Glenn Hegar, Comptroller of Public Accounts of the State of Texas and Ken Paxton, Attorney General of the State of Texas v. Gulf Copper and Manufacturing Corporation

IN THE SUPREME COURT OF TEXAS
══════════
No. 17-0894
══════════

GLENN HEGAR, COMPTROLLER OF PUBLIC ACCOUNTS OF THE STATE OF TEXAS,
AND KEN PAXTON, ATTORNEY GENERAL OF THE STATE OF TEXAS,
PETITIONERS,
v.

GULF COPPER & MANUFACTURING CORPORATION, RESPONDENT
══════════════════════════════════════════
ON PETITION FOR REVIEW FROM THE
COURT OF APPEALS FOR THE THIRD DISTRICT OF TEXAS
══════════════════════════════════════════

Argued October 9, 2019

JUSTICE LEHRMANN delivered the opinion of the Court.

In this franchise-tax case, the Comptroller determined that a taxable entity paid an

insufficient amount for the 2009 tax year. The Comptroller and the entity disagreed about whether

the entity, in calculating the amount of franchise tax owed, could exclude certain payments from

its revenue under Texas Tax Code subsection 171.1011(g)(3) and include certain costs in its “cost

of goods sold” (“COGS”) subtraction under section 171.1012. The taxable entity paid the

additional taxes under protest and sued to recover the disputed amount. The trial court rendered

judgment for the taxpayer. The court of appeals affirmed with respect to the revenue exclusion,

reversed with respect to the COGS subtraction, and remanded for further proceedings involving

the proper calculation of the COGS subtraction. We agree with the court of appeals that the
Comptroller incorrectly disallowed the revenue exclusion. With regard to the COGS subtraction,

we agree with the court of appeals that the subtraction must be calculated on a cost-by-cost basis

and that the calculation method accepted by the trial court was improper. However, unlike the

court of appeals, we hold that the taxpayer is not entitled to include costs under subsection

171.1012(i) in calculating its COGS subtraction. Accordingly, we affirm the court of appeals’

judgment in part, reverse it in part, and remand the case to the trial court for further proceedings

consistent with this opinion.

I. Background

Gulf Copper and Manufacturing Corporation is in the business of surveying, repairing, and

upgrading offshore oil-and-gas rigs for rig owners and drilling contractors who in turn use the rigs

to drill offshore wells for exploration-and-production companies. The rigs are used to drill

multiple wells, which are located all over the world. After completing a drilling project, a rig sits

idle until a drilling contract calls for its use. At that point, the rig is brought to Gulf Copper’s

shipyards and drydocks, including those on the Texas coast. Gulf Copper then prepares the rig for

its next drilling project in accordance with the applicable governmental regulations, certification

requirements of marine classification societies, and contract terms of that project.

The process of preparing the rig begins with surveying the rig to determine what repairs

and upgrades must be made. Gulf Copper’s subsidiary Sabine Surveyors performs those surveys. 1

After the surveys are completed, repairs and upgrades commence. One example of a repair is the

replacement of corroded portions of a rig’s steel hull. That process involves cutting out corroded

steel, cutting new plates of raw steel, sandblasting the new plates, coating and painting the new

1
Throughout this opinion, “Gulf Copper” refers to both Gulf Copper and Sabine Surveyors.

2
plates, and fitting and welding the new plates onto the hull of the rig. Another example of a repair

is sandblasting and painting parts of the hull that have not been replaced. An example of an

upgrade is changing the size and configuration of bunkrooms to comply with a country’s labor

laws. Gulf Copper pays subcontractors to work along with its employees on those tasks.

During the accounting period for the 2009 tax year, 2 Gulf Copper experienced both an

increase in business and a shortage of employees due to recent hurricanes that had damaged rigs

and displaced workers. Gulf Copper thus engaged substantially more subcontractors than usual

during the 2009 tax year.

Gulf Copper timely filed its 2009 Texas franchise-tax form, reporting that it owed $210,605

in taxes, and timely paid that amount. The Comptroller conducted a desk audit and determined

that Gulf Copper had underpaid. The Comptroller concluded that Gulf Copper had improperly

excluded from total revenue $79,405,230 in payments to subcontractors under subsection

171.1011(g)(3) of the Texas Tax Code, which allows revenue exclusions for certain subcontractor

payments, or had improperly subtracted those payments as costs of goods sold under subsection

171.1012(i). The Comptroller further determined that Gulf Copper had improperly subtracted

other survey, repair, and upgrade costs under subsection 171.1012(i) totaling $72,711,734.

Concluding that Gulf Copper’s records were inadequate to calculate the amount owed, the

Comptroller used a “sampling audit method” to do so. TEX. TAX CODE § 111.0042. Based on that

method, the Comptroller estimated Gulf Copper’s subtractable cost of goods sold to be fifty

percent of Gulf Copper’s overall costs at its Galveston and Port Arthur facilities and five percent

of Gulf Copper’s costs at its Corpus Christi facility. The Comptroller calculated a tax deficiency

2
The accounting period for the 2009 franchise-tax report year was May 1, 2007 to April 30, 2008.

3
of $692,626.66 plus interest—totaling $838,117.84—and demanded payment. Gulf Copper made

the payment under protest and filed this suit in Travis County district court. See id. § 112.052.

The trial court held a bench trial and rendered judgment in favor of Gulf Copper. The court

concluded that Gulf Copper was entitled to exclude from total revenue, under Tax Code subsection

171.1011(g)(3), its payments to subcontractors totaling $79,405,230; that Gulf Copper was entitled

to subtract, as costs of goods sold under section 171.1012, the $72,711,734 in survey, repair, and

upgrade costs not already excluded; 3 and that Gulf Copper’s method of calculating its COGS

subtraction was proper. In its final judgment, the trial court ordered the Comptroller to reimburse

Gulf Copper the full amount it had paid under protest, plus interest and costs. The Comptroller

appealed.

The court of appeals held that sufficient evidence supported the trial court’s conclusion

regarding Gulf Copper’s entitlement to a revenue exclusion under subsection 171.1011(g)(3). 535

S.W.3d 1, 4, 13 (Tex. App.—Austin 2017). The court also concluded that the Comptroller had

erroneously limited the costs that Gulf Copper was entitled to subtract under subsection

171.1012(i). Id. at 20. However, the court held that the method Gulf Copper used to calculate its

COGS subtraction was improper and therefore reversed and remanded for a recalculation using

the proper test. Id. at 4. The Comptroller petitioned this Court for review, arguing that the

subsection 171.1011(g)(3) revenue exclusion does not apply to Gulf Copper’s disputed payments

to subcontractors and that subsection 171.1012(i) does not allow Gulf Copper to subtract its rig

3
A taxable entity may not exclude an amount from total revenue and also subtract that amount as a cost of
goods sold. TEX. TAX CODE § 171.1011(j). In the alternative to excluding subcontractor payments under subsection
171.1011(g)(3), the trial court held that Gulf Copper could subtract those payments as costs of goods sold, for a total
COGS subtraction of $152,116,964.

4
survey, repair, and upgrade work that is not a direct cost of acquiring or producing a good. Gulf

Copper filed a counter-petition, arguing that the method it used to calculate its COGS subtraction

was proper.

II. Discussion

Texas’s franchise tax is imposed on the privilege of doing business in the state, see In re

Nestle USA, Inc., 387 S.W.3d 610, 621–22 (Tex. 2012), and applies to what the Legislature has

denominated “taxable margin,” TEX. TAX CODE § 171.101. 4 In general, an entity determines its

franchise-tax obligation as follows. First, the entity must determine whether it is taxable or

whether it is exempted from the franchise tax. See id. § 171.051. It must then calculate its “total

revenue from entire business,” and certain funds are excluded from that amount. Id. § 171.1011.

The entity may then take one of several possible subtractions from its total revenue to arrive at its

“margin.” Id. § 171.101(a)(1). Next, the taxable entity multiplies its margin by the percentage of

the taxable entity’s gross receipts from business done in Texas to arrive at “apportioned margin.”

Id. §§ 171.101(a)(2), .106(a). Finally, the entity takes allowable deductions to arrive at its “taxable

margin.” Id. § 171.101(a)(3). The entity’s tax obligation is a percentage of its taxable margin. Id.

§ 171.002. 5

A. Revenue Exclusion for Subcontracting Payments

To calculate its taxable margin, a taxable entity must first calculate its total revenue. See

id. §§ 171.101, .1011. When calculating total revenue, the taxable entity may exclude from that

amount, among other things, certain flow-through funds described in section 171.1011. One

4
Unless otherwise noted, citations to the Tax Code are to the version applicable to the 2009 franchise-tax
report year. Differences between the applicable version and the current version are noted where relevant.
5
Tax credits and other tax rules and allowances may apply.

5
category of excluded flow-through funds encompasses certain payments to subcontractors

described in subsection 171.1011(g)(3). For the 2009 tax year, subsection 171.1011(g)(3)

provided:

(g) A taxable entity shall exclude from its total revenue, to the extent included
under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), only the following flow-
through funds that are mandated by contract to be distributed to other
entities:

...

(3) subcontracting payments handled by the taxable entity to provide
services, labor, or materials in connection with the actual or
proposed design, construction, remodeling, or repair of
improvements on real property or the location of the boundaries of
real property.

Id. § 171.1011(g)(3). The court of appeals held that all of the subcontractor payments Gulf Copper

sought to exclude under subsection (g)(3) qualified for the exclusion because those payments were

to provide services, labor, or materials “in connection with” the drilling of oil wells and because

those payments qualified as “flow-through funds” pursuant to Gulf Copper’s contracts with its

subcontractors. 535 S.W.3d at 11–13. The Comptroller disputes both of those conclusions.

First, the Comptroller argues that none of the work that Gulf Copper’s subcontractors did

was “in connection with” the construction of improvements on real property and therefore Gulf

Copper’s payments to its subcontractors do not qualify for the exclusion. Second, the Comptroller

argues that, even if the subcontractors’ work was “in connection with” the construction of

improvements on real property, the majority of Gulf Copper’s payments to subcontractors were

not “mandated by contract to be distributed to other entities” and therefore do not qualify for the

exclusion.

6
 1. “In Connection with” Requirement

The parties agree that the rig survey, repair, and upgrade work that Gulf Copper’s

subcontractors provided qualified as “services, labor, or materials” and that drilling an oil well

qualifies as the “construction . . . of improvements on real property,” but the parties disagree

whether the work was “in connection with” the drilling of oil wells. If Gulf Copper’s

subcontractors had worked directly on oil wells, the subsection (g)(3) exclusion would

undoubtedly apply. But Gulf Copper’s subcontractors did not survey, repair, or upgrade oil wells;

instead, the subcontractors’ work was done on rigs that were subsequently used to construct oil

wells. Thus, the issue is whether Gulf Copper’s subcontractors’ activities were sufficiently linked

to the drilling of oil wells.

The court of appeals noted that the phrase “in connection with” is “one of intentional

breadth, but not without logical limit.” Id. at 12 (quotations omitted). The court of appeals’ test

for whether “services, labor, or materials” are provided “in connection with” the drilling of an oil

well was whether there is a “reasonable connection” between the two, meaning a connection that

is “more than tangential or incidental.” Id. (quoting Titan Transp., LP v. Combs, 433 S.W.3d 625,

638–39 (Tex. App.—Austin 2014, pet. denied)).

