Last Friday, the Texas Supreme Court announced its decision in the Nestle USA, Inc. case. This was Nestle’s second constitutional challenge to the Texas franchise tax. Not surprisingly, the Court rejected Nestle’s challenge–it upheld the tax.
Nestle’s Challenge to the Texas Franchise Tax
Nestle’s approach was to take a “shotgun blast” to the tax. I call it this because the challenge was quite broad–Nestle’s brief contained a whole host of constitutional challenges to the tax. This included claims that the tax violated the Texas Constitution’s requirement that taxation be “equal and uniform,” as well as the U.S. Constitution’s guarantees of equal protection and due process. Nestle also included a Commerce Clause argument.
Nestle spent most of its time, effort, and briefing space on its argument under the Texas Constitution’s Equal and Uniform Clause. This Clause states, very simply, that “[t]axation shall be equal and uniform.” But Nestle continued to use its shotgun approach even under this single argument. Instead of focusing on just a few provisions that appeared to create an unequal tax, Nestle took aim at many different parts of the Texas franchise tax. Nestle also went gunning for the tax as a whole. It argued that the entire tax should be struck down, presumably for all taxpayers. This would have blown a multi-billion dollar hole in the Texas budget, and that’s just for taxes due in 2013. Had Nestle’s challenge succeeded, every taxpayer in the state would have presumably qualified for a full refund of all franchise tax paid in the last four years.
The first taxpayer that challenged the constitutionality of the franchise tax–Allcat Claims Service, L.P.–took a different approach. The Allcat approach was a carefully aimed “target shoot” instead of a shotgun blast. Allcat’s challenge focused only on one highly technical aspect of the tax (whether the tax was an unconstitutional income tax imposed on the net incomes of natural persons, now that partnerships paid the tax). Allcat also didn’t seek to overturn the tax for all taxpayers; it just sought protection for certain partnerships.
Both Nestle’s shotgun blast and Allcat’s target shot missed their marks. However, some may claim that Nestle’s broad shotgun approach will make it more difficult for other taxpayers to challenge the tax. The State’s attorneys will no doubt bring up the Nestle decision whenever a taxpayer argues that the statute is unconstitutional; the decision covers so much ground (in very broad sweeps) that lower-court judges may be tempted to hold that the taxpayer’s constitutional argument has already been resolved by the the Texas Supreme Court.
Any Bright News for the Texas Taxpayer?
Such a decision by a lower court would often be a mistake, because the Supreme Court was careful to limit its holding. The decision itself infers that Nestle was not meant to cover all constitutional challenges to the Texas franchise tax. In fact,the decision is helpful to taxpayer challenges. It confirms that the Equal and Uniform Clause in the Texas Constitution still has teeth. It holds that the Clause can still serve as a legitimate restriction on the Legislature’s power to tax.
The Nestle decision does not resolve every constitutional challenge to the Texas Franchise Tax. On page 23 of the opinion, the Court carefully notes that “Nestle does not challenge each and every deduction and exemption,” and only “[f]rom the examples [Nestle] cites,” the Court finds that Nestle has not proven that the tax violates the Texas Constitution. The Court’s holding is that “[T]he Legislature’s structuring of the franchise tax is reasonably related to its object.” The Court uses this paragraph to signal that there may be individual provisions of the Texas franchise tax that are indeed unconstitutional under the Equal and Uniform Clause–just not the provisions that Nestle cited. Additionally, the Legislature may eventually make changes to the statute that will make the tax (or portions of the tax) unconstitutional. The Comptroller’s interpretation of existing provisions of the tax may also be unconstitutional; since the Court doesn’t have original jurisdiction to hear such challenges, Nestle couldn’t have resolved them.
The Nestle decision gives new strength to Equal and Uniform challenges. In its brief, the State argued that analysis under the Texas Constitution’s Equal and Uniform Clause should be no different than analysis under the U.S. Constitution’s Equal Protection Clause (which only prevents the Legislature from treating differently persons that are in all relevant respects alike.). The Court rejects this argument in Nestle. Instead, the Court held that the Texas Equal and Uniform Clause is “more strict” than the Equal Protection clause; it restricts the Legislature’s power to tax more than the Equal Protection clause and the many state and federal cases that analyze the Fourteenth Amendment. The Court also provided more detail about the requirements that the Equal and Uniform Clause places on the Legislature:
- Although the Legislature may create tax classes that “pursue policy goals through tax legislation,” the policy goals must be “related to the taxation.” In other words, taxpayer classes under the Texas franchise tax must relate to business done in Texas.
- The Legislature’s classifications must not not only be rational, but must “attempt to group similar things and differentiate dissimilar things.” It’s highly questionable whether all of the franchise tax’s classifications do this.
- For the Texas franchise tax, classifications “must relate to differences in doing business that affect the value of the privilege [of doing business in Texas].” In Nestle, the Court took Nestle’s examples of allegedly unconstitutional classifications and determined whether the classification appropriately increased the tax on a class because it has a business benefit that other taxpayers don’t have, or decreased the tax on a class because it had a burden that other classes don’t have. The Court also states that a classification may be justified if it allows a class to take a deduction that other classes already receive. Such a provision actually makes the tax more equal, not less equal.
Although Nestle was a loss for the taxpayer, it wasn’t because the Supreme Court weakened the State’s burden under the Equal and Uniform Clause. The Clause still applies some legitimate restrictions that the Legislature and the Comptroller must respect.
Bullock v. Sage Energy Co. remains good law. Texas tax attorneys have always appreciated having the Texas Third Court of Appeals case of Bullock v. Sage Energy Co. (728 S.W.2d 465 (Tex. App. – Austin 1987, writ ref’d, n.r.e.) when bringing equal taxation claims, particularly against the Texas franchise tax. It’s one of the few cases where a court found a franchise tax provision to be unconstitutional. The State argued in Nestle that the taxpayer-friendly Sage Energy decision is an “outlier” and that “its reasoning is wrong.” The Texas Supreme Court disagreed. Sage Energy Co. remains good law, and the Nestle decision’s approval of it further indicates that the Equal and Uniform Clause truly does provide legitimate taxpayer protection. The Court uses Sage as “an example of an unreasonable classification in the franchise tax.”
The lower courts have jurisdiction to hear most constitutional challenges to the Texas franchise tax. Regarding jursidiction, the Court continued to follow the approach it laid out in its Allcat and first Nestle decisions. The Texas Supreme Court has original and exclusive jurisdiction to hear a constitutional challenge for some cases, and the district courts have original jurisdiction in others. The question is not whether the challenges are “facial” or “as-applied,” but whether a constitutional challenges to the franchise tax “are of general public interest and call for a speedy determination.” If so, the Supreme Court has original jurisdiction. The district courts have original jurisdiction for all other cases, including constitutional “challenges to how the Comptroller assesses, enforces, or collects the franchise tax.” Now that the Court has further explained its guidance regarding jurisdiction, taxpayers may have greater opportunity to choose their venue based on how they plead their cases. After Nestle, the best strategy will often be to take the case to district court instead of straight to the Supreme Court.
Conclusion: Constitutional Challenges to the Texas Franchise Tax are Still Viable
Although Nestle was a loss for the taxpayer, the opinion may eventually help other taxpayers prevail. If you believe your business is paying more than its fair share of the franchise tax, consider speaking to a Texas tax attorney. A valid constitutional challenge may exist.