Court Ruling Could Undermine Major Taxes

Texas businesses might get their next big tax break not from the Legislature but from the courts.

In a ruling last week, the state’s 3rd Court of Appeals punched a potentially huge hole in the state’s franchise tax, allowing the parent company of AMC movie theaters to use a liberal definition of its cost of goods sold.

If that holds up on appeal, it means just over $1.1 million to AMC, but it could cost the state of Texas $1.5 billion annually, according to estimates from the state comptroller. The state’s sales tax — it’s biggest single source of revenue — could also take a hit, because the court’s ruling on franchise taxes turned on a legal definition that is also used in the sales tax code.

The ruling applies to taxes collected over the past four years; if it stands, that could mean up to $6 billion in tax refunds, according to the comptroller.

“The tagline is that the 3rd Court of Appeals ruling really turns two of the major funding streams for the state of Texas on its head,” said Comptroller Glenn Hegar.

Hegar said the ruling will be appealed and that, without a final ruling, he won’t change his estimate of how much money the state can spend over the next two years. Although a final ruling could be months or years away, he briefed top state officials and budget writers about the litigation this week.

“I’m not trying to get people’s attention, but it could be a huge thing and I wanted them to know it’s out there,” he said.

The case hinges on a definition of “tangible personal property” that includes “personal property that can be seen, weighed, measured, felt or touched, or that is perceptible to the senses in any other manner.”

AMC takes “perceptible to the senses” to include movies, and if that’s the case, contends all of its costs for space should be included in its cost of goods sold. The comptroller argued that AMC is selling intangible property or a service and that it shouldn’t be included.

To compute its franchise taxes, the movie chain (like other businesses) subtracts its cost of goods sold from its total revenue and pays taxes based on the difference. Increasing the costs lowers the amount being taxed. The court ruled that AMC can include costs of exhibiting films in that calculation — a decision that means the theater chain will get $1.1 million in refunds for taxes it already paid.

According to an analysis done by the comptroller’s office, “defining [tangible personal property] so broadly potentially allows all service providers to now qualify for the [cost of goods sold] deduction, if the service is perceptible to the senses.”

The appellate court’s interpretation of those definitions could have a larger impact on the franchise tax and, perhaps, on the sales tax, too.

The comptroller has not estimated the impact on sales taxes, but the sales tax code includes the same definition of tangible personal property as the one in question. In that case, the court’s ruling could play both for and against the state’s interests. A lawyer might be able to claim tax exemptions for computers used to prepare briefs, which would cost the state. But that lawyer’s services could potentially be opened to taxation, which would add to the state’s tax revenue.

“We’ll work through the process,” Hegar said. “Ask for a rehearing, go to the Supreme Court and this is going to last for a while. I hope we win on appeal.”