Using that test, the court of appeals determined that Gulf Copper’s work that rendered rigs

“able to perform the drilling services required to drill a particular well” qualified for the (g)(3)

revenue exclusion. Id. The court of appeals considered it a closer question whether “work that

makes a rig compliant with general requirements imposed by marine classification societies or

with state and federal regulations generally applicable to offshore drilling rigs and their operations”

also qualified for the exclusion. Id. But the court did not answer that question; instead, it held

7
that, because the Comptroller argued only that none of Gulf Copper’s payments to subcontractors

qualified for the (g)(3) exclusion, the Comptroller failed to preserve the argument that some of

those payments qualified but others did not. Id. at 12–13.

Turning to the parties’ arguments, the Comptroller concedes, in agreement with the court

of appeals, that “in connection with” broadens the scope of work to which the (g)(3) exclusion

applies beyond the actual “design, construction, remodeling, or repair of improvements on real

property.” However, the Comptroller insists that the work at issue in this case is too remote from

those activities to be “in connection with” them. Specifically, the Comptroller argues that Gulf

Copper’s work is temporally remote because it occurs before drilling; physically remote because

it occurs in waterfront yards away from the drilling site; and contractually remote because Gulf

Copper’s contracts are not with well owners, but with rig owners and others who in turn contract

with those well owners. The Comptroller acknowledges that Gulf Copper’s work is necessary and

essential for the drilling of oil wells but argues that if all subcontracting payments for necessary

and essential work were excludable, the exclusion would be so broad as to do away with the

franchise tax in the real-estate-development and oil-and-gas industries. 6

On the other end of the spectrum, Gulf Copper argues that the phrase “in connection with”

is one of expansive breadth and that even a tangential relationship is enough to put Gulf Copper’s

work “in connection with” the construction of improvements on real property. See ExxonMobil

Pipeline Co. v. Coleman, 512 S.W.3d 895, 900–01 (Tex. 2017) (interpreting the phrase “in

6
The Comptroller also argues that if the text is ambiguous, it should be construed against the taxable entity
because the revenue exclusion is a tax exemption. We do not address that argument because the text is unambiguous.

8
connection with” in the Texas Citizens Participation Act and holding that a “tenuous or remote

relationship” was sufficient).

While the phrase “in connection with” undoubtedly broadens the scope of the exclusion

beyond work done directly on a well or other real property, the extent of that expansion is what is

at issue here. See Aleman v. Tex. Med. Bd., 573 S.W.3d 796, 802 (Tex. 2019) (“Typically, when

applying statutes requiring a connection between two things, our analysis hinges on how direct

that connection must be.”). Chapter 171 of the Tax Code does not define “in connection with” or

provide any related definitions. In the absence of a statutory definition, “we must give a term its

commonly accepted meaning.” Gilbert v. El Paso Cty. Hosp. Dist., 38 S.W.3d 85, 89 (Tex. 2001).

Additionally, it is “a fundamental principle of statutory construction that words’ meanings cannot

be determined in isolation but must be drawn from the context in which they are used.” Willacy

Cty. Appraisal Dist. v. Sebastian Cotton & Grain, Ltd., 555 S.W.3d 29, 39 (Tex. 2018). Webster’s

defines the noun “connection” as “the act of connecting: a coming into or being put in contact”;

“the state of being connected or linked”; and “relationship or association in thought (as of cause

and effect, logical sequence, mutual dependence or involvement).” WEBSTER’S THIRD NEW

INTERNATIONAL DICTIONARY (2002). 7 “Generally, the use of the phrase ‘in connection with’ does

not imply a material or significant connection although context may indicate otherwise.” Tarrant

County v. Bonner, 574 S.W.3d 893, 898 (Tex. 2019). Therefore, to determine whether the

7
Webster’s similarly defines the adjective “connected” as “joined or linked together” and “having the parts
or elements logically related or continuous”; defines the transitive verb “connect” as “to join, fasten, or link together
usu[ally] by means of something intervening” and “to place or establish in any of various intangible relationships
(as . . . a relationship of things similar in purpose, motivation, configuration, or substance)”; and defines the
intransitive verb “connect” as “to have a relationship.” WEBSTER’S THIRD NEW INTERNATIONAL DICTIONARY (2002).

9
Legislature intended for the phrase “in connection with” in subsection 171.1011(g)(3) to imply

more than a tangential connection, we must look to the phrase’s statutory context.

In chapter 171, the Legislature has enacted an extensive and detailed set of rules that

differentiate in highly specific ways between types of entities and the types of activities in which

they engage. For example, subsection 171.1011(g-10) applies to an “entity that is primarily

engaged in the business of transporting barite . . . a mineral used as a weighing agent in oil and gas

exploration,” and subsection (g-11) applies to an “entity that is primarily engaged in the business

of performing landman services.” 8 Subsection (g)(3) itself includes a specific list of activities that

the work of the taxable entity’s subcontractors must be “in connection with,” namely “design,

construction, remodeling, or repair of improvements on real property.” Thus, given chapter 171’s

detailed requirements, we conclude that “in connection with” in subsection (g)(3) requires more

than a remote, tangential relationship to the requisite design, construction, remodeling, or repair

of real-property improvements.

Notwithstanding that requirement, we agree with Gulf Copper that the rig survey, repair,

and upgrade work provided by its subcontractors is “in connection with” the drilling of oil wells.

The requisite connection between the two is not one of physical, temporal, or contractual

proximity, as the Comptroller urges. Rather, that connection is borne out by the trial court’s

unchallenged findings of fact. The trial court found that “Gulf Copper’s work enables the rigs

(1) to meet and maintain the certification requirements imposed by classification societies, (2) to

comply with governing regulations, and (3) to satisfy an exploration and production (‘E&P’)

8
The Legislature added these subsections in 2013, with an effective date of January 1, 2014. Act of May 27,
2013, 83d Leg., R.S., ch. 1232, § 7, 2013 Tex. Gen. Laws 3106, 3107 (codified at TEX. TAX CODE § 171.1011(g-10),
(g-11)).

