For Texas franchise tax, can a concessionaire exclude the percentage-of-receipts payments it makes to a venue owner or event promoter from total revenue as 'flow-through funds,' or deduct them as cost of goods sold?

Plain-English summary

Note: this ruling's conclusion still stands, but its discussion of "flow-through funds mandated by contract" is now superseded — see the alert above.

A company sells food and beverages at venues and events nationwide under concession agreements with facility owners and event promoters. Those agreements require the company to pay the venue owner or promoter a percentage of its food-and-beverage receipts. The company asked whether those percentage payments could be (1) excluded from its total revenue as "flow-through funds mandated by contract," or (2) deducted as cost of goods sold (COGS), on the theory that they're economically similar to a licensing or franchise fee for the right to sell.

The Comptroller said no to both:

• Not a flow-through-funds exclusion. Texas Tax Code § 171.1011(g) excludes from total revenue only three specific kinds of flow-through funds mandated by contract: (1) sales commissions to nonemployees, (2) the tax basis of underwritten securities, and (3) subcontracting payments tied to real-property construction, remodeling, or repair. The concession payments don't fit any of the three — and more fundamentally, they aren't "flow-through" at all, because the concession agreement only requires the company to pay the venue/promoter directly; nothing routes the money onward to a third entity. They're ordinary payments under an ordinary services contract, which § 171.1011(g) expressly does NOT let you exclude.
• Not cost of goods sold. COGS under § 171.1012 only covers costs of acquiring or producing goods. The company's own description of what it's buying — the exclusive right to sell food and beverages at the venue — is a selling cost, not a production or acquisition cost, and § 171.1012(e)(2) specifically excludes selling costs (including sales-related employee expenses) from COGS. Because the payments are selling costs, they also can't qualify as a licensing/franchise cost tied to goods produced.

What this means for you

Concessionaires, venue tenants, and similar percentage-of-receipts payors

Don't assume a contractually required percentage-of-receipts payment to a landlord, venue, or promoter is automatically excludable from total revenue. The flow-through-funds exclusion is a closed list of three items — sales commissions to nonemployees, underwriting basis, and real-property-construction subcontracting — and a payment has to actually be "flowing through" to a third party, not just owed under your own contract, to even get in the door.

Companies trying to characterize a sales-right fee as a production/COGS cost

The right to sell something is not the same as the cost of acquiring or producing it. If what you're paying for is access to a market or the right to make sales, expect the Comptroller to treat it as a selling cost excluded from COGS under § 171.1012(e)(2), even if you can draw an analogy to a licensing or franchise arrangement.

Anyone relying on this ruling's "flow-through funds mandated by contract" reasoning

Read the analysis with caution. The Comptroller's own alert says the bottom-line answer here (no exclusion, no COGS deduction) still holds, but the way it reasoned about "flow-through funds mandated by contract" no longer reflects current policy after Titan Transp., LP v. Combs — check STAR Accession No. 201606856L for the current analysis before citing this ruling's reasoning.

Common questions

Q: Can a business exclude from total revenue any payment it's contractually required to make to another party?
A: No — per this ruling, § 171.1011(g)'s flow-through-funds exclusion covers only three specific types of payments (nonemployee sales commissions, underwriting basis, and real-property-construction subcontracting), and the payment must actually flow through to a third party, not just be owed under the payor's own contract.

Q: Is a fee paid for the right to sell a product at a venue deductible as cost of goods sold?
A: No — per this ruling, a fee for the right to sell goods (as opposed to acquiring or producing them) is a selling cost, which § 171.1012(e)(2) expressly excludes from cost of goods sold.

Q: Does this ruling's reasoning about flow-through funds still apply today?
A: Use caution — per the Comptroller's own alert, the ruling's answer is still correct but its "flow-through funds mandated by contract" analysis was superseded by Titan Transp., LP v. Combs, 433 S.W.3d 625 (Tex. App.—Austin 2014, pet. denied); see STAR Accession No. 201606856L for the current analysis.

Citations and references

Statutes:

• Tex. Tax Code § 171.1011(g) (Total revenue — flow-through funds exclusion; closed list of three categories)
• Tex. Tax Code § 171.1012(d)(10) (Cost of goods sold — licensing/franchise costs directly associated with goods produced)
• Tex. Tax Code § 171.1012(e)(2) (Cost of goods sold — selling costs, including sales-related employee expenses, are excluded)

Superseding authority (flagged in the STAR document itself):

• Titan Transp., LP v. Combs, 433 S.W.3d 625 (Tex. App.—Austin 2014, pet. denied) — discussed in STAR Accession No. 201606856L, which supersedes this ruling's "flow-through funds mandated by contract" reasoning (though not its bottom-line conclusion)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=MAR
• Opinion: https://star.comptroller.texas.gov/view/201412007L

Original ruling text

ALERT: Although the response to this private letter ruling remains correct, the analysis
of “flow-through funds mandated by contract” contained in the response is no longer an
accurate statement of policy. See Star Accession No. 201606856L discussing the holding of
Titan Transp., LP v. Combs, 433 S.W.3d 625 (Tex.App.—Austin 2014, pet. denied).

