Texas Margin Tax Cost of Goods Sold Capitalization: A Review of New Texas Policy Letter Ruling 200801034L

The Comptroller of Public Accounts of the State of Texas (the “Comptroller”) reconsidered its policy of requiring taxpayers who elect to capitalize cost of goods sold (COGS) to assign a value of zero to their beginning inventory for purposes of computing the COGS deduction for report year 2008. The Comptroller’s new policy will allow said taxpayers to include their beginning inventory in the COGS computation. The discussion below provides a review of the beginning inventory issue and an analysis of the Comptroller’s original and current policy.

Tex. Tax Code Ann. § 171.1012(g)

Under Texas House Bill 3928 (HB 3928), taxpayers were given the option to expense or capitalize their COGS. HB 3928 revised the language of Tex. Tax Code Ann. § 171.1012(g) to read as follows:

A taxable entity that is allowed a subtraction by this section for a cost of goods sold and that is subject to Section 263A, 460, or 471, Internal Revenue Code, may capitalize that cost in the same manner and to the same extent that the taxable entity capitalized that cost on its federal income tax return or may expense those costs, except for costs excluded under Subsection (e), or in accordance with Subsections (c), (d), and (f). If the taxable entity elects to capitalize costs, it must capitalize each cost allowed under this section that it capitalized on its federal income tax return. If the taxable entity later elects to begin expensing a cost that may be allowed under this section as a cost of goods sold, the entity may not deduct any cost in ending inventory from a previous report. If the taxable entity elects to expense a cost of goods sold that may be allowed under this section, a cost incurred before the first day of the period on which the report is based may not be subtracted as a cost of goods sold. If the taxable entity elects to expense a cost of goods sold and later elects to capitalize that cost of goods sold, a cost expensed on a previous report may not be capitalized. [Emphasis added]

Based on the language above, it was not clear whether a taxpayer electing to capitalize COGS for the first report under the revised franchise tax could include its beginning inventory in the COGS deduction computation.

Comptroller’s Original Policy

The Comptroller’s original policy on this question was presented in 34 Tex. Admin. Code § 3.588(c)(2)(A) (2007) (“Rule”), which stated that:

A taxable entity that elects to capitalize costs on its first report due on or after January 1, 2008, may not include any costs incurred prior to the accounting period upon which the report was based.

The Comptroller had concluded that, because no revenue incurred before the tax year was included in the base, no deductions for costs incurred before the period on which the tax is based should be allowed. Under this policy, taxpayers electing to capitalize COGS would be required to assign a value of zero to its beginning inventory for purposes of computing the COGS deduction for the first report year.

Comptroller’s Revised Policy

On January 11, 2008, the Comptroller issued Letter Ruling No. 200801034L stating that the Comptroller’s position on the beginning inventory issue had changed. In the letter, the Comptroller stated that:

Our primary concern with allowing a beginning inventory for taxpayers electing to capitalize was a potential unequal treatment court challenge brought by taxpayers electing to expense COGS.

The letter further stated:

After researching all of the relevant court cases in Texas, however, we have decided to allow a beginning inventory for taxpayers electing to capitalize COGS. Our rule will be changed accordingly.

One of the court cases reviewed by the Comptroller was 3 Beall Brothers 3, Inc. v. Rylander, 2 S.W.3d 562 (Tex. App. Austin 1999). In that case, a fiscal year taxpayer (Bealls) that had merged out of existence argued that the additional tax was unconstitutional because the application of the additional tax rules resulted in unequal treatment between fiscal year and calendar year taxpayers. The court ruled that, because Bealls had the option of filing on a fiscal year or a calendar year, there were no grounds for an unequal treatment case, so long as the tax is rationally related to a legitimate governmental goal and the system operates equally within each class. Following that reasoning, taxpayers electing to expense COGS would have difficulty prevailing in an unequal treatment challenge because they have the option of expensing or capitalizing COGS and because the statute treats equally all taxpayers that choose to expense.

Illustration of the Effect of the Policy Change

Facts:

Original Policy:

Under the Comptroller’s original policy, as presented by Rule 3.588(c)(2)(A), the taxpayer’s COGS deduction for the first report under the revised franchise tax would be $8,000,000,000, computed as shown below:

Revised Policy:

Under the Comptroller’s new policy, the COGS deduction for the example above would be $11,000,000,000, computed as shown below: