Source: https://www2.deloitte.com/us/en/pages/tax/articles/tx-appellate-court-upholds-subcontractor-exclusion-while-reversing-and-remanding-on-cogs-methodology.html
Timestamp: 2019-04-24 01:14:52+00:00

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In this tax alert, we summarize the decisions of both the District Court and Court of Appeals as well as offer some taxpayer considerations.
Following an audit, the Texas comptroller (comptroller) determined the “labor” subcontractor payments were not eligible for the (g)(3) revenue exclusion and instead should be considered in the calculation of Gulf Copper’s COGS deduction.8 The comptroller also audited Gulf Copper’s COGS deduction and significantly reduced the expenses included in Gulf Copper’s COGS calculation.9 Ultimately, the comptroller found that only costs either directly or indirectly related to the “fabrication” of goods could properly be included in Gulf Copper’s COGS deduction under TTC § 171.1012.10 Gulf Copper paid the deficiency assessed under the comptroller’s revised computation and subsequently filed suit against the comptroller seeking a refund of all amounts paid under protest.
Taxpayers that have included certain subcontractor payments within total revenue may wish to consider filing a refund claim based on the additional guidance provided by the Court of Appeals on qualifying costs. In addition, taxpayers that have utilized their federal COGS as a starting point for determining their Texas COGS deduction should consult with their tax advisors to analyze potential Texas franchise tax implications.
1 Hegar v. Gulf Copper & Mfg. Corp., No. 03-16-00250-CV, at *32 (Tex. App.—Austin, Aug. 11, 2017, no pet. h.).
6 In 2013, Texas Tax Code § 171.1011 was amended to add “subcontract” in the introductory language of subsection (g); in addition, subsection (g)(3) was amended to substitute “made under a contract or subcontract entered into” for “handled” and added “remediation.” Acts 2013, 83rd Leg., ch. 1034 (H.B. 2766), § 1 (effective Jan. 1, 2014). The current language of the (g)(3) revenue exclusion states: “A taxable entity shall exclude from its total revenue, to the extent [reported to the federal IRS as income], only the following flow-through funds that are mandated by contract or subcontract to be distributed to other entities…subcontracting payments made under a contract or subcontract entered into by the taxable entity to provide services, labor, or materials in connection with the actual or proposed design, construction, remodeling, remediation, or repair of improvements on real property or the location of the boundaries of real property” (amendments emphasized). Tex. Tax Code § 171.1011(g). Thus, the 2013 amendments applicable to the (g)(3) revenue exclusion essentially clarified that payments made pursuant to a subcontract (that otherwise satisfy the requirements under TTC § 171.1011(g)) would qualify as an exclusion from revenue. As a result, the guidance provided under the Gulf Copper appellate opinion would have continued applicability under the current version of Texas Tax Code § 171.1011(g).
7 Gulf Copper & Mfg. Corp., No. 03-16-00250-CV, at *6.
8 As discussed in more detail below, the comptroller agreed that the amounts paid to the “outside specialty” subcontractors constituted flow-through funds mandated by contract to be distributed to other entities, and, therefore, were eligible for the exclusion from revenue under Texas Tax Code § 171.1011(g)(3). See id. at 14.
19 Id. at 14 (citing Titan Transp., LP v. Combs, 433 S.W.3d 625, 641 (Tex. App.—Austin 2014, pet. denied)). For additional information on the Titan Transportation decision, see Deloitte External Tax alert, Texas Comptroller Issues Revised Policy for Exclusions and Deduction for Cost of Goods Sold (July 19, 2016).
22 The Court of Appeals noted that the work performed by the subcontractors related to making a rig compliant with state and federal regulations may not be sufficiently related to the “actual or proposed” construction of an improvement to real property to meet the (g)(3) revenue exclusion requirement. However, the Court of Appeals declined to opine on this portion of the subcontractor payments as the Comptroller failed to make any distinction among the subcontractors’ various activities, but rather, simply argued that Gulf Copper was not entitled to take the (g)(3) revenue exclusion at all. As a result, the Comptroller failed to preserve the argument that Gulf Copper may have been permitted to claim a (g)(3) revenue exclusion for some of its subcontractor payments, while other subcontractor payments may have been for work too attenuated to an actual or proposed project to qualify. Id. at 17-18.
24 Id. at 19 (citing Tex. Tax Code § 171.1012(i)).
26 Id. (internal citations omitted).
32 Id. at 27. Specifically, the comptroller assigned percentages for each of Gulf Copper’s facilities, and then reviewed each type of Gulf Copper’s expenses for the facility and, if the expense was one that was generally eligible for inclusion in the COGS calculation (as determined by the comptroller), it allowed the cost on the percentage basis assigned to the facility where the activity generating the expense occurred. Id. at 29. For example, the comptroller allowed 50 percent of the labor costs associated with the Port Arthur facility, but based on the comptroller’s determination that 50 percent of the Port Arthur yard activities were “fabrication,” the comptroller determine that 50 percent of the labor costs at that facility were a direct cost of producing a good, and, therefore, eligible for the COGS deduction. Id.

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