10
company’s contractual requirements for a specific drilling project.” The trial court further found

that “[a] rig cannot be used for drilling unless it is properly certified, compliant, and satisfies the

contractual requirements for the project.” In light of the trial court’s findings that Gulf Copper’s

work was a necessary component of enabling the rigs to drill specific wells, we hold that Gulf

Copper provided its services and labor “in connection with” the drilling of those wells for the

purpose of subsection (g)(3).

2. “Mandated by Contract” Flow-Through Requirement

As noted, subsection 171.1011(g) generally allows a taxable entity to exclude certain

“flow-through funds that are mandated by contract to be distributed to other entities,” including

those funds that qualify under subsection (g)(3). TEX. TAX CODE § 171.1011(g). The Comptroller

argues that, even if Gulf Copper’s payments to subcontractors satisfy subsection (g)(3)

specifically, the majority of those payments are not “mandated by contract to be distributed to

other entities” and therefore are not “flow-through funds” that qualify for the exclusion. The court

of appeals disagreed with the Comptroller and held that because Gulf Copper was obligated by its

contracts with its subcontractors to pay the subcontractors for their work, Gulf Copper had met

subsection (g)’s flow-through requirement. 535 S.W.3d at 10–11. We agree with the court of

appeals and hold that Gulf Copper’s subcontractor payments met the flow-through requirement of

subsection 171.1011(g).

The Comptroller’s analysis begins with Gulf Copper’s contract with its customer.

According to the Comptroller, it is that contract that must mandate the distribution of funds to

other entities. Gulf Copper’s relevant contracts with its customers provided one of two

compensation methods for work provided. Under the “hourly” method, the customer was required

11
to pay Gulf Copper an hourly rate that was approximately fifteen to twenty percent more than Gulf

Copper anticipated its costs would be, thereby generating an unspecified profit margin for Gulf

Copper. Under the “cost-plus” method, the customer was required to pay Gulf Copper its cost of

paying subcontractors plus a specified percentage of that cost (usually between fifteen and twenty

percent), thereby generating a contractually specified profit margin for Gulf Copper.

The Comptroller argues that Gulf Copper’s cost-plus contract provisions met the flow-

through requirement contained in subsection 171.1011(g) but that the hourly contract provisions

did not. The key distinction, the Comptroller asserts, is that the cost-plus provisions allocated

exactly how much of the customer’s payment would go to Gulf Copper and how much Gulf Copper

would pay to other entities, while the hourly provisions left open the allocation of funds. In other

words, under a cost-plus provision, Gulf Copper was required to pay funds to other entities in order

to receive payment from its customer covering those costs, but under an hourly provision, Gulf

Copper could use the payments from its customer as Gulf Copper saw fit. Therefore, only the

cost-plus provisions “mandated” that funds be “distributed to other entities.” See TEX. TAX CODE

§ 171.1011(g).

However, as the court of appeals noted, the Comptroller’s argument rests on the faulty

premise that under subsection 171.1011(g), the only contract that can mandate the distribution of

funds to other entities is the taxable entity’s contract with its customer. See 535 S.W.3d at 11. A

taxable entity’s contract with a subcontractor is no less a contract than that entity’s contract with

12
a customer, and subsection 171.1011(g) does not include language suggesting a distinction

between the two. See TEX. TAX CODE § 171.1011(g). 9

The Comptroller advances several arguments in support of its position that the “contract”

in subsection (g) must be the contract between the taxable entity and its customer, but none of

those arguments are persuasive. First, citing subsection (g)’s reference to funds that are mandated

by contract to be distributed to “other entities,” the Comptroller contends that such entities do not

include those that are parties to the contract containing the mandate. Here, Gulf Copper and its

customer would be the parties to the contract, and the subcontractors would be the “other entities.”

The Comptroller argues that, to be entitled to the subsection (g)(3) exclusion, Gulf Copper’s

contracts with its customers must specifically require that payments be made to third parties like

subcontractors. But in context, the term “other entities” is not used to make a distinction between

parties and non-parties to a contract. Rather, the term “other entities” is used to distinguish

between the “taxable entity” and entities besides the taxable entity. Indeed, the only specific

“entity” mentioned in subsection 171.1011(g) is the “taxable entity.” Id. § 171.1011(g) (“A

taxable entity shall exclude from its total revenue . . . only the following flow-through funds that

are mandated by contract to be distributed to other entities . . . .” (emphasis added)). Under

subsection (g)’s plain language, Gulf Copper’s contracts with its subcontractors, which require

payment to entities other than Gulf Copper, qualify as the pertinent “contract.”

9
The current version of subsection 171.1011(g), not applicable here, excludes “flow-through funds that are
mandated by contract or subcontract to be distributed to other entities” and that are “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.” TEX. TAX CODE § 171.1011(g)(3) (new language emphasized).

13
 The Comptroller also cites subsection 171.1011(i) to support his argument that the

“contract” in subsection (g) must be Gulf Copper’s contracts with its customers. Subsection (i)

provides in its entirety that “[e]xcept as provided by Subsection (g), a payment made under an

ordinary contract for the provision of services in the regular course of business may not be

excluded.” Id. § 171.1011(i). According to the Comptroller, subsection (i) shows that the

Legislature did not intend to allow revenue exclusions based on “ordinary contract[s].” But

subsection (i) provides an exception to its general prohibition of exclusions based on such

contracts, and that exception is subsection (g). Id. Thus, rather than supporting the Comptroller’s

argument, subsection (i) confirms that subsection (g), when applicable, allows an exclusion even

for an “ordinary contract . . . in the regular course of business.” Id.

