The Third Court of Appeals issued its opinion today in Combs v. Newpark Resources, Inc., its first case under the revised Texas franchise tax law (also known as the Texas margin tax). The opinion rejects the Texas Comptroller’s narrow interpretation of the Texas franchise tax’s cost of goods sold deduction in favor of the taxpayer’s broader interpretation of the taxing statute.
The court made two main rulings. First, it ruled that the Texas franchise tax considers a combined group’s business as a whole when determining its cost of goods sold deduction. Second, it ruled that, when determining whether an entity qualifies for the cost of goods sold deduction because it furnishes labor or materials to a real property construction project, the appropriate definition of the word “labor” is the common, general, expansive definition of the term.
The Texas franchise tax law requires taxpayers engaged in a unitary business that are more than 50 percent owned by the same owner to file as a combined group. The Texas Tax Code treats this combined group as a single taxable entity, and requires the entire combined group to elect one of the Texas franchise tax deductions, usually compensation or cost of goods sold.
Typically, under the Texas franchise tax law, a taxpayer who deducts cost of goods sold may only deduct costs associated with goods that it owns. However, the Texas Tax Code treats a taxpayer “furnishing labor or materials to a project for the construction, improvement, remodeling, repair or industrial maintenance . . . of real property” as the owner of the labor and materials it provides for Texas franchise tax law purposes. Therefore, these taxpayers may include costs associated with furnishing labor and materials to construction projects in their cost of goods sold.
The taxpayer in the Newpark Resources, Inc. case is a combined group and describes itself as an “integrated oilfield services company.” (Note that The Seay Law Firm does not represent Newpark Resources, Inc. and had no involvement in this case.) The combined group’s business involved the manufacture, sale, injection, and removal of “drilling mud,” which is used during the oil and gas well drilling process to cool and lubricate the drill bit and to facilitate the removal of waste material from the hole being drilled. Different members of the combined group engaged in different business activities. One member manufactured drilling mud components, another produced, sold, and injected the drilling mud, and a third, known as NES, removed the drilling mud waste from the drilling site, transported it away, and disposed of it. The Comptroller argued that the combined group could not include NES’s costs in its cost of goods sold deduction because NES itself sold no goods and did not provide labor or materials to real property construction projects.
The court first ruled that a combined group’s business must be viewed as a whole when considering which costs the group may include in its cost of goods sold deduction. The Texas Tax Code states that a combined group is a single taxable entity for Texas franchise tax law purposes. However, the Comptroller argued that each member of a combined group must determine its cost of goods sold individually, based only on its own activities. The Comptroller based this argument on the language of the provision of the Texas Tax Code that describes how a combined group should mathematically calculate its cost of goods sold deduction. This section states that the group should “determin[e] the cost of goods sold for each of its members . . . as if the member were an individual taxable entity,” then add these amounts of up and subtract intergroup costs. However, the Third Court of Appeals rejected the Comptroller’s argument, finding that it was inconsistent with the statutory structure. It found that the Texas Tax Code provision on which the Comptroller relied described only an “accounting mechanism,” and that such accounting mechanisms aren’t meant to place additional limitations on taxpayer’s rights.
The court also ruled that the combined group could include the costs NES’s activities – removing, transporting away, and disposing of drilling mud waste – in its cost of goods sold deduction because in conducting these activities, the combined group provided labor to real property construction projects. In doing so, the court adopted the common, general, and expansive definition of the word “labor.”
This decision is a definite victory for taxpayers. The Third Court of Appeals adopted the more expansive interpretations of the statute, which generally allow larger deductions for taxpayers, rather than the narrower interpretations that the Texas Comptroller adopted. However, it is likely that the Texas Comptroller will appeal this decision to the Texas Supreme Court, so this decision will not be final until the conclusion of that appeal.
Taxpayers who previously adopted the Texas Comptroller’s narrower positions, either on their own, as the result of a Texas franchise tax audit, or as a result of guidance from the Texas Comptroller, should consider whether they may be able to file Texas franchise tax refund claims. Taxpayers should consult with a Texas tax professional, such as a Texas tax attorney, to determine whether they have potential Texas franchise tax refund claims as a result of this decision.