Texas Court of Appeals Reverses District Court and Rules that Cost of Goods Sold Does Not Include the Installation of Sold Automotive Parts

DALLAS, March 1, 2017 /PRNewswire/ -- On February 24, 2017, the Texas Third Court of Appeals ("Appellate Court") ruled in Hegar v. Autohaus LP. LLP, that the taxpayer, an automobile dealership, was not entitled to subtract as cost of goods sold (COGS) its labor costs to repair and install parts on customer-owned vehicles. The Appellate Court began with the Tax Code definition of "production" in section 171.1012(c), which includes "construction, installation, manufacture, development, mining, extraction, improvement, creation, raising, or growth." It determined that the word "installation" in the context of "construction" and "manufacture" addresses the direct costs of "producing the goods."  As a result, it determined that the word "installation" was not ambiguous because it was not capable of multiple meanings.

In determining whether the labor costs were for "producing the goods," the Appellate Court decided that installing automotive parts did not involve making or completing the goods. Rather, because the parts were "already-completed," it concluded that the costs related to a "service," which is expressly excluded from COGS. Though the Opinion referenced, the definition of "services" in Combs v. Newpark, which is "labor that does not produce a tangible commodity," the Appellate Court did not apply that definition to the facts.

The "already-completed" analysis is somewhat peculiar, given the broad categories of allowed costs that fall under the "direct costs of acquiring or producing the goods" in subsection (c). These other costs are not individually rescrutinized to determine whether they constitute a direct cost of acquiring or producing the good sold. Under section 171.1012(c)(4), allowed costs are "handling costs, including costs attributable to processing, assembling, repackaging, and inbound transportation costs." In addition, subsection (c)(5) allows "storage costs, including the costs of carrying, storing, or warehousing property…." These allowed costs do not produce a tangible commodity but are necessary to place the good for sale. Thus, these types of costs are also part of the context in which a COGS determination should be made. Excluded costs under subsection (e) cover costs such as selling, distribution, and rehandling, which occur after a good has been placed for sale. 

As with any cost of goods sold case, the unique facts and circumstances make the presentation of evidence a key factor in successfully resolving such cases.

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