Moreover, we do not read the phrase “mandated by contract” to mean that a contract must

contain language designating specific funds to be passed through the taxable entity on their way

from the customer to the subcontractor. Instead, “mandated by contract” in this context simply

means that the taxable entity’s obligation to pay its subcontractor is a contractual one, and “flow-

through” means that the customer is compensating the taxable entity for that subcontractor’s work.

This compensation necessarily flows through the taxable entity because the taxable entity, under

its contractual obligation to the subcontractor, cannot exercise discretion in retaining the funds.

As a general matter, “subcontracting payments” are payments the taxable entity makes to another

entity to do work or provide materials that the taxable entity is in turn obligated to provide its

customer and for which that customer is compensating the taxable entity. Because the taxable

entity is contractually obligated to pay its subcontractors to do that work, the funds are “mandated

by contract” to flow through the taxable entity to the subcontractor. In this way, the taxable entity’s

14
customer contracts and subcontracts work together to flow the relevant funds from the customer,

through the taxable entity, and to the subcontractor providing services, labor, or materials. Thus,

subsection (g) does not require funds to be earmarked in a contract, and “mandated by contract”

requires only that there be a contract or subcontract in place requiring that the taxable entity’s

subcontractors be paid.

The record in this case supports the trial court’s finding that Gulf Copper’s contractual

mandate to distribute flow-through funds to its subcontractors is contained within its customer

contracts and subcontracts and is supported by accounting records. This evidence shows that Gulf

Copper’s payments to subcontractors under the hourly method, like its payments under the cost-

plus method, qualify as flow-through funds excludable from revenue under subsection

171.1011(g). Gulf Copper presented testimony that its hourly customer contracts include a certain

rate per hour for labor and its subcontracts require it to pay subcontracting laborers a lower

specified rate per hour, which is the amount Gulf Copper seeks to exclude under subsection (g)(3).

The only distinction between the cost-plus method and the hourly method is that the

subcontractor’s rate of pay is specified in the customer contract under the cost-plus method, but in

the subcontract under the hourly method. As we have explained, that is a distinction without a

difference for purposes of the subsection 171.1011(g)(3) exclusion.

Moreover, evidence at trial indicated that Gulf Copper uses its accounting and invoicing

practices to ensure customer payments properly flow through to its subcontractors. Regarding

accounting, Gulf Copper introduced evidence that it uses the accrual method, linking each project’s

revenue to its costs and each cost to the pertinent material or labor provider. For each dollar of

revenue owed to Gulf Copper by the customer, Gulf Copper incurs an associated cost. Payment

15
to subcontractors is made after Gulf Copper receives payment from the associated customer. 10

Similarly, Gulf Copper’s invoicing practices connect its customer-paid revenues to its

subcontractor costs. Gulf Copper receives subcontractor invoices, uses those invoice amounts to

calculate its expected payment from the customer, passes on copies of the subcontractor invoices

with its own to the customer, and pays its subcontractors after receiving payment from the

customer.

In sum, we hold that the applicable version of subsection 171.1011(g) does not include the

requirement that a general contract mandate the transfer of specific funds to a subcontractor. The

record supports the trial court’s finding that Gulf Copper’s payments to its subcontractors pursuant

to its contracts with those subcontractors qualified as “flow-through funds that are mandated by

contract to be distributed to other entities.” Id. § 171.1011(g). We therefore agree with the court

of appeals that Gulf Copper was entitled to exclude all its disputed subcontractor payments under

subsection 171.1011(g)(3).

B. Cost-of-Goods-Sold Subtraction

As explained, after a taxable entity calculates its total revenue, it takes a subtraction from

total revenue to calculate its margin, which is used in turn to calculate the amount of franchise tax

owed. When making that subtraction, the taxable entity may subtract one of several categories

listed in section 171.101,11 and Gulf Copper chose to subtract an amount referred to as the “cost

10
The customer has a strong interest in seeing subcontractors paid, as nonpayment could lead to a maritime-
law lien on the customer’s property, i.e., the rigs in this case.
11
The taxable entity subtracts the category that results in the lowest margin. TEX. TAX CODE § 171.101(a)(1)
(the taxable entity’s margin is “the lesser of” the options provided).

16
of goods sold.” Id. § 171.101(a)(1)(B)(ii)(a). As noted, this is commonly referred to as a COGS

subtraction.

The provision governing the COGS subtraction defines “goods” as “real or tangible

personal property sold in the ordinary course of business of a taxable entity.” Id. § 171.1012(a)(1).

Generally, the amount of the COGS subtraction includes “all direct costs of acquiring or producing

the goods,” id. § 171.1012(c), plus additional specified costs such as “deterioration of the goods,”

id. § 171.1012(d), and limited administrative and overhead costs, id. § 171.1012(f), but does not

include other enumerated costs such as “distribution” and “rehandling” costs, id. § 171.1012(e).

Ordinarily, a taxable entity may include a cost in its COGS subtraction only if the taxable entity

“owns the goods,” which it sells in the ordinary course of its business. Id. § 171.1012(i).

The Comptroller has determined that some of Gulf Copper’s costs qualify for the COGS

subtraction under subsections (c), (d), and (f), and those costs are not in dispute. For example,

Gulf Copper manufactures steel plates that it installs on the hulls of oil rigs to replace parts of the

hulls that have corroded, and the Comptroller agrees that those steel plates are “goods” under

section 171.1012 and that Gulf Copper may subtract the costs of manufacturing and installing

them. At issue is whether Gulf Copper may also include other costs under a limited extension of

the allowable COGS subtraction contained in subsection 171.1012(i) and whether Gulf Copper’s

method of calculating its COGS subtraction was proper.

