FILED
17-0894
12/20/2017 1:53 PM
tex-21414862
SUPREME COURT OF TEXAS
BLAKE A. HAWTHORNE, CLERK
No. 17-0894
IN THE SUPREME COURT OF TEXAS
_________________________________________________________________
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 and Manufacturing Corporation,
Respondent.
_________________________________________________________________
On Petition for Review
from the Third Court of Appeals at Austin, Texas
Appeal No. 03-16-00250-CV
_________________________________________________________________
Petition for Review
_________________________________________________________________
KEN PAXTON JACK HOHENGARTEN
Attorney General of Texas Tax Division Chief
State Bar No. 09812200
JEFF MATEER Tax Division
First Assistant Attorney General P.O. Box 12548; MC-029
Austin, Texas 78711-2548
BRANTLEY STARR TEL: (512) 475-3503
Deputy First Assistant Attorney FAX: (512) 478-4013
General
Counsel for Petitioners
JAMES E. DAVIS
Deputy Attorney General for Civil
Litigation
IDENTITY OF PARTIES AND COUNSEL
Petitioner:
Glenn Hegar, Comptroller of Public Accounts of the State of Texas
Ken Paxton, Attorney General for the State of Texas
Counsel for Petitioners
JACK HOHENGARTEN
Tax Division, Division Chief
Office of the Attorney General
State Bar No. 09812200
Tax Division MC 029
PO Box 12548
Austin, Texas 78711-2548
Tel: (512) 475-3503
Fax: (512) 478-4013
Jack.hohengarten@oag.texas.gov
Appellate Counsel
CHARLES K. ELDRED
Assistant Attorney General, Tax Division
State Bar No. 00793681
Office of the Attorney General
P.O. Box 12548 (MC 029)
Austin, Texas 78711-2548
Tel: (512) 475-1743
Fax: (512) 478-4013
charles.eldred@oag.texas.gov
Appellate and Trial Counsel
Respondents
Gulf Copper and Manufacturing Corporation
Page ii
Counsel for Respondents
James F. Martens
State Bar No. 13050720
jmartens@textaxlaw.com
Danielle Ahlrich
State Bar No. 24059215
dahlrich@textaxlaw.com
MARTENS, TODD, LEONARD & AHLRICH
301 Congress Ave., Suite 1950
Austin, Texas 78701
Tel: (512) 542-9898
Appellate and Trial Counsel
and
Amanda Taylor
BECK REDDEN, PLLC
ataylor@beckredden.com
State Bar No. 24045921
515 Congress Ave., Suite 1900
Austin, Texas 78701
Tel: (512) 708-1000
Appellate and Trial Counsel
Page iii
TABLE OF CONTENTS
Identity of Parties and Counsel ................................................................ii
Table of Contents ..................................................................................... iv
Index of Authorities.................................................................................. vi
Record References ..................................................................................viii
Statement of the Case ............................................................................viii
Statement of Jurisdiction .......................................................................... x
Issues Presented...................................................................................... xii
Statement of Facts .................................................................................... 1
Summary of the Argument ....................................................................... 5
Argument ................................................................................................... 7
I. Gulf Copper’s costs in repairing and outfitting drilling rigs,
and Sabine Surveyors’ costs in surveying marine vessels,
were not deductible as costs-of-goods sold. ................................... 7
A. Background: Tax Code section 171.1012. .................................... 7
B. There was no evidence of section 171.1012(i) costs to
support a remand. ........................................................................ 9
C. The court of appeals’ decision regarding section
171.1012(i) also defeats other key provisions in the
cost-of-goods-sold statute............................................................ 14
II. Gulf Copper cannot exclude the contested subcontractor
payments from revenue under Tax Code §171.1011(g)(3). ......... 16
A. Background: Section 171.1011(g)(3)............................................ 16
B. There is no evidence that the subcontract work constituted
“services, labor, or materials in connection with the actual
or proposed design, construction, remodeling, or repair of
improvements on real property”................................................. 18
Page iv
C. There is no evidence that the subcontractor payments
constituted “flow-through funds that are mandated by contract
to be distributed to other entities.” ............................................ 21
Prayer ...................................................................................................... 25
Certificate of Compliance ........................................................................ 26
Certificate of Service ............................................................................... 26
Appendix .................................................................................................. 27
Appendix Table of Contents .................................................................... 28
Page v
INDEX OF AUTHORITIES
Cases
Combs v. Newpark Resources, Inc.,
422 S.W.3d 46 (Tex. App.—Austin 2013, no pet.) ......................... 12, 13
Owens Corning v. Hegar,
04-16-00211-CV, 2017 WL 1244444, at *3 (Tex. App.—San Antonio
Apr. 5, 2017, pet. denied) ..................................................................... 24
Sheshunoff v. Sheshunoff,
172 S.W.3d 686 (Tex. App.—Austin 2005, pet. denied) ...................... 10
Titan Transp. LP v. Combs,
433 S.W.3d 627 (Tex. App.—Austin 2014, pet. denied) .......... 18, 19, 24
Statutes
Tex. Gov't Code § 311.011(a) ............................................................. 12, 23
Tex. Gov't Code § 22.001(a) ...................................................................... ix
Tex. Prop. Code § 53.023 ......................................................................... 10
Tex. Prop. Code § 53.001(3) & (4) ........................................................... 10
Tex. Prop. Code § 53.001(4)(B) ................................................................ 11
Tex. Prop. Code § 53.021 ......................................................................... 10
Tex. Prop. Code § 56.001(1) ..................................................................... 11
Tex. Tax Code §171.1011(i) ..................................................................... 16
Tex. Tax Code § 171.1011(g)(3) ....................................................... passim
Tex. Tax Code § 171.1012................................................................ passim
Tex. Tax Code § 171.1012(a)(3)(B)(ii) and (c)(1) ....................................... 5
Tex. Tax Code § 171.1012(a)(3)(B)(ii) ............................................. 5, 8, 14
Tex. Tax Code § 171.1012(c).................................................................. 4, 6
Tex. Tax Code § 171.1012(h) ................................................................... 11
Page vi
Tex. Tax Code § 171.1012(i) ............................................................ passim
Tex. Tax Code § 171.1012(a)(1) and (c) ..................................................... 8
Tex. Tax Code § 171.1012(c), (d), (f) ...................................................... 4, 6
Rules
34 TAC § 3.588 ........................................................................................ 10
Other Authorities
79th Leg., 3d C.S., ch.1, § 5, 2006 Tex. Gen. Laws 1, 10
(amended 2013) .................................................................................... 17
Act of May 2, 2006, 79th Leg., 3rd C.S., ch. 1, § 5, 2006 Tex. Gen. Laws
1, 8 (former Tex. Tax Code § 171.101(a)), current version at Tex. Tax
Code § 171.101(a)(1)............................................................................... x
42. Tex. Reg. 5235-36 (Sept. 29, 2017) .................................................... 10
Page vii
RECORD REFERENCES
References to the Clerk’s Record are in the form “CR.[Page#]”
References to the Reporter’s Record are in the form
“[Volume#].RR.[Page#]”
References to Plaintiff’s Exhibits are in the form “PX[Exhibit#]”
References to Defendants’ Exhibits are in the form “DX[Exhibit#]”
References to items in the Appendix are in the form “App.[Appendix#]”
STATEMENT OF THE CASE
Nature of the case: Franchise tax protest suit under Chapters
112 and 171 of the Texas Tax Code.
Course of Proceedings: Lawsuit filed November 4, 2014. CR.3.
Bench Trial February 1–2, 2016. Judgment
entered
February 22, 2016. CR 294–95 [App.1].
Notice of Appeal filed April 13, 2016. CR
302–03.
Trial Court : 201st District Court, Travis County, Texas
The Honorable Amy Clark Meachum.
Disposition: Judgment for Plaintiff/Appellee.
Plaintiff/Appellee entitled to refund of
$838,117.84 plus statutory interest.
Parties to the appeal: Appellants:
Glenn Hegar, Comptroller of Public
Accounts of the State of Texas, and Ken
Paxton, Attorney General for the State of
Texas
Page viii
Appellee:
Gulf Copper and Manufacturing
Corporation
Court of appeals: Third Judicial District of Texas at Austin
Justices who Chief Justice Rose,
participated: Justices Field and Bourland
Citation: Hegar v. Gulf Copper and Manufacturing
Corporation, No. 03-16-0250-CV, 2017 WL
3471064 (Tex. App.—Austin Aug. 11, 2017)
(herein, “Opinion at __.”) [App. C]
Disposition: The Third Court of Appeals, opinion by
Justice Field, affirmed in part and
reversed and remanded in part to 201st
Judicial District Court, Travis County,
Texas, for further proceedings. Motion for
Rehearing denied September 21, 2017.
Page ix
STATEMENT OF JURISDICTION
This Court has jurisdiction under Texas Government Code section
22.001(a) because the case presents issues important to the
jurisprudence of the state, specifically important issues of statutory
interpretation that impact state revenue.
Although Gulf Copper can deduct the contested amounts on its
federal corporate income tax return or its financial statements, not all
legitimate business expenses are deductible for margin tax purposes. By
restricting margin tax deductions and thereby expanding the tax base,
the Legislature was able to reduce the tax rate from 4.5 percent under
the former earned surplus tax to one percent or less under the margin
tax. See, Act of May 2, 2006, 79th Leg., 3rd C.S., ch. 1, § 5, 2006 Tex. Gen.
Laws 1, 8 (former Tex. Tax Code § 171.101(a)), current version at Tex.
Tax Code § 171.101(a)(1).
If, however, the balance between the low margin tax rate and the
limited deductions is disrupted, there could be a significant revenue
impact to the State of Texas. Accordingly, this Court should give
serious consideration to the implications of the Opinion below, which
Page x
allows service providers to take the cost-of-goods-sold deduction when
they are not selling goods, and further, allows taxpayers to exclude
revenues from margin merely because they are paying expenses owed
under a contract.
Page xi
ISSUES PRESENTED
1. Do the services performed by Gulf Copper or its subsidiary
constitute “furnishing labor or materials to a project for the
construction, improvement, remodeling, repair, or industrial
maintenance ... of real property” such that Gulf Copper may
deduct under Tax Code section171.1012(i) its costs of:
a. Repairing or upgrading drilling rigs at Gulf Copper’s
waterfront facilities, before the commencement of offshore
drilling; or
b. Surveying marine vessels, including drilling rigs at Gulf
Copper’s waterfront facilities?
2. May Gulf Copper exclude from its total revenue, under Tax Code
section 171.1011(g)(3), hourly payments made to subcontractors?
