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Combs v. Newpark Resources, Inc.

Court of Appeals of Texas, Third District, Austin

December 31, 2013

Susan Combs, Comptroller of Public Accounts of the State of Texas; and Greg Abbott, Attorney General of the State of Texas, Appellants
Newpark Resources, Inc., Appellee



For Appellee: Mr. James F. Martens, Ms. Danielle V. Ahlrich, Ms. Lacy L. Leonard, Martens, Todd & Leonard, Austin, TX; Ms. Amanda G. Taylor, Hohmann, Taube & Summers, L.L.P., Austin, TX.

For Appellant: Mr. Charles K. Eldred, Assistant Attorney General, Financial Litigation, Tax, and Charitable Trusts Division, Austin, TX.

Before Chief Justice Jones, Justices Pemberton and Field.


Page 47

Scott K. Field, Justice

In this suit to recover franchise taxes paid under protest, appellants Susan Combs, Comptroller of Public Accounts for the State of Texas, and Greg Abbott, Attorney General of the State of Texas (collectively, the Comptroller), appeal from the trial court's final judgment in favor of appellee Newpark Resources, Inc. On appeal, the Comptroller asserts that the trial court erred in concluding that Newpark was entitled to a tax refund because (1) Newpark's subsidiary, Newpark Environmental Services, LLC (NES), did not qualify for a cost-of-goods-sold deduction and (2) Newpark was not entitled to exclude from its total revenue NES's payments to subcontractors. See Tex. Tax Code § § 171.1011(g)(3), 171.1012. We affirm the trial court's judgment.


Structure of the franchise tax

Because this Court has not previously analyzed the most recent incarnation of Texas's franchise tax, we begin our discussion with a brief overview of the franchise tax. The franchise tax is a tax on the value and privilege of doing business in Texas. See In re Nestle USA, Inc., 387 S.W.3d 610, 612 (Tex. 2012 ) (orig. proceeding). The tax was enacted in 1893 but has been significantly restructured several times. See id. at 612-13 (discussing history of franchise tax). The current version of the franchise tax is codified in chapter 171 of the Tax Code, which was adopted in 2006 as part of the legislature's " effort to provide lasting property tax relief, establish a stable and long-term source of funding for public schools, and meet the June 1, 2005 deadline set in West Orange-Cove ." In re Allcat Claims Serv., L.P., 356 S.W.3d 455, 458-59 (Tex. 2011) (orig. proceeding) (citing Neeley v. West Orange-Cove Consol. Indep. Sch. Dist., 176 S.W.3d 746, 753-54 (Tex. 2005) (concluding that previous school-funding scheme was unconstitutional)). " The tax is still based primarily on revenue and only secondarily on capital, and now applies to every for-profit entity doing business or chartered in Texas that is distinct from its owners." In re Nestle USA, 387 S.W.3d at 614.

As the supreme court explained, the current franchise tax is generally calculated using the following formula:

Total Revenue -- General Deduction: the greater of either the Cost of Goods Sold, Compensation, or 30%

= Margin

x Percentage of gross receipts from Texas business
= Taxable Margin
x Tax Rate (0.5% for entities primarily engaged in wholesale or retail trade, 1% for all others)
= Franchise tax


The calculation of total revenue is governed bye section 171.1011 of the Tax Code. Generally, total revenue is " income reported to the federal IRS with various deductions, limitations, and exceptions." See id. at 615 (listing several exclusions from total revenue). The relevant revenue exclusion in this case is set out in section 171.1011(g)(3) and requires a taxable entity to exclude from total revenue all " flow-through funds that are mandated by contract to be distributed to" subcontractors that " provide services, labor, or materials in connection with" various improvements to real property.

After calculating total revenue, a taxable entity may take one of three general deductions: cost of goods sold, compensation,

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or 30% of total revenue. The cost-of-goods-sold deduction, which is the deduction Newpark elected to take in this case, is governed by section 171.1012 of the Tax Code. This provision allows a company to deduct " 'all direct costs of acquiring or producing goods,' some indirect costs like insurance, utilities, and quality control, and up to 4% of other 'indirect or administrative overhead costs.'" See id . (quoting Tex. Tax Code § 171.1012(a)(1), (c)--(d), (f)).

Newpark and its subsidiaries are " [a]ffiliated entities engaged in a unitary business." In re Nestle USA, Inc., 387 S.W.3d at 614; see also Tex. Tax Code § 171.1014. Therefore, Newpark files a single tax report for the combined group. The group must elect to take the same general deduction--meaning all members must take either a cost-of-goods-sold, compensation, or 30% deduction. See Tex. Tax Code § 171.1014(d). With this background in mind, we turn to the specific facts of this case.

Factual and procedural background

Newpark describes itself as an " integrated oilfield services company," providing services to third-party " exploration and production companies" that are necessary for the drilling of oil and gas wells. Newpark's primary business activity--at least with respect to the disputed issues in this case--involves the manufacture, sale, injection, and removal of " drilling mud." [1] Drilling mud is a product that is injected into a well hole as it is being drilled to cool and lubricate the drill as well as to facilitate the removal of rock, soil, and other " waste material" from the hole.

Newpark, as the parent company, uses several subsidiaries for its various drilling-mud operations. One subsidiary manufactures the industrial minerals that go into making drilling mud; another subsidiary produces, sells, injects, and removes the drilling mud from the well; and NES--the main subsidiary at issue in this appeal--removes the resulting nonhazardous waste materials from the drilling site, transports the waste to NES's underground disposal sites, and injects the waste into the sites for permanent disposal. NES hires subcontractors to operate the trucks and barges that haul waste to the disposal sites.

Newpark explained that its customers generally purchase Newpark's services as an " integrated service package" rather than separately from each subsidiary. Contracts are usually between the customer and Newpark and its " subsidiaries and affiliated companies unless expressly excluded by written agreement." These contracts generally do not specify what subcontractors, if any, Newpark or its subsidiaries will use to provide their services.

The Comptroller conducted a " desk audit" of Newpark's franchise-tax returns for 2008 and 2009 and asked Newpark to explain its subsidiaries' business activities. Newpark explained NES's business as outlined above, and based on that description, the Comptroller determined that Newpark owed an additional $186,547.03 for 2008 and $205,698.98 for 2009, plus penalties and interest. This adjustment was based on the Comptroller's determination that NES's disposal of waste material was a service that did not qualify for a cost-of-goods-sold deduction. Newpark paid the

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additional tax under protest and filed this underlying protest suit.

In its suit, Newpark asserted that it was entitled to include NES's expenses in Newpark's overall cost-of-goods-sold deduction. See id . § 171.1012. Alternatively, Newpark argued that it was entitled to exclude a nearly equivalent amount from its total revenue based on NES's flow-through payments to subcontractors for hauling the waste.[2]See id . ยง 171.1011(g)(3). Newpark also claimed additional cost-of-goods-sold deductions for its various indirect and ...

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