cost-of-goods-sold deduction if the taxpayer sells real or tangible personal property. Service providers and sellers of intangible personal property have generally not qualified for the deduction. In American Multi-Cinema Inc. v. Hegar,1 a movie theater company argued that it sold tangible personal property to movie goers, while the Comptroller argued that the taxpayer either provided a service—the movie-going experience—or sold intangibles—licenses to view movies. The Court held in favor of the theater, based on the statutory definition for tangible personal property as “personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner.” As a result, AMC was entitled to deduct costs associated with providing this “good,” including auditorium costs.
The Comptroller will likely petition the Texas Supreme Court to review this decision. If the Texas Supreme Court allows the decision to stand, certain service providers and sellers of intangible property (as previously categorized) may have a legal basis to assert that they qualify for the cost-of-goods-sold deduction (i.e., the services or intangibles are in some manner perceptible to the senses and are therefore tangible personal property). The Texas Comptroller’s office acknowledges the refund opportunities this decision presents, estimating that it could cost Texas $1.5 billion annually in reduced franchise tax revenue as well as $6.5 billion in refunds for open tax years.
A taxpayer previously categorized as a service provider or a seller of intangible personal property that is considering whether to argue that it sells tangible personal property should approach this decision carefully. The Texas sales tax and property tax definitions of “tangible personal property” are similar to the franchise tax definition. Accordingly, legal arguments or factual assertions made to qualify for the cost-of-goods-sold deduction could have the unintended consequence of weakening the taxpayer’s position that it does not sell or own tangible personal property for sales tax and property tax purposes. That said, this decision may provide a basis for expanding the types of activities that qualify for the sales tax manufacturing exemption, which requires the production of tangible personal property for sale.