This question turns on:
a. Whether payments were “made under a contract . . . to
provide services, labor, or materials in connection with the
actual or proposed design, construction, remodeling, or repair
of improvements on real property,” when the subcontractor
payments were for work repairing or upgrading drilling rigs
at Gulf Copper’s waterfront facilities, before the
commencement of offshore drilling.
b. Whether payments Gulf Copper made to subcontractors are
“flow-through funds that are mandated by contract to be
distributed to other entities,” when Gulf Copper was not
required by contract to use customer payments to pay
subcontractors.
3. [Unbriefed] Gulf Copper had the burden of proof on its cost-of-
good-sold claim. Where Gulf Copper put on no evidence of
allowable costs according with section 171.1012 or controverting
the Comptroller’s cost-by-cost analysis—relying instead on an
erroneous legal argument—did the court of appeals err in
remanding the case for a new trial on Gulf Copper’s cost-of-
goods-sold claim?
Page xii
STATEMENT OF FACTS
The margin tax dispute.
The court of appeals correctly stated the nature of the case as a suit
“seeking a refund of franchise taxes that Gulf Copper paid under protest.”
Specifically, this franchise or “margin” tax case involves a dispute over
(1) the amounts Gulf Copper may deduct as cost of goods sold, and (2) the
amounts that it may exclude from its revenues.
Gulf Copper’s business.
The trial court made the following findings of fact regarding Gulf
Copper’s business. Gulf Copper is primarily engaged in the business of
surveying, manufacturing, upgrading, and repairing offshore drilling
rigs. CR. 296-97[App. B] (Finding of Fact 10). 1 Gulf Copper repairs rigs
0F
by removing defective portions, manufacturing replacement components,
and installing the replacement components onto the rigs. Gulf Copper
also manufactures and installs new components for rigs that do not
1 Although Gulf Copper manufactures components for the rigs, it is undisputed
that it does not own, manufacture or sell the rigs themselves. 3.RR.39–40; see
also Opinion at *4-5.
Page 1
replace an existing component. Finding of Fact 12.
Gulf Copper’s customers are primarily rig owners and drilling
contractors who use their offshore rigs to drill for oil and gas on behalf
of exploration and production (“E&P”) companies. Finding of Fact 9.
Gulf Copper’s work enables the rigs (1) to meet and maintain the
certification requirements by classification societies, (2) to comply
with governing regulations, and (3) to satisfy an E&P company’s
contractual requirement for a specific drilling project. Finding of Fact
16.
Gulf Copper owns all of the outstanding shares of a subsidiary
named Sabine Surveyors. Finding of Fact 1. Sabine Surveyors is a
limited partnership primarily engaged in the business of marine vessel
surveying. Finding of Fact 2. For franchise tax report year 2009 (the
accounting period of May 1, 2007 to April 30, 2008), Gulf Copper, Sabine
Surveyors, and others (hereinafter collectively referred to as “Gulf
Copper”) joined in the filing of combined franchise tax report. Finding of
Fact 7.
With regard to the exclusions from revenue, the trial court made
Page 2
these additional findings of fact. Gulf Copper performs its work using
both employees and subcontractors. Finding of Fact 22. Gulf Copper’s
customers often approve or require Gulf Copper’s use of certain
subcontractors to complete the work... Finding of Fact 23.
Gulf Copper charges its customers for subcontractor work using a
formula that is based upon Gulf Copper’s actual cost of the
subcontractor(s) plus a mark-up. Regardless of how the subcontractor is
billed, Gulf Copper’s resulting mark-up to the customer is generally
between 15-20 percent. Finding of Fact 24. When Gulf Copper’s
customers pay Gulf Copper for work performed by subcontractors, Gulf
Copper retains the portion of the payment attributable to its mark-up
(generally between 15- 20 percent) and flows through the remainder of
the customer’s payment to the subcontractor. Finding of Fact 25. The
subcontractor payments flow from Gulf Copper’s customer, through Gulf
Copper, to Gulf Copper's subcontractors who performed the work for the
customer. Finding of Fact 26.
Page 3
Finally, it is undisputed that “[t]he drilling rigs are delivered to
Gulf Copper’s facility where Gulf Copper performs the work…” Opinion
at * 4.
The Comptroller’s audit.
The Comptroller audited Gulf Copper and assessed additional
franchise taxes in the amount of $692,626.66 (plus interest, for a then
current total of $838,117.84). The two major adjustments were to: (1) the
cost-of-goods-sold deduction and; (2) the exclusion from revenue of
subcontractor payments.
The Comptroller allowed the cost-of-goods-sold deduction for labor
costs incurred in the production or “fabrication” of rig components and
parts installed on the rigs (and thus “sold” to the rig owners), plus other
costs specifically allowable under the statute. See Opinion at * 3; see also
Tex. Tax Code § 171.1012(c), (d), (f). But the Comptroller disallowed, as
non-deductible “services,” Gulf Copper’s labor costs incurred in installing
components, removing defective components, painting, welding, fixing
cranes, sandblasting, and coating—because none of those labor costs
were shown to be costs of acquiring or producing “goods” for sale. See id.
Page 4
§ 171.1012(a)(3)(B)(ii) and (c)(1); CR. 297 (Findings of Fact 10, 12, 13
[App. B]; 2.RR.131-32, 188, 192.
The Comptroller auditor also disallowed Sabine Surveyors’ costs in
his calculation of Gulf Copper’s cost-of-goods-sold deduction—because
surveying is a service and the costs of surveying are not costs of acquiring
or producing “goods” for sale. 5.RR.11–15.
As to the second audit issue, the Comptroller auditor determined
that the $79,405,230 in payments to subcontractors did not meet the
statutory requirements for the exclusion from revenue, and should be
considered instead in the calculation of Gulf Copper’s cost-of-goods-sold
deduction.
