Texas Comptroller's Decision, STAR Accession No. 202102006H

The claimant, a California-based designer and manufacturer of semiconductor fabrication equipment, filed amended Texas franchise tax returns for report years 2012 through 2016 seeking refunds based on increased cost-of-goods-sold (COGS) deductions for research and development activities. The claimant's refund claims incorporated the same research expense amounts it had reported as qualified research expenses on its federal Form 6765 in claiming the federal research credit under IRC section 41. The Comptroller's auditor allowed COGS deductions for expense accounts he could identify as clearly research-related, but denied deductions for a number of large accounts — including 'salary and wages,' 'bonus,' 'depreciation expense,' and 'cost center to cost center allocation' — where the account descriptions did not establish a connection between the expenses and goods the claimant sold.

Qualifying for the Federal Credit Does Not Automatically Establish Texas COGS Eligibility

The claimant argued that because its Form 6765 research expenses necessarily qualified as IRC section 174 research and experimental expenditures, they must also qualify as Texas COGS deductions under Tax Code section 171.1012(c)(9), which allows a taxable entity to include in COGS its costs attributable to research, experimental, engineering, and design activities described by IRC section 174. The Administrative Law Judge rejected this equivalence, explaining that IRC section 174 itself applies to research and development costs regardless of whether the resulting product is ever sold — the Treasury Regulations expressly state that 'the ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility under section 174.' Texas's COGS deduction, by contrast, is available only for section 174-type expenses that relate to goods the taxable entity actually sells, consistent with the Comptroller's 2015 policy guidance (STAR Accession No. 201504069L) and a subsequent 2018 amendment to 34 Texas Administrative Code section 3.588(d)(9).

Account-Level Descriptions Were Insufficient Documentation

Because the claimant's evidence consisted only of the amount of research expenditures reported on its federal returns and a listing of the general-ledger accounts in which those costs were recorded, the Administrative Law Judge found no evidentiary basis to conclude that the costs in the denied accounts — as opposed to the accounts the auditor had already allowed — related to goods the claimant sold rather than, for example, general corporate overhead or research on internal-use or unsold products. The claimant's own representative conceded that the disputed accounts were 'book' accounts used for the company's 10-K financial reporting rather than 'tax' accounts calibrated to the COGS deduction, and that some included costs that likely did not qualify.

The Comptroller adopted the Administrative Law Judge's Amended Proposal for Decision, affirming the partial denial of the claimant's refund claims for all five report years.

Significance: This decision clarifies that Texas's COGS deduction for research and development costs, though it borrows IRC section 174's definition of qualifying expenditures, is narrower than the federal provision in one key respect — a taxpayer must independently substantiate that the qualifying research relates to goods it actually sells, and cannot rely on its federal Form 6765 research credit substantiation as a substitute for that Texas-specific showing.