The Third Court of Appeals issued a new opinion today in American Multi-Cinema, Inc. v. Hegar, over a year and a half after the Texas Comptroller filed a motion for rehearing. The new opinion leaves in places the Third Court of Appeals’ prior ruling that a movie theater company may include costs of exhibiting films in its Texas franchise tax COGS deduction, because films meet the definition of “tangible personal property,” and are, therefore, goods. However, the court changed its reasoning in the new opinion in a manner that makes the opinion more limited in scope. We discuss the differences between the two opinions and the implications of the new opinion below.
The First Opinion
In the first opinion, the Third Court of Appeals held that the movie theater company could include costs of exhibiting films in its cost of goods sold deduction for Texas franchise tax purposes because films meet the definition of “tangible personal property,” and are, therefore, goods. It held in this opinion that films meet the definition of “tangible personal property” because they are perceptible to the senses. Thus, the Third Court of Appeals determined that AMC sold a good when it showed its customers films in its theaters.
Another question for the Court was, what were AMC’s costs of production? The Comptroller argued (and the trial court found) that only AMC’s costs associated with the speakers and screens in the auditoriums qualified as COGS. AMC argued that its production costs included the costs associated with the entire square footage of its auditoriums, including rent and depreciation. The Third Court of Appeals agreed with AMC. It declared the statutory definition of “production” to be unambiguous, and focused on the words “creation” and “improvement” in the definition. The Court determined that “create” means “to bring into existence,” and “improve” means “to make greater in amount or degree” and “to enhance in value or quality.”
There was evidence in the record that AMC’s auditoriums “improved on what [was] originally provided” by the studios due to their engineering to produce quality acoustics. The Comptroller argued that the theaters had “consumption space” (the auditoriums) and “production space” (the screens and projection rooms, but provided no evidence of this. The Court therefore sided with AMC, attributed the auditoriums to “production,” and allowed AMC to include the costs in the Texas Franchise Tax COGS deduction.
The Comptroller’s Reaction
The Texas Comptroller filed a Motion for Rehearing in the AMC case on June 5, 2015. Later, the Texas Comptroller posted an article on his web site arguing that if the AMC opinion became final, it could cost the state $1.5 billion per year. The article reasoned that the AMC opinion would allow nearly any type of service provider to include their costs in cost of goods sold because most services are “perceptible to the senses.” For example, the article suggests that janitorial service providers would qualify for the cost of goods sold deduction under this AMC opinion because customers are able to perceive cleaner facilities after the janitorial service provider performs their services.
The Second Opinion
Over a year and a half later, on January 6, 2017, the Third Court of Appeals issued a new opinion in the AMC case. This opinion maintained the original holding. However, the new opinion holds that films meet the definition of “tangible personal property” found in a special provision of the Texas franchise tax law that defines mass-distributed films and other types of media products as tangible personal property for the purpose of the cost of goods sold deduction. The new opinion expressly refuses to decide whether films meet the more general definition of tangible personal property.
This change means that the AMC opinion, for the purposes of defining tangible personal property for cost of goods sold purposes under the franchise tax, likely only applies to taxpayers involved in producing, distributing, or displaying mass-distributed media. It remains open whether the sale of some services or other types of potential goods perceptible to the senses may qualify for the cost of goods sold deduction. We anticipate that other litigation may help clarify this issue. We also note that this decision is not yet final and it is also potentially subject to review by the Texas Supreme Court.
In the wake of this decision, taxpayers who find themselves uncertain of their Texas sales tax obligations may wish to seek the advice of a Texas tax professional, such as a Texas tax attorney, in order to clarify their obligations.