Gulf Copper paid the assessment under protest, and these two
adjustments are the principal issues in this Petition for Review.
SUMMARY OF THE ARGUMENT
Cost-of-goods-sold deduction
There is no evidence in the record to support the contested
deductions. Gulf Copper does not own or sell drilling rigs – it repairs
and outfits them at its waterfront facility. The repair and outfitting of
Page 5
drilling rigs is not the sale of “goods.” Therefore, Gulf Copper’s costs in
repairing and outfitting the rigs are not deductible as costs of acquiring
or producing “goods” under Tax Code § 171.1012(c), (d), or (f).
Furthermore, in performing rig work at its waterfront facility, Gulf
Copper is not “furnishing labor or materials to a project for the
construction, improvement, remodeling, repair, or industrial
maintenance . . . of real property. . .” Rather, it is providing repair and
outfitting services to the owner of equipment, who in turn, contracts with
the E&P company to provide that equipment for offshore drilling. This
indirect relationship does not qualify Gulf Copper for the cost-of-goods-
sold deduction under Tax Code § 171.1012(i). Gulf Copper’s rig work adds
value to the rigs, but it does not add value to any real-property project.
Gulf Copper’s affiliate, Sabine Surveyors, does not own or sell goods
either. And similarly, Sabine Surveyors is not by virtue of its surveying
services, furnishing labor or materials “to a project for the construction,
improvement, remodeling, repair, or industrial maintenance ... of real
property,” so as to qualify for the cost-of-goods-sold deduction under Tax
Code § 171.1012(i).
Page 6
Revenue exclusion for subcontractor payments
With regard to the flow-through exclusion from revenue, the
payment of subcontractors for rig repair, before the commencement of
drilling, does not constitute evidence of payment for “services, labor, or
materials in connection with the actual or proposed design, construction,
remodeling, or repair of improvements on real property” under Texas Tax
Code §171.1011(g)(3).
Furthermore, the flow-through exclusion is proper only where the
taxpayer is contractually obligated to pay its subcontractors from or
based on payments that it has received from other parties, and, here,
there is no such contract in evidence.
ARGUMENT
I. Gulf Copper’s costs in repairing and outfitting drilling rigs,
and Sabine Surveyors’ costs in surveying marine vessels,
were not deductible as costs-of-goods sold.
A. Background: Tax Code section 171.1012.
Gulf Copper determined its “margin” by deducting cost of goods sold
from total revenue. Opinion at *3. The cost-of-goods-sold deduction is
governed by Tax Code section 171.1012, which permits a business to
Page 7
subtract “all direct costs of acquiring or producing the goods.” Tex. Tax
Code § 171.1012(a)(1) and (c).
“Goods” means “real or tangible personal property sold in the
ordinary course of business of a taxable entity.” Id. The definition of
“tangible personal property” expressly excludes “services.” Id.
§ 171.1012(a)(3)(B)(ii)). Thus, sellers of services are not ordinarily
eligible for the cost-of-goods-sold deduction.
To take a deduction under the cost-of-goods-sold statute, the entity
must own the “goods” that it sells. Id. § 171.1012(i). Gulf Copper did not
own the drilling rigs that it repaired and outfitted, and Sabine Surveyors
did not own the marine vessels that it surveyed. The third sentence of
subsection (i), however, allows certain service providers to subtract their
costs from revenue as cost-of-goods-sold by “considering” them to be
owners of their labor and materials:
A taxable entity furnishing labor or materials to a project for
the construction, improvement, remodeling, repair, or
industrial maintenance ... of real property is 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.
Page 8
B. There was no evidence of section 171.1012(i) costs to
support a remand.
Because there was no evidence supporting application of the
subsection (i)’s third sentence, the court of appeals erred when it
concluded that:
Gulf Copper presented evidence at trial that, to some extent,
Gulf Copper’s employees provided labor and materials to
projects for improvement of real property (drilling oil wells).
The Comptroller was obligated to consider to what extent the
activities of Gulf Copper’s employees were essential and
direct components of those specific projects.
Opinion at *14.
Similarly, the court erred when it concluded that “Sabine
Surveyors’ costs should have been analyzed on a cost-by-cost basis to
determine which of those costs met the requirement that they be integral,
essential, and direct components of the offshore drilling process.” Id.
Remand is inappropriate here, because Gulf Copper and its
subsidiary’s services do not constitute “furnishing labor and materials to
a project for the construction, improvement, remodeling, repair, or
industrial maintenance ... of real property. . .” Thus, their services do
not qualify for the cost-of-goods-sold deduction under subsection (i). Tex.
Tax. Code § 171.1012(i).
Page 9
Subsection (i)’s phrase “furnishing labor or materials” is nearly
identical to the Property Code phrase “furnishes labor or materials.” See
Tex. Prop. Code § 53.021 (“Persons Entitled to Lien”). Therefore, it is
reasonable to assume that the Legislature intended substantially similar
meanings. See, e.g., Sheshunoff v. Sheshunoff, 172 S.W.3d 686, 692
(Tex. App.—Austin 2005, pet. denied) (“When the same or a similar term
is used in the same connection in different statutes, the term will be
given the same meaning in one as in the other, unless there is something
to indicate that a different meaning was intended.”)