1. Applicability of Subsection 171.1012(i)

Subsection 171.1012(i) extends the scope of the COGS subtraction by providing that,

despite the general requirement that the taxable entity own the goods:

A taxable entity furnishing labor or materials to a project for the construction,
improvement, remodeling, repair, or industrial maintenance . . . of real property is

17
 considered to be an owner of that labor or materials and may include the costs, as
allowed by this section, in the computation of cost of goods sold.

Id. The Comptroller and Gulf Copper agree that drilling an oil well is “a project for

the . . . improvement . . . of real property” but dispute both whether Gulf Copper’s work involves

“labor or materials” and whether Gulf Copper’s work constitutes “furnishing” that labor or

materials “to a [drilling] project.” Gulf Copper argues that the costs associated with its work

surveying, repairing, and upgrading oil rigs qualify for the COGS subtraction under the

requirements of subsection (i). For example, Gulf Copper argues that the labor costs associated

with painting the existing hull of an oil rig qualify for the COGS subtraction.

As discussed further below, the court of appeals concluded that the amount of a taxable

entity’s COGS subtraction must be calculated on a cost-by-cost basis and that Gulf Copper failed

to use the proper calculation method. 535 S.W.3d at 14–15, 18, 20. Thus, without determining

whether subsection (i) applies to any of Gulf Copper’s particular disputed costs, the court of

appeals remanded the case to the trial court for a proper calculation. Id. at 20. However, the court

of appeals disagreed with the Comptroller’s assertion that none of those costs could be properly

included in the COGS calculation under subsection (i) and articulated what the court considered

the proper test for making that determination. Id. at 14, 20. The court of appeals’ test for whether

subsection (i) applies to a taxable entity’s work was to determine whether the work is an “essential

and direct component” of the real-property project. Id. at 14 (quoting Hegar v. CGG Veritas Servs.

(U.S.), Inc., 581 S.W.3d 228, 232 (Tex. App.—Austin 2016, no pet.)). Because the Comptroller

maintains that subsection (i) does not apply to any of Gulf Copper’s disputed costs, we first address

that question.

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 We begin by noting that despite some similarities, the language governing the applicability

of the subsection 171.1011(g)(3) revenue exclusion discussed above—which allows a taxable

entity to exclude certain subcontracting payments to provide services, labor, or materials in

connection with the actual or proposed design, construction, remodeling, or repair of

improvements on real property—differs in significant respects from the language in the extension

to the COGS subtraction contained in subsection 171.1012(i)—which applies to a taxable entity

furnishing labor or materials to a project for the construction, improvement, remodeling, repair, or

industrial maintenance of real property. Thus, our holding that Gulf Copper is entitled to the

171.1011(g)(3) revenue exclusion does not determine whether Gulf Copper may take a COGS

subtraction under subsection 171.1012(i).

As to subsection (i), the parties agree that drilling an oil well is “a project for

the . . . improvement . . . of real property” and that providing labor or materials for the actual

drilling of oil wells constitutes “furnishing labor or materials to” a well-drilling project. But they

disagree as to whether Gulf Copper’s activities, which occurred on oil rigs in Gulf Copper’s

shipyards and drydocks far from the drilling sites, fall within the scope of “furnishing labor or

materials to” such well-drilling projects.

The Comptroller argues that subsection (i)’s language is narrower than the language of the

subsection 171.1011(g)(3) revenue exclusion. We agree. The list of activities in the (g)(3) revenue

exclusion includes “design,” which occurs off-site, and is not limited to actual “design,

construction, remodeling, or repair” but also includes “proposed design, construction, remodeling,

or repair.” See TEX. TAX CODE § 171.1011(g)(3) (emphasis added). The list of activities in

subsection (i), on the other hand, is limited to activities that typically occur on-site, namely

19
“construction, improvement, remodeling, repair, or industrial maintenance,” and does not include

the “proposed” form of those activities. See id. § 171.1012(i). Furthermore, the phrase “in

connection with” in the (g)(3) exclusion, discussed above, is an expanding term, while the phrase

“furnishing . . . to” in subsection (i) is restricting language directed toward the real property on

which the construction, improvements, or repairs are taking place. See 535 S.W.3d at 14 (noting

that the work at issue must be a “direct component” of the real-property project to qualify under

subsection (i)).

Gulf Copper’s labor and materials were not directed toward real property, but toward

preparing equipment for later use on real property. Specifically, Gulf Copper’s contractual

responsibilities were to inspect, repair, and upgrade equipment (i.e., oil rigs), which themselves

were owned by other entities, that would subsequently be used by others on well-drilling projects

in remote locations. As the Comptroller correctly points out, Gulf Copper’s work on oil rigs in its

waterfront yards was not itself a well-drilling project. Instead, Gulf Copper’s labor and materials

can be fairly characterized as having been furnished to its own project of fulfilling its contracts to

repair and upgrade equipment and not to a project for the construction or improvement of real

property. See Sunstate Equip. Co. v. Hegar, ___ S.W.3d ___, ___ (Tex. 2020) (holding that a

taxable entity’s delivery of heavy-construction rental equipment to and from job sites, where the

equipment would be used by others as part of a real-property construction project, did not itself

qualify as labor “furnished to a project for the construction or improvement of real property, within

the meaning of [subsection (i)]”). In fact, when Gulf Copper performed work on oil rigs, those

rigs were between drilling projects.

20
 Gulf Copper, like the taxable entity in Sunstate, essentially proposes a but-for test for

subsection (i), whereby labor or materials are furnished to a project for the construction or

improvement of real property if the construction or improvement could not occur without them.

As we explain in Sunstate, such a requirement finds no basis in subsection (i)’s text and would

result in allowing “almost any labor [or materials to] be characterized as meeting that test, no

matter how remote or indirectly related to the real property” at issue. 12 Id. at ___. Such a but-for

test would be untenable, and subsection (i)’s restrictive language does not extend in that direction.

