economy Fiscal Notes

Franchise Tax Lawsuit Could Cost Texas $1.5 Billion a Year Legal Case Turns on Fundamental Definitions

To argue about what a movie really is sounds like the stuff of art-house reviews and film school seminars. But the Texas Comptroller's office has spent three years arguing in court about the appropriate way in which to think about the movie-watching experience. The matters at stake are monetary rather than aesthetic — and could have a multi-billion-dollar impact on the state's finances.

This court case, American Multi-Cinema (AMC) Inc. v. Hegar et al, centers on the question of whether movies shown in a theater count as the sale of "tangible personal property" (TPP), which must be property "perceptible to the senses" under Texas law. Traditionally, in implementing the law, the Comptroller has considered movie theaters to be providing a service rather than any sort of tangible product.

The designation matters because, under Texas' primary business tax, the franchise or "margins" tax, businesses that own and sell TPP can deduct the direct costs associated with its acquisition or production in calculating their tax liability through a deduction called Cost of Goods Sold (COGS). The law clearly states that TPP does not include services or intangible goods such as trademarks, copyrights and licenses. Therefore, businesses that only sell services or intangible property cannot include production and other costs in their COGS deduction.

Or at least that was the presumption until recently.

In late April 2015, a panel of judges from Texas' Third Court of Appeals made a surprisingly broad ruling that the movie theater chain AMC actually produces and sells TPP within the statutory definition when it exhibits a movie. If the act of showing a movie in a theater constitutes the sale of a tangible good under this definition, because the movie is perceptible to the eye and ear, then virtually anything "perceptible to the senses" may qualify as TPP, effectively rendering the term meaningless.

Goods and Property

The AMC litigation involves two key legal concepts.

Cost of Goods Sold: a deduction allowed under Texas' franchise tax that generally includes costs related to the acquisition and production of goods for sale. For a restaurant, COGS could include costs that go into the production of food, such as kitchen staff wages and the costs of ingredients, ovens and other cooking equipment. It was not considered to include costs associated with selling or consuming the items, such as the wages paid to wait staff or the costs of cash registers and restaurant décor.

Tangible Personal Property: personal property that can be seen, weighed, measured, felt or touched or that is perceptible to the senses in any other manner. In a restaurant, this would refer to the food and drink sold to and consumed by customers. Additional Texas statutes have expanded the definition to include products such as DVDs and computer programs.

The real-world consequences of this decision become apparent when considering how it could affect the tax liability of service businesses, a fast-growing part of the state's economy. For example, a domestic worker cleaning a house is currently considered a service provider under Texas law. Under the Court of Appeals' interpretation, however, a clean house could be considered "perceptible," so housecleaning might be classified as TPP. That distinction would allow all cleaning products and equipment purchased by a cleaning service to qualify as COGS.

Multiply that small example by all the services provided and intangible products sold in Texas, and the cumulative fiscal impact due to the expanded COGS deduction could rise to $1.5 billion each year — about 26 percent of the franchise tax's total collections. Furthermore, businesses can amend their tax returns for up to four years back under Texas law. Refunds as a result of these amendments could reach up to $6 billion.

Does Showing a Movie Create "Tangible" Personal Property?

The definition of TPP in the franchise tax portion of the Texas Tax Code has evolved since the margins tax — the current form of the state's franchise tax — became effective in 2008.

That portion of the code initially defines TPP as "personal property that can be seen, weighed, measured, felt or touched, or that is perceptible to the senses in any other manner." [Emphasis added.] Any grocery store contains examples of TPP: a package of paper towels, a carton of eggs or a bouquet of flowers.

Legislation passed in 2007, however, tweaked the TPP definition to include "films ... and other similar property ... without regard to the means or methods of distribution or the medium in which the property is embodied ... " At the time, this was understood to bring the costs involved in the creation of media content such as movies, TV shows or music under the umbrella of TPP.

During the 2013 legislative session, the margins tax was revised significantly. Tucked in this package of reforms was a new statutory provision specifically crafted to address AMC's wish to claim a COGS deduction for exhibiting a film. This provision allows movie theaters to include the cost of "acquisition, production, exhibition or use of a film or motion picture, including expenses for the right to use the film or motion picture" in the COGS deduction.

This narrowly drawn provision was specifically intended for movie theaters, for inclusion in tax returns beginning in 2014. At the time, the Comptroller's office estimated that the new law would cost the state about $3 million in lost revenue each year. This estimate, however, could not have anticipated the much larger potential losses from the Third Court of Appeals' recent decision, which interprets terms not limited to movie theaters.

The following table shows the three statutory provisions related to TPP that are central to the AMC case, as well as their estimated potential impact to the state budget.

If Watching a Move in a Theater Qualifies as a Sale of TPP Under This Definition...
Estimated Fiscal Impact Statutory Provision Implications
High 171.1012(a)(3)(A)(i): "Perceptible to senses" Could allow many service providers and others to include certain costs in COGS. Cost to state estimated at $1.5 billion a year as well as a potential $6 billion in refunds.
High 171.1012(a)(3)(A)(ii): "films and other similar property...without regard to medium" Could allow other media/entertainment companies to include certain costs in COGS deduction. No estimated fiscal impact available.
Low 171.1012(t): for movie theaters, COGS can include exhibition costs Restricted to movie theaters. Cost to state estimated at $3 million a year.

