Texas Supreme Court Rules No Three-Factor Apportionment for Texas Franchise Tax

The Texas Supreme Court recently issued its opinion in Graphic Packing Corp. v. Hegar.  It upheld the Third Court of Appeals’s ruling 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.  However, in doing so, it relied on different reasoning than the Third Court of Appeals.  Unlike the Third Court of Appeals, it did not rule on whether the Texas franchise tax was an “income tax” as defined by the Multistate Tax Compact.  Instead, the Texas Supreme Court held that it was within the Texas Legislature’s power to require the use of only single sales factor apportionment under the Texas Franchise Tax because the member states of the Multistate Tax Compact did not intend for the Compact to be a binding reciprocal agreement.  We discuss this 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 specify 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, 16 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 Texas Supreme Court upheld the Third Court of Appeals’s holding that taxpayers may not use the Multistate Tax Compact’s three-factor apportionment method to apportion their taxable margin under the Texas franchise tax.  However, the Texas Supreme Court’s reasoning was different from that of the Third Court of Appeals.  The Third Court of Appeals held hat 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 didn’t meet the Multistate Tax Compact’s definition of an “income tax.” On the other hand, the Texas Supreme Court expressly refused to rule on whether the Texas franchise tax met the definition of an income tax.  It instead ruled that the instead, the Texas Supreme Court held that it was within the Texas Legislature’s power and not a violation of the Contracts Clause of the United States Constitution to require the use of only single sales factor apportionment under the Texas Franchise Tax because the member states of the Multistate Tax Compact did not intend for the Compact to be a binding reciprocal agreement.  The Texas Supreme Court examined the compact itself as well as the actions of the Multistate Tax Commission and member states to make this determination.

Implications for Taxpayers

The Graphic Packaging decision is not yet final — the taxpayers may still file a Motion for Rehearing or file a Petition for Review with the United States Supreme Court .  Thus, the possibility remains that the decision may be reversed by the Texas Supreme Court on rehearing or by the United States Supreme Court if it opts to review the decision (Note that the United States Supreme Court has declined review of decisions from other states addressing the same issue in the past).  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.  But, since the Texas Supreme Court did not rule on whether the Texas franchise tax is a net income tax, the question remains open regarding 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 or take other action as a result of the Graphic Packaging decision.


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