On August 31, 2021, the Fourteenth Court of Appeals (the “Court”) issued its Opinion in the case Hegar v. Xerox Corporation, No. 14-19-00358-CV, upholding the district court’s judgment that awarded Xerox Corporation (“Xerox” or the “taxpayer”) a refund from the use of the 0.5% tax rate rather than 1.0% tax rate. Tax Code § 171.002(c) allows use of the lower rate by an entity that is primarily engaged in a wholesale trade. The Court also upheld the denial of the Comptroller’s counterclaim to reduce the taxpayer’s cost of goods sold (COGS) subtraction. The claim relates to Xerox’s 2008 and 2009 reports, which had been assessed tax.
One-Half Tax Rate
In an extremely fact-intensive case, including 46 findings of fact by the district court, the Houston Court of Appeals resolved whether Xerox was allowed under Tax Code § 171.002(c) to use the one-half tax rate (which currently is .375%) to compute its franchise tax. To qualify for the lower rate, a taxable entity’s total revenue must primarily be from a retail or wholesale trade, and less than 50% of those revenues can come from products it or an affiliate produces. The selling of merchandise qualifies as wholesale trade activities described by SIC Code Manual, Division F.
Xerox had a large sales force that distributed its equipment and supplies for sale. In many cases, a financing lease was used for the equipment, which qualified for sales-type lease accounting treatment. Part of the criteria for such accounting treatment was that the term be at least 75% of the economic life of the property and the payments equal or exceed 90% of the fair value of the property. However, Xerox had retained title to the property. At the end of the lease term, the equipment was returned and was typically scrapped. The Comptroller argued that the majority of Xerox’s revenues were from leasing equipment and providing services, not from “selling” because title was not transferred.
To determine whether transfer of title was required, the Court construed the ordinary meaning of the term “selling” because the Legislature did not provide a definition, and the parties did not assert that the term had a technical or particular meaning. Nor did the statutory context indicate a more limited definition applied. The Court determined that the issue of whether the ordinary meaning of “selling,” “sold,” or “sale” requires the transfer or passage of title was an issue of first impression in Texas.
After careful consideration, including reviewing the definitions of “sale” discussed in Hegar v. American Multi-Cinema, Inc., No. 17-0464, 2020 WL 1648043 (Tex. Apr. 3, 2020) (“AMC”), the Court determined that the terms do not require the transfer or passage of title, though they do require the transfer of the item being sold. The Court also reiterated that its analysis must be based on the substance, not the form of the transaction, referencing Gulf Chemical & Metallurgical Corp. v. Hegar, 460 S.W.3d 743, 749-50 & n.10 (Tex. App.—Austin 2015, no pet.). As a result, the Court determined that the trial court did not err in concluding that Xerox’s primary source of revenues was from a wholesale trade, which resulted in the application of the reduced tax rate in the computation of Xerox’s Texas franchise tax liability.
Expanding on its position that Xerox sold services, or at least not goods, by not transferring title to its leased equipment, the Comptroller filed a counterclaim and argued that Xerox had overstated its COGS. Under Tax Code § 171.1012(a)(1), “goods” are defined as “real or tangible personal property sold in the ordinary course of business of a taxable entity.” However, the Court refused to strictly construe the COGS provision because it is not tantamount to an exemption, as determined by Sunstate Equip. Co., LLC v. Hegar, 601 S.W.3d 685, 690 (Tex. 2020). Further, it relied on its previous analysis regarding the meaning of “sold” to reject the Comptroller’s argument that the leased equipment was not considered “sold” because there was no transfer or passage of title.
The Court also determined that the trial evidence must conclusively establish all facts necessary to support the Comptroller’s recovery on the counterclaim. Ultimately, however, the Comptroller was not able to show by the numerous, specifically challenged costs that Xerox’s COGS should have been less than the total subtracted for the report years at issue.
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