Texas—never known for doing anything on a small-scale—is starting off 2017 with what is likely to be billions of dollars worth of good news for the Comptroller. On January 6, the Third District Court of Appeals released a substituted opinion in American Multi-Cinema Inc. v. Hegar, No. 03-14-00397-CV, a case dealing with the scope of the Texas franchise tax costs of goods sold (“COGS”) deduction. The Comptroller’s office predicted that the court’s original decision, issued in 2015, would cost the state $1.5 billion in annual franchise tax revenue and $6 billion in potential refund claims. The substituted opinion, which substantially narrows the scope of the court’s original holding on what types of costs qualify for the COGS deduction, should alleviate these fiscal concerns for now.

The taxpayer in this case, American Multi-Cinema (“AMC”), a national movie theater chain, argued that the costs it incurred to exhibit films should be included in its COGS deduction. The Comptroller disagreed, arguing that the exhibition of a film does not constitute the selling or production of goods. In short, when computing franchise tax liability, taxpayers may elect to deduct COGS from their tax base (or they may elect to take other, alternative deductions). Only costs incurred to acquire or produce “goods” may be included in the COGS computation. Furthermore, only real and tangible personal property sold in the ordinary course of business qualify as “goods” under the relevant statute (Tex. Tax Code § 171.1012(a)(1)); tangible personal property is in turn defined, in part, as “personal property that can be seen, weighed, measured, felt, or touched or that is perceptible to the senses in any other manner.” Tex. Tax Code § 171.1012(a)(3)(A)(i).

The original opinion, which was issued in April 2015, held that AMC could include the costs of exhibiting films in its COGS deduction because the films met the definition of “tangible personal property” in that they were “perceptible to the senses.” Additionally, because the statutory definition of “production,” included both “creation” and improvement,” the court also held that AMC’s production costs included the costs associated with the entire square footage of its auditoriums, including rent and depreciation, and were not, as the Comptroller had argued, limited to costs associated with the screens and projectors within the theater. In June 2015, the Comptroller filed a motion for rehearing and published an article concluding that the “cumulative fiscal impact due to the expanded COGS deduction could rise to $1.5 billion each year — about 26 percent of the franchise tax’s total collections” and could result in up to $6 billion in refunds. The Comptroller’s concern was that the expansive “perceptible to the senses” definition of tangible personal property could extend the COGS deduction to any service provider, even those that are not producing goods in a traditional sense; for example, a clean home that follows the provision of housekeeping services is certainly perceptible to the homeowner’s senses.

The appellate court has now issued a substituted opinion, which is generally consistent with its April 2015 opinion aside from one targeted and critical difference—the rationale upon which the COGS allowance is based. The substituted opinion holds that film exhibition costs are includable in COGS, not because the films are tangible personal property under Texas Tax Code section 171.1012(a)(3)(A)(i) by being perceptible by the senses, but rather because a different subsection of the same statute expressly defines films and other media products that are “mass-distributed” as tangible personal property. See Tex. Tax Code § 171.1012(a)(3)(A)(ii). The court expressly declined to address whether the films were tangible personal property under the “perceptible to the sentences” subsection (leaving this question ripe for future controversy). The appellate court’s substituted opinion did not alter its conclusion on the types of costs that could be included (i.e., that costs were not limited to the screens and projectors).

Thus, the American Multi-Cinema case, which months ago was poised to have an expansive reach for various types of businesses subject to the franchise tax, now seems to be limited to producers and sellers of mass-distributed media. While the substituted opinion is sobering news for service providers anxious to prove that they were actually selling something “perceptible to the senses,” the holding can be beneficial for taxpayers in other areas. For example, the Texas sales tax definition of tangible personal property is the same as the franchise tax definition, so taxpayers arguing that something was tangible personal property under American Multi-Cinema’s original expanded definition for COGS purposes could have been stuck with that classification for sales tax purposes and thereby potentially subject to sales tax on otherwise nontaxable services and intangibles. Also, if the expanded definition of tangible personal property was upheld, the Comptroller could seek to assert that out of state companies had physical presence in the state for nexus purposes (i.e., by having “property” in the state) even if their only presence in the state was through intangibles or other services that could somehow be perceived through the senses. Such an aggressive stance would not be entirely surprising in light of positions that the Comptroller has taken in the past—most notably, that licensing software into Texas created physical presence and substantial nexus for the out-of-state licensor because software is classified as tangible personal property for sales tax purposes, even if it is, in reality, merely an intangible compilation of electronic information. See SOAH Docket No. 304-13-5657.26 (Sept. 19, 2014).

While the American Multi-Cinema case may not bring about the fiscal crisis that the Comptroller warned of in 2015, the story may not be over. The Comptroller’s office is still considering next steps such as an appeal to the Texas Supreme Court, although such an appeal seems highly unlikely given that the substituted opinion results in a far less significant loss of tax revenues. Additionally, and, perhaps, more importantly, while the appellate court in American Multi-Cinema was able to revise its analysis and issue the same decision on narrower grounds, the issue of what constitutes tangible personal property for the COGS deduction has now been “let out of the bag,” and it may only be a matter of time before this issue makes its way back to the courts.