The Property Code provides that a person who “furnishes labor or
materials” for the construction, repair, or demolition of a real property
improvement may establish a lien on the real property to secure payment
for the labor done or material furnished. See Tex. Prop. Code §§ 53.021
and 53.023 (“Payment Secured by Lien.”). The definitions limit “labor”
and “materials” to those used in the “direct prosecution” of the work. Id.
at § 53.001(3) & (4). 2
1F
2 The Comptroller has proposed rules amending 34 TAC § 3.588, which
would use the Property Code definitions to define “labor” and “materials”
in section 171.1012(i). See 42. Tex. Reg. 5235-36 (Sept. 29, 2017).
Page 10
Application of the Property Code definitions provides this clear test
for costs claimed under subsection (i): could Gulf Copper obtain a lien on
the offshore drilling project? Here, the answer is “no.” Mechanics and
materialman’s liens are limited to “running repairs” performed on
equipment while it is being used on the project site. See Tex. Prop. Code
§ 53.001(4)(B). 3
2F
Gulf Copper tendered no evidence that the costs it seeks to deduct
included any of these activities. Indeed, to establish its entitlement to
the disputed deductions, Gulf Copper relied solely on an erroneous legal
interpretation of subsection 171.1012(h)—which the court of appeals
expressly rejected. Opinion at *9, 12. This lack of evidence requires a
rendition of judgment regarding section 171.1012 costs rather than
remand.
The definitions of “labor” and “materials” in the Property Code –
limiting the terms to labor and materials used in the “direct prosecution”
of a project – accord with subsection (i)’s words and phrases in their
3 Furthermore, mineral property liens under Property Code Chapter 56 are
limited to “digging, drilling, torpedoing, operating, completing, maintaining,
or repairing an oil, gas, or water well.” Tex. Prop. Code § 56.001(1).
Page 11
proper context, as well as with the rules of grammar and usage. See Tex.
Gov't Code Ann. § 311.011(a) (West 2013). The phrase “to a project for the
construction, improvement . . . of real property” is prepositional phrase
that functions as an adjective modifying and limiting the antecedent
phrase “furnishing labor or materials.”
The court of appeals nonetheless concluded that Gulf Copper
“presented evidence at trial that, to some extent” it provided labor or
materials that were “essential and direct components” of “specific
projects.” Opinion at *14. The court’s “essential and direct components”
language comes from its opinion in Newpark. In that case, the court
distinguished labor that was an “essential and direct component” of the
drilling project from labor “too far removed” from the project. Opinion
at *14 (citing Combs v. Newpark Resources, Inc., 422 S.W.3d 46, 57 (Tex.
App.—Austin 2013, no pet.)).
The taxpayer in Newpark was able to obtain the subsection (i)
deductions for labor furnished in hauling away used drilling mud and
other waste products from oil well drilling sites. 422 S.W.3d at 48. But
that labor was provided to the oil wells. In contrast, Gulf Copper’s work
was at least two steps removed from a real-property project. It provided
Page 12
outfitting and repair services to its customers—the rig owners—who, in
turn, contracted with the E&P companies to provide them with the rigs
for offshore drilling. The E&P companies then used the rigs in projects
for real-property improvements or construction.
This Court has never adopted the “essential and direct components”
test in Newpark. But even if the Court accepts that formulation, the
repair and outfitting of a rig owned and operated by a third party, prior
to commencement of drilling by yet another third party at a different site
offshore, cannot be viewed as a “direct component” of drilling. Gulf
Copper’s work is “too far removed” from the construction project.
Gulf Copper fixed construction equipment. As a matter of law,
fixing or upgrading construction equipment prior to its utilization is
not “furnishing labor or materials to a project for the construction,
improvement ... of real property” under subsection (i). Just as fixing
a bulldozer before its delivery to and use on a construction site should be
properly classified as the repair of tangible personal property rather than
real-property improvements, so Gulf Copper’s rig work at its waterfront
yards constituted the repair and upgrading of tangible personal property,
not “furnishing labor or materials to” a construction project. Gulf
Page 13
Copper’s rig work added value to the rigs, but it did not add value to any
real-property project.
This analysis applies with equal if not greater force to Sabine
Surveyors, which inspected the rigs and other marine vessels. There is
no evidence the subsidiary inspected offshore drilling operations or any
other real-property improvements.
C. The court of appeals’ decision regarding section
171.1012(i) also defeats other key provisions in the
cost-of-goods-sold statute.
The court’s decision undermines the explicit exclusion of “services”
from the definition of “tangible personal property” and thus from the
definition of “goods.” See id. § 171.1012(a)(3)(B)(ii). It does so by
allowing the taxpayer to deduct labor costs for installing components,
removing defective components, painting, welding, fixing cranes,
sandblasting, and coating—even though these services had only an
indirect relationship to the construction or improvement of real property.
CR. 296-97 (Findings of Fact No. 10, 12 and 13)[App. B]; 2.RR.131–32,
188, 192.
The cost of a service may be allowable in a cost-of-goods-sold
deduction only if the service is a cost of acquiring or producing a “good”
Page 14
that an entity sells or is labor in the “direct prosecution” of a real-property
project. Returning to the example of a bulldozer, this is why under
section 171.1012, the salaries of employees who paint, repair, upgrade a
bulldozer for sale would be allowable in the seller’s cost-of-goods-sold
deduction. The salaries are costs of “producing” the equipment “sold.”
But apart from the acquisition or production expenses for the sale
of the bulldozer, costs of providing services to repair, upgrade, or paint
the bulldozer are not deductible. And these services do not qualify for the
deduction simply because the owner of the bulldozer repaired, upgraded
or painted subsequently provides it to a real-property project. Nor
would the person performing the repair, upgrade or painting be able to
claim the deduction.
