State & Local Tax Alert
Breaking state and local tax developments from Grant Thornton LLP
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Texas Comptroller Amends Revised Texas Franchise Tax Cost of
Goods Sold Rule
On June 5, the Texas Comptroller of Public Accounts amended the administrative rule
governing the Revised Texas Franchise Tax (RTFT) cost of goods sold (COGS)
deduction.1 The Comptroller’s amendments to the rule interpreting the existing statute
that authorizes and defines the COGS deduction2 are effective retroactive to the January
1, 2008 effective date of the RTFT to the extent a taxpayer’s statute of limitations
remains open. The most significant changes contained in the rule are the allowance of
certain amended reports and the adoption of certain Internal Revenue Code (IRC)
Section 263A (UNICAP) principles, which may allow indirect labor costs and property
taxes to be treated as direct (100 percent) COGS deductions. However, there may be
situations under which costs previously considered to be fully deductible could now be
reclassified as service costs subject to a 4 percent COGS limitation.
Significant Rule Changes
Margin Computation Method Changes Allowed
The amendment memorializes the relatively new Comptroller policy which allows
taxpayers to file amended returns to change their margin computation method.
Taxpayers now have the option to change their method of computing margin among the
COGS deduction, the compensation deduction, 70 percent of total revenue or E-Z
computation methods (to the extent the COGS and/or E-Z computation methods are
available). Previously, the rule did not allow for taxpayers to amend their franchise tax
reports to change their method to the COGS or compensation methods.3 The rule also
confirms that an election may be changed as part of an audit. This policy shift was first
adopted by the Comptroller in June 2012.4
Release date
June 20, 2013
States
Texas
Issue/Topic
Franchise Tax
Contact details
John LaBorde
Houston
T 832.476.3605
E john.laborde@us.gt.com
Terry Gaul
Houston
T 832.476.5088
E terry.gaul@us.gt.com
Adam Hines
Houston
T 832.476.3665
E adam.hines@us.gt.com
Shelly Butler
Houston
T 832.476.5049
E shelly.butler@us.gt.com
Pat McCown
Dallas
T 214.561.2350
E pat.mccown@us.gt.com
Dan Manley
Dallas
T 214.561.2449
E dan.manley@us.gt.com
Giles Sutton
Dallas
T 704.632.6885
E giles.sutton@us.gt.com
Jamie C. Yesnowitz
Washington, D.C.
T 202.521.1504
E jamie.yesnowitz@us.gt.com
Chuck Jones
Chicago
T 312.602.8517
E chuck.jones@us.gt.com
34 TEX. ADMIN. CODE § 3.588.
TEX. TAX CODE ANN. § 171.1012.
3 34 TEX. ADMIN. CODE § 3.588(c)(3).
4 Letter No. 201206444L, Texas Comptroller of Public Accounts, June 12, 2012.
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Guidance on Direct and Indirect Labor Costs
The Comptroller has concluded that the COGS statute5 allows taxable entities to include
fully in their COGS deduction both direct and indirect labor costs, other than certain
service costs, that are of the type of costs subject to capitalization or allocation under IRC
Sections 263A and 460.6 The Comptroller does not directly address situations in which a
taxable entity is not subject to IRC Sections 263A or 460; situations in which a taxable
entity did not properly apply UNICAP principles on its federal tax return; or situations
where a taxable entity has deducted current period UNICAP expenses on its federal tax
return but has not reported the expenses on Treas. Form 1125-A. However, the
Comptroller’s reference to the type of costs subject to capitalization or allocation under
IRC Sections 263A and 460 and the preamble to the regulations7 would suggest the
Comptroller’s intent to apply UNICAP principles to all of these situations. The allowance
of indirect labor costs as direct COGS deductions is a significant shift in Comptroller
policy, as this issue has been the source of many audit controversies.8
Labor costs have been expanded to include IRS Form W-2 wages, IRS Form 1099
payments for labor, temporary labor expenses, payroll taxes, pension contributions, and
employee benefits expenses, including, but not limited to, health insurance and per diem
reimbursements for travel expenses, to the extent those expenses are deductible for federal
tax purposes.9
“Service Costs” Defined
Pursuant to statute, indirect or administrative costs, including mixed service costs which
are allocable to the acquisition or production of goods, may be considered COGS, though
the includible amount cannot be more than 4 percent of the taxpayer’s total indirect or
administrative overhead costs (including the mixed service costs.10 For the first time, the
Comptroller has formally defined the term “service costs” in the amended rule, as follows:
“. . . indirect and administrative overhead costs that can be identified
specifically with a service department or function, or that directly benefit
or are incurred by reason of a service department or function . . . [A]
service department includes personnel (including costs of recruiting,
hiring, relocating, assigning and maintaining personnel records or
employees); accounting (including accounts payable, disbursements, any
TEX. TAX CODE ANN. § 171.1012(c)(1) provides that COGS includes all direct costs of acquiring
or producing goods, including labor costs.
