Service Company Expenses Includable in Combined Group’s COGS Deduction

Jan. 16, 2014

In Combs v. Newpark Resources Inc., the Texas Court of Appeals upheld a trial court’s ruling that a taxpayer could include the qualifying expenses of its unitary affiliate in its cost of goods sold (COGS) computation, even though the affiliate was a service company.

The Texas franchise tax is imposed on a unitary basis on the lesser of:

  1. 70 percent of revenue
  2. Revenue less payroll
  3. Margin (revenue less COGS)

In Newpark Resources, the court held that COGS is computed using the qualifying COGS of all members of a unitary group, even if some unitary group members would not qualify for the deduction on a stand-alone basis. In the fact pattern addressed in Newpark Resources, one member of the unitary group was a manufacturer eligible for the COGS deduction and another member was a service provider not eligible for the COGS deduction on a stand-alone basis. The service provider’s services were supplied to the other member of the unitary group in connection with the activity that qualified for the COGS. The Texas comptroller asserted that the unitary affiliate’s expenses did not qualify as COGS because it was a service provider.

The court disagreed with the Texas comptroller, holding that a member of a combined group can claim a COGS deduction for qualifying costs even if the goods for which the costs are incurred are owned by another member of the unitary group. The court further held that the COGS deduction is available even if the unitary affiliate is not entitled to the COGS deduction on a stand-alone basis.

As a result of the court’s decision, taxpayers who have filed unitary returns in Texas might be able to file a refund claim for additional COGS. Taxpayers whose Texas franchise tax liability was based on 70 percent of revenue or on revenue less compensation might also be able to file refund claims if their tax liability after considering these additional COGS deductions is less than the amount reported on their original return.

The Texas comptroller is expected to appeal the decision to the state Supreme Court.

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