Similarly, Gulf Copper is not selling rigs to a third-party, but
rather, is providing repair and outfitting services performed at its
waterfront facility. 4 That the rigs are then used by another third party
3F
4 Again, the comptroller has already allowed the deduction for the labor costs
incurred in “producing” “goods”—i.e., parts and components Gulf Copper
installed on the rigs and thus sold.
Page 15
to drill offshore does not transform Gulf Copper’s services into “labor”
used in “direct prosecution” of the project under subsection (i).
II. Gulf Copper cannot exclude the contested subcontractor
payments from revenue under Tax Code §171.1011(g)(3).
A. Background: Section 171.1011(g)(3)
Taxpayers such as Gulf Copper must first determine their revenue
before deducting cost of goods sold to determine “margin.” In limited
circumstances, the Texas Legislature has allowed taxpayers to exclude
receipts that they are obligated by law or contract or fiduciary duty to
pass on to another. The theory is that the receipts do not truly represent
the revenue of the taxpayers. However, taxpayers are not allowed to
exclude receipts merely because the receipts are used to pay the
taxpayers’ expenses. If that were the case, the “margin” tax would become
a net income tax. To prevent just that outcome, Tax Code §171.1011(i)
specifically provides:
Except 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.
In this case, the question is whether the payments were made
under an ordinary contract for the provision of services or whether they
Page 16
were flow-through payments to subcontractors under section
171.1011(g)(3), which provided during the period at issue:
A taxable entity shall exclude from its total revenue, to the
extent [reported to the IRS as income], 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.
Act of May 19, 2006, 79th Leg., 3d C.S., ch.1, § 5, 2006 Tex. Gen.
Laws 1, 10 (amended 2013) (“the (g)(3) revenue exclusion”).
There are two requirements at issue: there must be “flow-
through funds that are mandated by contract to be distributed to
other entities,” and the flow-through funds must be for “services,
labor, or materials in connection with the actual or proposed design,
construction, remodeling, or repair of improvements on real
property.”
Page 17
B. There is no evidence that the subcontract work
constituted “services, labor, or materials in connection
with the actual or proposed design, construction,
remodeling, or repair of improvements on real property”
Finding of Fact 29 reads in part, “Gulf Copper, through its
employees and subcontractors, provides labor and materials in
connection with the actual or proposed construction or repair of
improvements on real property;…” CR.298 [App.2]. This finding tracks
the statutory language of section 171.1011(g)(3) and is really a conclusion
of law reviewed de novo, without deference. It should be rejected.
The court of appeals conceded that the phrase “in connection with”
is “one ‘of intentional breadth,’ but not without ‘logical limit.’” Opinion
at *7 (quoting Titan Transp. LP v. Combs, 433 S.W.3d 627, 637-38 (Tex.
App.—Austin 2014, pet. denied)). The “logical limit” has been exceeded
here for these reasons:
• Gulf Copper’s work was temporally remote from the projects to
improve real property – the work was performed before drilling
operations commenced.
• Gulf Copper’s work was physically remote from the projects to
improve real property – the work was performed on tangible
personal property at Gulf Copper’s waterfront yards and not at the
offshore drilling sites, or oil and gas wells.
Page 18
• Gulf Copper’s work was contractually remote from the projects to
improve real property – Gulf Copper’s contracts were with the rig
owners, not the project owners, and Gulf Copper was not a
subcontractor to the project owners.
And, when Gulf Copper finished its work, the offshore drilling
projects had no greater value than before Gulf Copper started. This is
the “logical limit” of the (g)(3) revenue exclusion. 5 4F
Of course, the rigs that Gulf Copper repairs and modifies are used
by third parties to construct oil and gas wells, and oil and gas wells are
improvements to real property. For this reason, the State does not
challenge Findings of Fact 20: “Offshore drilling rigs are necessary and
essential to the drilling of offshore oil and gas wells because the wells
could not be drilled without the drilling rigs”) or Finding of Fact 30 (“The
labor and materials provided by Gulf Copper through its employees and
subcontractors are necessary, essential, and integral to the construction
5 While this part of the (g)(3) revenue exclusion is similar to the real-property
project requirement in the third-sentence of subsection (i), there are
differences. Subsection (i) does not contain the word “services.” It refers to
“labor or materials furnished “to” a real-property project, rather than “services,
labor or materials” provided “in connection with” such projects. Nevertheless,
Gulf Copper’s work does not qualify for the revenue exclusion even under the
broader phrasing in subsection (g)(3). It is still too “remote or attenuated” to
qualify. See Titan Transp. 433 S.W.3d at 638. The court of appeals’ decision
does not account for the use of different words and phrases in these two
subsections.
Page 19
… of oil and gas wells.”). CR.298, 299 [App.2].
But just as narrow focus on necessity or indispensability would
improperly broaden the statutory test under subsection (i), these findings
are, as a matter of law, insufficient to pull the subcontractor payments
into the (g)(3) revenue exclusion. The taxpayer’s indispensability
argument—which is really none other than a “but for,” cause-in-fact
argument—“proves too much.” Undoubtedly, there are many necessary
or essential preconditions—business organization, administrative
services support, surveying, geoseismic testing, research—for oil wells
and other real-property projects. And, no doubt, these and other
necessary preconditions will themselves require the furnishing of labor
or materials.