December 30, 2014

Re: Private Letter Ruling Request #141330652

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request for a private letter ruling dated May 6, 2014. Detrimental
reliance is provided in accordance with Rule 3.10, the Taxpayer Bill of Rights.

You requested guidance on the comptroller’s interpretation of the exclusion
from revenue under Tax Code Ann. 171.1011(g) [ENDNOTE 1] and cost of goods
sold under Section 171.1012(d)(10) as they relate to payments made by COMPANY
A. We issue this private letter ruling as the agency has not previously
addressed the precise facts presented by this inquiry and existing authorities
are not sufficiently clear to provide a definitive answer.

RELEVANT FACTS
COMPANY A provides food and beverage service at venues and events throughout
the country.

COMPANY A enters into concession agreements with facility owners and event
promoters for the right to sell food and beverages during events. Under the
concession agreements COMPANY A is required to make payments to the facility
owners or event promoters based on a percentage of receipts from the sales of
all food and beverages made during events.

RULINGS AND ANALYSIS
COMPANY A requests guidance as to whether the payments made by COMPANY A to
facility owners or event promoters under concession agreements qualify as
exclusions from total revenue under Section 171.1011(g) or are deductible as
cost of goods sold under Section 171.1012(d)(10).

COMPANY A contends that the payments qualify for exclusion under Section
171.1011(g) because the payments are mandated by contract to be distributed to
the facility owners or event promoters.

Section 171.1011(g) states “A taxable entity shall exclude from its total
revenue, to the extent included [in the entity’s total revenue], ONLY THE
FOLLOWING flow-through funds that are mandated by contract or subcontract to be
distributed to other entities:

(1) sales commissions to nonemployees, ...;
(2) the tax basis ... of securities underwritten; and
(3) subcontracting payments made under a contract or subcontract entered into
by the taxable entity to provide services, labor, or materials in connection
with the actual or proposed design, construction, remodeling, remediation, or
repair of improvements on real property or the location of the boundaries of
real property.”

The payments made by COMPANY A to the facility owners or promoters are not
flow-through funds mandated by contract to be distributed to other entities.
For funds to be “mandated by contract to be distributed to other entities,”
there must be a contract between two entities that mandates that funds go to
some other entity. The sample concession agreement provided by COMPANY A only
mandates that COMPANY A pay the facility owner or promoter; there is no
flow-through payment to any other entity.

Additionally, the phrase “only the following flow-through funds” limits the
exception to the three types of flow-through funds specifically enumerated.
COMPANY A presented no facts that its payments to facility owners or event
promoters are sales commissions to nonemployees, tax basis of securities
underwritten, or subcontracting payments related to real property improvements;
therefore, even if COMPANY A’s payments were flow-through funds mandated by
contract (which they are not), COMPANY A could not exclude its payments to
facility owners or event promoters from its total revenue because the funds are
not the types specifically allowed.

Further, Section 171.1011(g) states, “Except as provided by Subsection (g), a
payment made under an ordinary contract for the provision of services in the
regular course of business may not be excluded.” Payments made by COMPANY A
under concession agreements are not flow-through funds but are instead payments
under an ordinary contract and may not be excluded from total revenue.

With regards to cost of goods sold, COMPANY A states that its payments made
under concession agreements approximate the fair market value of the exclusive
right to sell food and beverage and argues that the payments it makes to
facility owners or event promoters are identical to licensing and franchise
costs incurred by a film or television producer.

Section 171.1012(d)(10) includes in cost of goods sold the following costs in
relation to the good “licensing or franchise costs, including fees incurred in
securing the contractual right to use a trademark, corporate plan,
manufacturing procedure, special recipe, or other similar right directly
associated with the goods produced.” Section 171.1012(e)(2), however,
specifically excludes from cost of goods sold “selling costs, including
employee expenses related to sales.” Rule 3.588(e)(10) and (g)(2) basically
restate the statutory language and do not provide additional guidance.

Section 171.1012 only allows costs related to acquisition and production of
goods. COMPANY A’s own description of the rights received under the agreement
indicates that the rights it receives are to SELL food and beverages. A payment
for the exclusive right to sell concessions is not a production or acquisition
cost allowed under Section 171.1012. COMPANY A’s payments are selling costs and
are specifically excluded from cost of goods sold under Section 171.1012(e)(2).
Because we conclude that the payments are selling costs covered by Section
171.1012(e)(2) that cannot be deducted from the cost of goods sold, we also
conclude that the payments cannot be for a license or franchise agreement
directly related to any goods that are produced.

If you have questions about this private letter ruling, please email us at
https://www.window.state.tx.us/taxhelp and reference Private Letter Ruling

141330652.

Sincerely,

Tax Policy Division

ENDNOTES:
1.References to Section are to Texas Tax Code Annotated (Vernon 1992).