Note: References are to the Texas Tax Code.

While the 2013 law allowed AMC to include the cost of exhibiting films in its COGS deduction (as of September 1, 2013), the company sought to maximize its tax refund by convincing the courts that the movie experience it offers qualifies as a product under the most basic TPP definition. In other words, AMC maintains it is not a movie exhibition service, but instead defines its business as the production and sale of a tangible personal product that is "perceptible to the senses." Essentially, the company needed to convince the courts that seeing a movie in a theater is more akin to buying a chair than purchasing a service.

To do so, AMC put extensive effort into describing the process required to turn a movie into the sensory experience viewers enjoy in a theater.

It wasn't simply showing a movie, the company argued, but instead was putting extensive work and expense into producing a product — projectors must be purchased, maintained and serviced, sound levels need equalizing and so forth. Even the design and construction of the theater space itself, down to the upholstery on the seats, is a cost contributing to the movie-watching experience, according to this logic.

"When each of these integrated elements functions correctly, the result is 'the premium motion picture sight and sound experience,'" wrote AMC in its initial brief. In short, the final "product" AMC sells is the total sensory experience one receives in a movie theater, which exists only in the minds of its patrons.

Is an "Experience" Property?

The Comptroller's office took issue with this conflating of TPP and "experience." AMC's customers do not leave with a personal copy of the movie. In fact, distributing a physical copy of the film would violate AMC's agreement with movie production companies. Instead, the only "personal property" customers leave with are memories, which the Comptroller's office argued are not tangible products under any previous interpretation and are highly unlikely to be what the Legislature intended to include in its various definitions of TPP.

"AMC characterizes what it sells when it exhibits movies as experiences and memories," the Comptroller's office wrote in its brief. "But even if the Court accepts this characterization, experiences and memories are not property, but are instead part of human life. They are not subject to ownership. They cannot be bought or sold. There is no precedent describing experiences and memories as property."

The Comptroller's office asserted that this interpretation of TPP was directly at odds with an entire body of media and entertainment law, as well as the historical interpretation of TPP in other areas of Texas tax law, such as those pertaining to the sales and use tax.

The Texas sales tax and the concept of TPP were both introduced into Texas law in 1961 (the sales and franchise taxes use the same initial definition of TPP). Since its introduction, TPP has never before been interpreted as encompassing services. In fact, the Texas Legislature specifically mentioned "amusement services," such as movie theaters and concert halls, in a sales tax provision listing taxable services added to the law in 1984. (The sales and use tax applies to sales of taxable services as well as sales of TPP.)

An additional provision related to taxable services includes the "repair, remodeling, maintenance, and restoration of tangible personal property." How could one maintain or repair a "product" that is only assembled inside an individual's mind? Clearly, the Comptroller's office argued, the Legislature intended TPP to describe concrete, corporeal objects.

While AMC focused on defining the movie-watching experience itself as the "product," an additional argument from the Comptroller's office focused on what AMC actually sells — movie tickets. Tickets are, the Comptroller proposed, nothing more than a license to view a movie at a particular time and place, and licenses generally are considered to be intangible goods.

AMC responded by insisting that its product is the experience, not the ticket, arguing that its customers are not merely purchasing the right to sit in a darkened theater. Instead, its patrons are purchasing a tangible product, namely the sights and sounds of the film, which are "perceptible to the senses" as required under Texas law.

The Comptroller's office then proposed that the court find AMC to be a movie-exhibition company that performs a service, rather than produces a product. It relied on a 2013 Third Court of Appeals decision that defined services, following Webster's Dictionary, as "useful labor that does not produce a tangible commodity," noting that "railroads, telephone companies and physicians perform services although they produce no goods."

Court Sides With AMC

The Third Court of Appeals grounded its AMC decision in the fact that the statutory definition of TPP includes, among other things, the requirement that the property be "perceptible to the senses." The court agreed with the characterization that AMC's exhibition of films was "visible to the sight and...perceptible to sound" and echoed its claim that its films were "creative content that is consumed."

The court also addressed the lack of a physical product by noting that Texas tax law does not have a "take-home requirement," meaning that TPP can be sold without the purchaser gaining ownership of any physical matter.

The court further bolstered its definition of movie watching as TPP by pointing to the 2007 addition to the definition, as embodied in Texas Tax Code 171.1012(a)(3)(A)(ii):

...films, sound recordings, videotapes, live and prerecorded television and radio programs, books, and other similar property embodying words, ideas, concepts, images, or sound, without regard to the means or methods of distribution or the medium in which the property is embodied, for which, as costs are incurred in producing the property, it is intended or is reasonably likely that any medium in which the property is embodied will be mass-distributed by the creator or any one or more third parties in a form that is not substantially altered.

The court then cited an AMC witness who suggested that the movie screen itself is a "medium" in which the property is embodied (despite the fact that the film as embodied on a theater screen is not intended to be "mass-distributed" in any form).

This is unlikely to be the last word on the AMC case. The Comptroller's office intends to request a rehearing.

Depending upon the court's decision on rehearing, the AMC case is likely to be appealed to the Texas Supreme Court. A decision at that level may be years away. FN

Note: The legal arguments described in this article have been summarized for clarity and accessibility. To understand all of the issues involved in this case, readers may wish to review briefs and other materials on file with the Third Court of Appeals.