Therefore, we hold that under subsection 171.1012(i), the requisite labor or materials must

be furnished to or incorporated into the real property itself. Gulf Copper did not furnish labor or

materials to a project for the construction or improvement of real property within the meaning of

subsection (i) because, to the extent that Gulf Copper furnished labor or materials, Gulf Copper

furnished that labor and those materials to the oil rigs it surveyed, repaired, and upgraded, and

those rigs—although subsequently used on well sites to drill wells—were not and did not become

part of the wells or well sites themselves. 13 See id. at ___ (providing equipment to a real-property

project does not in itself constitute furnishing labor to that project). Accordingly, like the taxable

entity in Sunstate, Gulf Copper cannot be considered “an owner of that labor or materials” and

may not use subsection (i) as a basis to include certain costs in its COGS subtraction.

12
The Comptroller invites us to import the definitions of “labor” and “materials” from chapter 53 of the
Texas Property Code into chapter 171 of the Tax Code, which defines neither term. Because we assume that Gulf
Copper furnished labor and materials, we need not address that argument.
13
“Material” is defined as “the basic matter (as metal, wood, plastic, fiber) from which the whole or the
greater part of something physical (as a machine, tool, building, fabric) is made.” WEBSTER’S THIRD INTERNATIONAL
DICTIONARY (2002). Gulf Copper certainly furnished “materials” that were incorporated into the rigs, but it furnished
nothing that was incorporated into the well or well site.

21
 2. Costs Allowed Under Subsections 171.1012(c)–(f)

Notwithstanding our holding on subsection (i), Gulf Copper also argues that because some

of its costs of preparing rigs to drill wells undisputedly qualify for subtraction under the general

COGS provisions, i.e., subsections 171.1012(c), (d), and (f), it may include all costs of surveying,

repairing, and upgrading rigs that are not otherwise expressly excluded, e.g., by subsection (e).

Gulf Copper argues that its work surveying, repairing, and upgrading rigs is part of an integrated

project of preparing those rigs to drill wells, and, because that project involves some production

and acquisition of goods, Gulf Copper may subtract all of its costs associated with the overall

project. 14 The Comptroller, on the other hand, argues that the only costs Gulf Copper may subtract

are those costs shown to be independently includable under section 171.1012. Characterizing this

issue as a question of the proper method of calculating the COGS subtraction, the court of appeals

held that section 171.1012 “requires a cost-by-cost analysis to determine whether the cost fits one

of the types and categories eligible for inclusion in the calculation.” 535 S.W.3d at 18. We agree

with the court of appeals that Gulf Copper was required to show that each of its costs independently

qualified under section 171.1012.

As noted, subsection 171.1012(c) generally provides that the “cost of goods sold includes

all direct costs of acquiring or producing the goods, including” a list of specific costs like labor,

14
Gulf Copper also argues that all of its activities in preparing a rig to drill a well qualify as acts of production,
but that is simply a variation on Gulf Copper’s integrated-project argument: both are arguments for production by
proximity. Under the latter, costs may be included because the activities are integrated with acts of production
although they are not acts of production themselves, and under the former, costs may be included because the activities
are acts of production themselves, but only in the sense that they are similar to other activities that are in fact acts of
production. For example, Gulf Copper argues that painting is an “intermediate act[] of manufacture,” but that is true
only if it is in fact part of a manufacturing process. Determining whether painting is part of a manufacturing process
requires inquiring into whether that painting in particular is part of a manufacturing process, not whether some of the
taxable entity’s painting is part of a manufacturing process.

22
materials, handling, and storage, among others. TEX. TAX CODE § 171.1012(c). Subsection (d)

provides a list of additional costs that may be included in the cost of goods sold, id. § 171.1012(d),

while subsection (e) enumerates “costs in relation to the taxable entity’s goods” that are expressly

excluded from the cost of goods sold, id. § 171.1012(e). Subsection (f) allows subtraction of up

to four percent of “indirect or administrative overhead costs” that “are allocable to the acquisition

or production of goods.” Id. § 171.1012(f). Thus, the costs that may be subtracted under the

general COGS provisions must relate to the acquisition or production of “goods” as defined in

subsection (a)(1). Id. § 171.1012(a)(1) (defining “goods” as “real or tangible personal property

sold in the ordinary course of business of a taxable entity”).

Gulf Copper begins its argument with the premise that the scope of costs allowed under

section 171.1012 is expansively broad. Gulf Copper argues that subsections (c) and (d) “openly

allow[] subtractible [sic] costs” while subsections (e) and (f) “narrowly circumscrib[e] those

limits,” pointing, for example, to the fact that the list of costs in subsection (c) is not exhaustive.

Gulf Copper thus submits that, as an entity that produces some “goods” as part of its project of

preparing rigs to drill wells, it may include in its COGS subtraction all costs of that project so long

as the costs are not specifically excluded or limited under subsections (e) and (f).

As further support for its argument that the scope of costs eligible for the COGS subtraction

is expansively broad and that a taxable entity is not required to show that each cost independently

qualifies for the subtraction, Gulf Copper points to subsection 171.1012(h), which reads in its

entirety:

A taxable entity shall determine its cost of goods sold, except as otherwise provided
by this section, in accordance with the methods used on the federal income tax
return on which the report under this chapter is based. This subsection does not

23
 affect the type or category of cost of goods sold that may be subtracted under this
section.

Id. § 171.1012(h). Gulf Copper takes the subsection’s reference to “methods used on the federal

income tax return” to mean that it was required to use the amount it had reported under Internal

Revenue Code section 263A as the starting point for its COGS calculation. 15 Because Internal

Revenue Code section 263A does not specify which costs are eligible for a tax subtraction in the

same way that section 171.1012 does, Gulf Copper argues that a showing of independent

qualification for the COGS subtraction for each cost is not necessary and is in fact prohibited.

