United States

Texas: Franchise Tax Is Not an Income Tax; Compact Election Not Allowed

Aug 03, 2015
From KPMG TaxWatch

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In the latest decision addressing the availability of the Multistate Tax Compact’s three-factor apportionment election, a Texas appeals court ruled that the election was not allowed in computing Texas franchise (margin) tax liability.  The taxpayer at issue had filed its 2008 and 2009 franchise tax reports using the single-sales factor apportionment formula found in the franchise tax statutes. On its 2010 return, the taxpayer apportioned its income to Texas using the Compact’s evenly-weighted three factor formula. The Compact, codified in a separate section of Texas’ tax law, has remained on the books despite the state’s revision to its franchise tax in 2006. The taxpayer also filed amended franchise tax reports utilizing the three-factor formula for the 2008 and 2009 tax years. The Comptroller denied the taxpayer’s requested refunds for 2008 and 2009 and assessed additional franchise tax for 2010. The taxpayer protested, and the matter ultimately went to district court where the Comptroller’s motion for summary judgment was granted. The district court held, largely without explanation, that the taxpayer could not elect to use the Compact’s three-factor apportionment formula in determining its Texas franchise tax liability. The taxpayer subsequently appealed.

Before the appeals court, the taxpayer argued that (1) because the Legislature failed to expressly repeal the Compact, the election remained operative, (2) any implied repeal of the Compact was invalid because the Compact is an interstate agreement that is binding in its entirety on all party states (including Texas) unless and until a party state withdraws by repealing the compact, and (3) that the Texas franchise tax, under the terms of the Compact, is an income tax to which the election applies. The appeals court observed at the outset that the issue of whether the franchise tax is an income tax under the Compact is dispositive to the appeal because the Compact election can be made only with respect to income taxes. Therefore, the court assumed without deciding that the election was not impliedly repealed and moved to the issue of whether the franchise tax is an income tax.  

Under the Compact, as incorporated into Texas law, an “income tax” is defined 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.” A taxpayer’s franchise tax is generally the smallest of four amounts: (i) total revenue minus specified cost of goods sold (COGS), (ii) 70 percent of total revenue, (iii) total revenue minus $1 million, or (iv) total revenue minus specified compensation. The taxpayer argued that the franchise tax is an “income tax” because a taxpayer can subtract COGS, which includes certain indirect costs and indirect costs are expenses that are not “specifically or directly related to a particular transaction.” The court, however, seemed to take a view that each and every franchise tax base had to be based on net income, despite the fact that the taxpayer had filed using the COGS deduction. Specifically, the court noted that the franchise tax has four alternative bases and that total revenue and 70 percent of total revenue cannot be equated to “net income.”  Further, deducting a flat $1 million from total revenue was not akin to “deducting expenses from gross income.” In the court’s view, the taxpayer’s interpretation would require it to impermissibly rewrite the statute to essentially define net income as the amount arrived at by deducting “any” expense from gross income.

In addition, the court rejected the taxpayer’s reliance on the fact that the prior franchise tax law specifically stated that the Compact did not apply, whereas the Legislature did not adopt such specific language when it revised the franchise tax in 2006. In the court’s view, this was not a deliberate act to reactivate the Compact election, but was a result of the Legislature simply deleting provisions relating to the old franchise tax. In addition, at the time the franchise tax was revised, other provisions were contemporaneously adopted specifically stating that the revised franchise tax is not an income tax and that P.L. 86-272 does not apply. Next, the court rejected the taxpayer’s position that a tax must either be an “income tax” or a “gross receipts tax” and as the franchise tax was clearly not a gross receipts tax, it was by default an income tax. Although the court agreed with the taxpayer that the franchise tax did not fall within the definition of a “gross receipts tax,” it did not agree that it followed that the franchise tax was therefore an “income tax. Lastly, the court declined to follow the Michigan Supreme Court’s opinion in IBM. In fact, the court rather summarily determined that the Texas franchise tax was not sufficiently similar to the Michigan Modified Gross Receipts Tax for that decision to be helpful to the taxpayer. For more information on Graphic Packaging v. Hegar, please contact Doug Maziur at 713-319-3866.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.