6 34 TEX. ADMIN. CODE § 3.588(d)(1). The rule specifically references Treas. Reg. §§ 1.263A-1(e)
and 1.460-5.
7 Texas Register, Vol. 38, No. 22, 3415 et seq., May 31, 2013.
8 See Letter No. 201108182L, Texas Comptroller of Public Accounts, Aug. 30, 2011, which guidance
should now be rendered obsolete.
9 34 TEX. ADMIN. CODE § 3.588(d)(1)(A).
10 TEX. TAX CODE ANN. § 171.1012(f).
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payroll functions); data processing; security; legal; general financial
planning and management; and other similar departments or functions.11
While the definition in the rule definition parallels the definition contained in Treas. Reg.
§1.263A-1(e)(4)(i), it should be noted that the Comptroller is defining the term “service
costs,” and not “mixed service costs,” the term actually used in the statute. Further, the
rule uses the terms “service costs” and “indirect or administrative overhead costs”12
interchangeably, which is distinct from the phrase “indirect or administrative overhead
costs, including all mixed service costs” that is used in the statute.
Inclusion of Property Taxes in COGS Deduction
The inclusion of taxes in the COGS deduction has been expanded to include property
taxes paid on buildings and equipment related to acquiring or producing any material.13
Although not stated in the rule, this inclusion logically could extend to property taxes paid
upon inventory for sale. Similar to the allowance of indirect labor, the allowance of
property taxes as a direct COGS deduction is a shift in policy by the Comptroller.14
Commentary
The Comptroller’s policy changes with respect to amended returns, indirect labor costs,
property taxes and the recognition and adoption of federal UNICAP principles present
potential opportunities for taxpayers. Because the rule amendments apply retroactively,
benefits may be recognized by amending prior year reports or revisiting prior audit results,
to the extent the statute of limitations remains open. In addition, taxpayers should assess
the potential ASC 740 impacts of the retroactively amended rule for financial reporting
purposes.
The distinction between indirect labor costs fully includible in the COGS deduction and
service costs includible at 4 percent, at most, in the COGS deduction remains unclear.
The Comptroller’s adoption of the definition of service costs in the rule, and the
application of that term, potentially expands the law’s definition and application of
“indirect or administrative overhead costs, including all mixed service costs.”15 The effect
of this expansion is that more costs could be subject to the 4 percent limitation and may
not be fully deductible under the rule, in contrast to what the law would suggest.
Consider, for example, a taxpayer who has a single department responsible for hiring
employees for both its headquarters and its manufacturing facility. Because this
department handles both production and non-production hiring, the labor costs for this
department should be considered mixed service costs.16 As a result, costs that previously
34 TEX. ADMIN. CODE § 3.588(b)(9).
34 TEX. ADMIN. CODE § 3.588(f).
13 34 TEX. ADMIN. CODE § 3.588(d)(11).
14 See Letter No. 201002890L, Texas Comptroller of Public Accounts, Feb. 2, 2010, which guidance
should now be rendered obsolete.
15 TEX. TAX CODE ANN. § 171.1012(f).
16 Treas. Reg. § 1.263A-1(e)(4)(ii)(C).
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may have been includible, in whole or in part, in the Texas COGS deduction could now be
subject to the 4 percent indirect COGS deduction limitation under the amended rule.17
Alternatively, consider the example of a taxpayer that has a department solely responsible
for hiring employees for its manufacturing facility or function. The labor costs for this
department would be considered to be “service costs that directly benefit or are incurred
by reason of the performance of the production or resale activities of the taxpayer.”18 The
costs are not “mixed service costs” for federal UNICAP purposes, and are capitalizable
service costs for federal tax purposes.19 The corollary to this treatment is that the costs
would be fully includible in the RTFT COGS deduction.20 But as a result of the
Comptroller’s application of “service costs” in lieu of “mixed service costs,” the subject
costs may be limited to the 4 percent indirect COGS deduction limitation under the
amended rule.
The Comptroller’s changes to labor costs, service costs, and property taxes rely heavily on
federal UNICAP principles. The allowance of property taxes as a direct COGS deduction
results from the Comptroller’s recognition of IRC Section 263A principles. The reliance
on UNICAP principles for labor costs and property taxes may allow for similar
interpretations and treatment of other costs where taxpayers are lacking direct guidance.
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34 TEX. ADMIN. CODE § 3.588(b)(9), (f).
Treas. Reg. § 1.263A-1(e)(4)(ii)(A).
19 Treas. Reg. § 1.263A-1(e)(4)(iii)(B).
20 TEX. TAX CODE ANN. § 171.1012(c)(1); 34 TEX. ADMIN. CODE § 3.588(d)(1).
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