When calculating its COGS subtraction for the 2009 franchise-tax report year, Gulf Copper

used the amount it had reported under Internal Revenue Code section 263A as its starting point.

Gulf Copper then subtracted from that amount those costs that are expressly disallowed by

subsection 171.1012(e) and limited by subsection 171.1012(f). The result was the amount Gulf

Copper used as its cost of goods sold.

Gulf Copper’s approach to including costs in its COGS subtraction is flawed for several

reasons. First, the Legislature enacted a detailed set of requirements and provided that the

allowable “costs” must meet those requirements. See, e.g., id. § 171.1012(c) (“The cost of goods

sold includes all direct costs of acquiring or producing the goods, including . . . .” (emphasis

added)), (d) (“The cost of goods sold includes the following direct costs in relation to the taxable

entity’s goods.” (emphasis added)). By section 171.1012’s plain terms, only the costs that meet

those statutory requirements may be subtracted.

15
Internal Revenue Code section 263A applies to “[r]eal or tangible personal property produced by the
taxpayer” and “[r]eal or personal property described in section 1221(a)(1) which is acquired by the taxpayer for
resale,” and provides which costs of that property must be treated as inventory costs and which costs must be
capitalized. 26 U.S.C. § 263A(a)–(b).

24
 Additionally, subsection 171.1012(h) states twice that federal methods do not govern the

substance of the COGS calculation: first when it subordinates its requirements to other provisions

of section 171.1012 with the proviso “except as otherwise provided by this section,” and second

when it explicitly provides that “[t]his subsection does not affect the type or category of cost of

goods sold that may be subtracted under this section.” Id. § 171.1012(h). Therefore, federal

methods are to be used only when there are gaps in the Texas statute. For example, as the court

of appeals noted, because the Tax Code gives no specific instruction as to what accounting method

a taxable entity must use in calculating its costs under section 171.1012 (e.g., cash or accrual), a

taxable entity must use the same accounting method it used on its federal return. See 535 S.W.3d

at 17. Subsection 171.1012(h) thus does not affect the specific mandates contained in other parts

of section 171.1012, such as the detailed requirements of subsections (c) through (f), which are the

core of the COGS subtraction. 16 Accordingly, whether a particular cost may be included in the

COGS subtraction is not dependent on whether a taxable entity engages in some qualifying

activities but rather on whether that cost independently meets the requirements of section

171.1012.

Finally, Gulf Copper argues that using a cost-by-cost method will be burdensome on its

business. But, even assuming the relevance of that argument, the applicable version of the Tax

Code provides an efficient alternative for calculating margin: multiply total revenue by 0.7. See

16
Gulf Copper reads too much into subsection (g), which provides a limited instance in which a taxable entity
subject to Internal Revenue Code section 263A must utilize its federal tax return. TEX. TAX CODE § 171.1012(g) (“If
the taxable entity elects to capitalize [rather than expense] costs, it must capitalize each cost allowed under this section
that it capitalized on its federal income tax return.”).

25
id. § 171.101(a)(1)(A). If a taxable entity wishes to avail itself of a COGS subtraction, it must be

willing to meet the concomitant requirements.

Gulf Copper alternatively asserts that it in fact met those requirements and demonstrated

that “the remaining costs were within the scope of the non-exhaustive list of costs allowed by (c)

and (d).” In light of our conclusions that the methodology accepted by the trial court was incorrect

and that none of Gulf Copper’s costs qualify for inclusion in its COGS subtraction under

subsection (i), we think this argument is best considered by the trial court on remand. While we

see no basis for either party to reopen the record, the parties may present argument to the trial court

on remand regarding whether the record evidence supports Gulf Copper’s assertion that its costs

independently qualify for the COGS subtraction under subsections (c) through (f) and, in turn, that

the amount of Gulf Copper’s subtractable costs was greater than the amount the Comptroller

calculated using a sampling audit method. 17

III. Conclusion

We agree with the trial court and the court of appeals that Gulf Copper was entitled to

exclude from its revenue the full $79,405,230 in subcontractor payments under subsection

171.1011(g)(3), and we affirm the court of appeals’ judgment in that respect. We further agree

with the court of appeals that the COGS subtraction under section 171.1012 must be calculated on

a cost-by-cost basis. However, we disagree with the court of appeals’ holding that some of Gulf

17
Our holding that costs must independently qualify for subtraction under section 171.1012 in no way
detracts from the validity of an audit conducted using the sampling audit method under Tax Code section 111.0042,
as the court of appeals suggested it might. See 535 S.W.3d at 20. Rather, the Comptroller’s use of a sampling method
is governed by section 111.0042’s parameters. See TEX. TAX CODE § 111.0042(b) (detailing when such methods are
appropriate), (d) (providing that a transaction in a sample period will be separately assessed if the taxpayer
demonstrates that the transaction is not representative of the taxpayer’s business operations), (e) (requiring dismissal
of the audit as to that portion established by projection based on a sampling method that the taxpayer demonstrates
was not in accordance with generally recognized sampling techniques).

26
Copper’s costs may be included in its COGS subtraction under subsection 171.1012(i). Finally,

we hold that the parties may present argument to the trial court on remand as to whether, under the

existing record, the amount of Gulf Copper’s subtractable costs utilizing a proper cost-by-cost

calculation method exceeds the amount of the COGS subtraction allowed by the Comptroller.

Accordingly, we affirm the court of appeals’ judgment in part, reverse it in part, and remand the

case to the trial court for further proceedings consistent with this opinion.

________________________________
Debra H. Lehrmann
Justice

OPINION DELIVERED: April 3, 2020

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