But the mere fact that the disputed labor or materials are in the
causal chain leading up to the real-property project is not evidence
supporting the (g)(3) revenue exclusion. Another precondition of the
project would be a written drilling contract between the rig owner and
the E&P company. Should the law firm that drafted the contract for the
rig owner be able to exclude its expenses because the expenses were
incurred “in connection with” the improvement of real property? Gulf
Page 20
Copper is in the same position as the law firm, providing services to the
rig owner antecedent to the drilling project and not providing any value
to the drilling project itself.
C. There is no evidence that the subcontractor
payments constituted “flow-through funds that are
mandated by contract to be distributed to other
entities.”
Even if the Court rejects the State’s primary contention and finds
that the subcontractor payments were made in connection with the
construction or improvements of real property, there must still be
evidence that the payments were mandated by contract to be distributed
to the subcontractors.
Gulf Copper’s two biggest contracts with rig owners, the Pride and
Helix contracts, involved two types of subcontractor labor – hourly and
cost-plus.
Under the hourly labor provisions, employees of the subcontractor
worked side-by-side with Gulf Copper employees, performing the same
work. Gulf Copper paid these subcontractors a flat hourly rate. And
under the Pride and Helix contracts, the rig owners paid Gulf Copper a
higher flat hourly rate—paying the same rate for regular labor performed
Page 21
by Gulf Copper employees and its subcontractors. 2.RR.110–113.
4.RR.104–05; PX1 at P00220 (Pride Contract) [App.9]; PX2 at P0072
(Helix contract). Indeed, with respect to regular labor, the Pride and
Helix contracts said nothing at all about subcontractors.
But for the second type of subcontractor labor involving specialty
services, the Pride and Helix contracts specified that payments were cost
plus 15% (in the case of the Pride contract) and cost plus 20% (in the case
of the Helix contract). PX1 at P00221 [App.9]; PX2 at P00073 [App.10];
2.RR.112. 6
5F
At trial, the State conceded that $32.0 million in subcontractor
payments—reflecting the specialty services governed by the cost-plus
provisions in the Pride and Helix contracts—were flow-through funds
mandated by contract to be distributed to the subcontractors. But the
State continued to urge that the other payments—reflecting the hourly-
rate subcontractors—were not flow-through funds. With respect to
those payments, no contract mandated that any customer payment for
6 Gulf Copper also made subcontractor payments under six other contracts in
addition to the Pride and Helix contracts. But none of those six contracts
were cost-plus contracts. PX3, PX4, PX5, PX6, PX7, PX8.
Page 22
labor be distributed to the subcontractors. The trial court and the court
of appeals erred when they concluded these payments were nonetheless
flow-through funds mandated by contract to be distributed to other
entities. Opinion at *6.
Though Gulf Copper was contractually obligated to pay the
subcontractors for “labor,” it was not contractually obligated to pass on
or flow-through customer payments to them. That makes all the
difference under the plain language of the statute. Neither the court of
appeals nor Gulf Copper pointed to any contractual mandate in the
customer contracts or in the subcontracts that required Gulf Copper to
share customer payments with its subcontractors.
When examining statutory text, the Code Construction Act
mandates that the Court read words and phrases in context and construe
them according to the rules of grammar and usage. Tex. Gov't Code Ann.
§ 311.011(a) (West 2013); see also supra at 11-12. The phrase “flow-
through funds that are mandated by contract to be distributed to other
entities” is a single unified requirement. The dependent clause “that are
mandated by contract to be distributed to other entities” is an adjective
Page 23
that specifies and limits the type of flow-through funds excludable from
revenue.
The court of appeals’ approach effectively reads out of the statute
the requirement that a contract mandate that funds be distributed to
other entities. Gulf Copper was not contractually obligated to mark-up
anything or, for that matter, to do anything at all besides paying the
subcontractors an hourly rate.
Although the court of appeals relied on Titan Transp., LP v. Combs,
433 S.W.3d 625 (Tex. App.—Austin 2014, pet. denied), that case is readily
distinguishable. There, the taxpayer had “contracts with its
subcontractors that required [the taxpayer] to pay 84% of its gross
receipts [from customers] to independent contractors.” Titan Transp.,
433 S.W.3d at 630.
Alternatively, in the event of ambiguity, this statute is a tax
exclusion, which like tax exemptions, must be construed strictly against
Gulf Copper. See Owens Corning v. Hegar, 04-16-00211-CV, 2017 WL
1244444, at *3 (Tex. App.—San Antonio Apr. 5, 2017, pet. denied)
(holding that the cost-of-goods-sold deduction is a tax exemption for the
same reason).
Page 24
PRAYER
For these reasons, the court should grant the petition for review and
upon further briefing on the merits, reverse and render judgment.
Respectfully submitted,
KEN PAXTON
Attorney General
JEFFREY C. MATEER
First Assistant Attorney General
BRANTLEY STARR
Deputy First Assistant Attorney
General
JAMES E. DAVIS
Deputy Attorney General for Civil
Litigation
/s/ Jack Hohengarten
JACK HOHENGARTEN
Tax Division Chief
State Bar No. 09812200
Tax Division MC 029
PO Box 12548
Austin, Texas 78711-2548
Tel: (512) 475-3503
Fax: (512) 478-4013
Attorneys for Petitioners
Page 25
CERTIFICATE OF COMPLIANCE
I certify the Petitioner’s Petition for Review contains 4493 words, excluding
portions exempted by Rule 9.4(i)(1).
