Court of Appeals Rules No Three-Factor Apportionment, Texas Franchise Tax Is Not an Income Tax

The Texas Third Court of Appeals issued its opinion yesterday in Graphic Packaging Corp. v. Hegar, No. 03-14-00197-CV.   It ruled that taxpayers may not choose to use the Multistate Tax Compact’s three-factor apportionment method to apportion their taxable margin under the Texas franchise tax.  In doing so, the Third Court of Appeals held that the Texas franchise tax is not an “income tax,” as defined by the Multistate Tax Compact.  We discuss the decision and its implications for Texas taxpayers in further detail below.

Background

For state tax purposes, apportionment is the method by which a taxpayer determines how much of its income (or, in Texas, taxable margin) is taxable to a particular state as opposed to other states.  State tax laws specify which apportionment methods taxpayers may use.  The Texas franchise tax statutes specifies only one apportionment method, the single sales factor method.  Under this method, the percentage of sales a taxpayer makes to Texas residents is the percentage of its taxable margin that is taxable to Texas.

Another apportionment method is a three-factor apportionment method, which looks at (1) the percentage of a taxpayer’s property located in a particular state; (2) the percentage of a taxpayer’s sales that it makes to a particular state’s residents; and (3) the percentage of a taxpayer’s payroll paid to residents of a particular state.  The Multistate Tax Compact allows for this apportionment method.

Many U.S. states entered into an agreement known as the Multistate Tax Compact in the late 1960s.  Currently, 17 states, including Texas, are parties to this agreement.  These states agreed to make the provisions of the Multistate Tax Compact, which are uniform laws regarding matters such as tax administration and tax base apportionment, part of their state tax statutes.  One of the provisions of the Multistate Tax Compact states that, for the purposes of a state’s income tax, taxpayers may choose to apportion the tax base using either the method that the state’s own statutes provide, or the three-factor apportionment method provided in the Multistate Tax Compact.  The Multistate Tax Compact defines an “income tax” as “a tax imposed on or measured by net income including any tax imposed on or measured by an amount arrived at by deducting expenses from gross income, one or more forms of which expenses are not specifically and directly related to particular transactions.”

The Graphic Packaging Decision

In Graphic Packing, the Third Court of Appeals found that taxpayers may not use the Multistate Tax Compact’s three-factor apportionment method to apportion their taxable margin under the Texas franchise tax. (Note that Seay & Traphagan, PLLC does not represent Graphic Packaging and has had no involvement in this case).  The Third Court of Appeals stated that the Multistate Tax Compact’s three-factor apportionment method was not available under the Texas franchise tax because, according to the court, the Texas franchise tax doesn’t meet the Multistate Tax Compact’s definition of an “income tax.”  The Third Court of Appeals said that the Texas franchise tax didn’t meet this definition because taxpayers only have a limited amount of deductions available under the Texas franchise tax, which the court did not deem sufficient to constitute the amount of “expenses” required to be deducted to meet the definition of a net income tax.

Implications for Taxpayers

The Graphic Packaging decision is not yet final — the taxpayers may still file a Motion for Rehearing and/or file a Petition for Review with the Texas Supreme Court.  Thus, the possibility remains that the decision may be reversed by the Third Court of Appeals on rehearing, or by the Texas Supreme Court if it grants a Petition for Review filed by the taxpayer.  However, if the decision does become final, this would mean that taxpayers may only use the single sales factor apportionment method under the Texas franchise tax.  This result would be particularly unfavorable to businesses with large amounts of property and payroll out of state that make many Texas sales — much more of their taxable margin would be apportioned to Texas under the single sales factor method.  Further, the determination that the Texas franchise tax is not a tax on net income would have implications for other areas of tax law — for example, Public Law 86-272, which states that, for the purpose of a state’s net income tax, merely entering a state for the purpose of soliciting orders is not enough contact to create nexus and therefore subject a business to that state’s net income tax.

Nevertheless, as Graphic Packaging is not yet final, taxpayers who filed their Texas franchise taxes using the single sales factor apportionment method may wish to determine whether they would be entitled to a refund if Texas allowed the three-factor apportionment method under the Texas franchise tax.  If so, these taxpayers may wish to seek the advice of a Texas tax professional, such as a Texas tax attorney, to determine whether they should file protective refund claims.


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