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The Texas Franchise Tax is imposed on taxable entities that do business in Texas or that are chartered or organized in the state.  Taxpayers subject to the Texas Franchise Tax may compute their tax liabilities under several alternative methods to determine which one results in the lowest amount of tax due.

One such method is to start with the total revenue from the entire business and subtract from that amount either a deduction for the taxpayer’s cost of goods sold (“COGS”) or a deduction for the compensation the taxpayer pays to its officers, directors, owners, partners and employees in determining taxable margin and the resulting tax liability.   A Texas appellate court decision last week may have made the deduction for COGS more valuable to taxpayers liable for Texas Franchise Tax.

In a Memorandum Opinion filed on March 9, 2016, the Texas Court of Appeals for the Third District (Austin, TX) affirmed the trial court’s decision that CGG Veritas Services (U.S.), Inc. ( “CGG Veritas”) was entitled to include its costs of labor and materials incurred to acquire and process seismic data for its clients in its deduction of COGS for Texas Franchise Tax purposes.  Hegar v. CGG Veritas Services (U.S.), Inc., No. 03-14-00713-CV (Mar. 9, 2016).   In computing its Texas Franchise Tax liability, CGG Veritas made the determination that deducting its COGS would provide a larger benefit than deducting its compensation paid.  Included in its COGS deduction were the costs of labor and materials incurred to acquire and process seismic data that it sold to clients who used the data to determine where to drill oil and gas wells.  CGG Veritas took the position that these costs were furnished “to a project for the construction, improvement . . . of real property” for purposes of Tex. Tax Code § 171.1012(i) and, pursuant to that section, it was entitled to include those costs in the computation of its COGS deduction.  Important to this position was that an oil and gas well was “real property” and that the drilling of such a well was a project for the construction of real property.  The State, on audit, at the trial court, and on appeal argued that CGG Veritas was a service provider who could not include the disputed costs in its deduction for COGS.

The appeals court applied its interpretation of the meaning of the term “labor” previously stated in Combs v. Newpark Resources, Inc., 422 S.W. 3d 46 (Tex. App. – Austin 2013) and concluded that the Texas legislature intended that entities subject to the Texas Franchise Tax could deduct a wide range of labor expenses, even those that might be described “services”, pursuant to section 171.1012(i).  According to the court, the test for whether a labor or material cost is includible in the COGS deduction in this context is whether the activity is an “essential and direct” component of the project for the construction of real property.

The appeals court then reviewed the findings of the trial court on this issue and found evidentiary support for the trial court’s determination that CGG Veritas’ costs for seismic data acquisition and processing activities were an integral, essential and direct component of the drilling process, a process clearly “a project for the construction of real property”.  Accordingly, the appeals court affirmed the trial court’s judgment in favor of CGG Veritas.

The decision in CGG Veritas Services (U.S.), Inc. indicates that “labor and materials for a project for the construction or improvement of real property” will be broadly interpreted for purposes of the Texas Franchise Tax COGS deduction.  The decision is important for other oilfield services companies who now also may find that a COGS deduction is preferable to a compensation deduction in determining taxable margin and the resulting tax liability.

The decision also has implications for taxpayers outside of the oilfield business who produce and sell or license intellectual property to customers for the construction or improvement of real property.  These latter taxpayers may find like CGG Veritas that the sum of (a) essential and direct labor and materials incurred for a project for the construction or improvement of real property and (b) all other costs that properly are includible in COGS will exceed the compensation deduction in arriving at taxable margin for Texas Franchise Tax purposes. Liskow & Lewis can help in this determination.