/s/ Jack Hohengarten
JACK HOHENGARTEN
CERTIFICATE OF SERVICE
I certify that on December 20, 2017, a copy of this document was served on
all parties and counsel of record by email and eservice, as follows:
James F. Martens
Danielle V. Ahlrich
MARTENS, TODD, LEONARD & AHLRICH
301 Congress Ave., Ste. 1950
Austin, Texas 78701
Amanda G. Taylor
BECK REDDEN LLP
515 Congress Avenue
Suite 1900
Austin, Texas 78701
/s/ Jack Hohengarten
JACK HOHENGARTEN
Page 26
No. 17-0894
IN THE SUPREME COURT OF TEXAS
_________________________________________________________________
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 and Manufacturing Corporation,
Respondent.
_________________________________________________________________
On Petition for Review
from the Third Court of Appeals at Austin, Texas
Appeal No. 03-16-00250-CV
_________________________________________________________________
APPENDIX TO PETITIONERS’ PETITION FOR REVIEW
________________________________________________________________
KEN PAXTON JACK HOHENGARTEN
Attorney General of Texas Tax Division Chief
State Bar No. 09812200
JEFF MATEER Tax Division
First Assistant Attorney General P.O. Box 12548; MC-029
Austin, Texas 78711-2548
BRANTLEY STARR TEL: (512) 475-3503
Deputy First Assistant Attorney FAX: (512) 478-4013
General
Counsel for Petitioners
JAMES E. DAVIS
Deputy Attorney General for Civil
Litigation
Page 27
APPENDIX TABLE OF CONTENTS
Tab
Final Judgment of the Trial Court……………………………………….A
Findings of Fact and Conclusions of Law……………………………….B
Opinion and Judgment of the Third Court of Appeals………………..C
TEX. TAX CODE § 171.1012………………………………………………....D-1
TEX. TAX CODE § 171.1011………………………………………………....D-2
TEX. PROP. CODE § 53.001……………………………………………….....D-3
TEX. PROP. CODE § 53.021…………………………………………....…….D-4
TEX. PROP. CODE § 53.023……………………………………..……..…….D-5
Page 28
APPENDIX A
Flied In The District Court
of Travis County, Texas
CAU SE NO. D-\-( ;N-1 4-004620
At FE~ 2jj016 Q ~
Velva L. Price , District Clerk
c; ULF COP PER & :vtA NUF ACT llRIN G
~ IN THF. DIST RIC T COl iRT OF
COR POR ATIO N,
§
Plain tiff §
§
v. §
§ TRA VIS COU NTY , TfX AS
GLENN HEG AR §
COM PTR OI.L F.R OF PUB LI C
§
ACC OUN TS OF TIIF . STATF: OF TEX AS;
§
AND KEN PAX TON , ATT ORN EY
~
GF:NF.RAL OF THE STA TE OF TEX AS,
§
Defendants
§ 53rc.t .JUl )ICIA L DIST RIC T
FINAL .JlJDG ME~ T
l)urin g the week o(Te hrua r:, I, 2016. the abov
e-entitled ma!tcr was tried to the bench in
the 20 I st District Court of Trav is County. Texas.
After cons idering the evickncc. the brid i ng. the
plead ings. and argument s of counsel, the Court
order s that Plaintiff is (.'t1titlc d t1) a fu ll refun J of
it s franchise ta:-: protest paym ent for repor t year
2009.
IT IS Tl !ERi TOR E ORDERED. AD.ll.:l)(iED /\ND
DECREE D that D-:lc ndant s shall pay
Plaintiff the full amou nt paid by Plain tiff unde
r prote st in thi s matte r ($838.1 17.84 ). plus al
l
statutory interest and costs as allow-:
(g-7) A taxable entity that is a qualified courier and logistics company shall exclude from its total revenue, to the
extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), subcontracting payments made by the taxable entity
to nonemployee agents for the performance of delivery services on behalf of the taxable entity. For purposes of this
subsection, “qualified courier and logistics company” means a taxable entity that:
(1) receives at least 80 percent of the taxable entity's annual total revenue from its entire business from a combination
of at least two of the following courier and logistics services:
(A) expedited same-day delivery of an envelope, package, parcel, roll of architectural drawings, box, or pallet;
(B) temporary storage and delivery of the property of another entity, including an envelope, package, parcel, roll
of architectural drawings, box, or pallet; and
(C) brokerage of same-day or expedited courier and logistics services to be completed by a person or entity under
a contract that includes a contractual obligation by the taxable entity to make payments to the person or entity
for those services;
(2) during the period on which margin is based, is registered as a motor carrier under Chapter 643, Transportation
Code, and if the taxable entity operates on an interstate basis, is registered as a motor carrier or broker under the
unified carrier registration system, as defined by Section 643.001, Transportation Code, during that period;
(3) maintains an automobile liability insurance policy covering individuals operating vehicles owned, hired, or
otherwise used in the taxable entity's business, with a combined single limit for each occurrence of at least $1 million;
(4) maintains at least $25,000 of cargo insurance;
(5) maintains a permanent nonresidential office from which the courier and logistics services are provided or arranged;
(6) has at least five full-time employees during the period on which margin is based;
(7) is not doing business as a livery service, floral delivery service, motor coach service, taxicab service, building supply
delivery service, water supply service, fuel or energy supply service, restaurant supply service, commercial moving and
storage company, or overnight delivery service; and
© 2017 Thomson Reuters. No claim to original U.S. Government Works. 5
§ 171.1011. Determination of Total Revenue from Entire Business, TX TAX § 171.1011
(8) is not delivering items that the taxable entity or an affiliated entity sold.