Pop quiz: when it comes to business earnings, the State of Texas imposes: (a) an income tax; (b) a business activity tax that is not an income tax; or (c) no tax at all. Good news (or bad news)—no matter which answer you chose, you may be right (or wrong). Right now, the answer appears to be (b), but in a few months we may find out that the answer is actually (a), and barring a change of course by the State Legislature, the answer may be (c) in the near future. One thing is clear; the Texas Franchise Tax (or “margin tax,” as it is colloquially known), is in a state of flux.
The Franchise Tax was first levied in 1907, and has seen several incarnations over the course of its existence. The Franchise Tax in its current form was put into place in 2006 to replace the 1991 version of the tax, which was based on a combination of taxable capital (total assets less debt) and earned surplus—essentially defined as corporate profits plus compensation paid to officers and directors. The “old” Franchise Tax was unpopular among taxpayers and was viewed by the state as an inefficient revenue-raiser, leading to a substantial overhaul of the tax in 2006.
The highlights of the “new” Franchise Tax included a substantially expanded tax base and its applicability to partnerships and professional associations that had previously been exempt from taxation (LLCs were subject to tax under the old Franchise Tax). The new tax was based on a concept called “taxable margin,” which has been described as something between a gross receipts base and a net income base and which has led to the pressing question of whether the Franchise Tax is an income tax. This question, which has implications in several contexts, including apportionment and the availability of Public Law 86-272 protections, is currently before the Texas Supreme Court in Graphic Packaging Corp. v. Hegar, Tex. Sup. Ct. No. 15-0669.
Graphic Packaging Corporation (“Graphic Packaging”) is a corporation headquartered in Georgia with sales operations in multiple states, including Texas. For the 2008 and 2009 tax years, Graphic Packaging initially apportioned its taxable margin to Texas using a formula based solely on receipts, as provided in the Franchise Tax chapter of the Texas Tax Code (Tex. Tax Code § 171.106(a)). However, Graphic Packaging later filed amended reports for 2008 and 2009 and an original 2010 report applying an equally-weighted property, payroll, and sales factor apportionment formula as provided by the Multistate Tax Compact (the “Compact”). Texas adopted the Compact—which contains the well-known election allowing taxpayers to choose either the equally-weighted UDITPA apportionment formula or a different state statutory formula—in 1967 and codified it in Chapter 141 of the Texas Tax Code. Later, Texas enacted a statute (Tex. Tax Code § 171.112(g)), expressly stating that for Franchise Tax reports due before January 1, 2008 the Compact did not apply. However, this provision was repealed for Franchise Tax reports due on or after that date. Therefore, Graphic Packaging argued that it was permitted to elect three-factor apportionment notwithstanding Texas’s statutory single-sales factor apportionment formula.
Although at first glance the Compact election appears to be available to taxpayers filing reports on or after January 1, 2008, the Comptroller of Public Accounts argued that because the Franchise Tax is not an income tax, the Compact is inapplicable. By its very terms, the Compact only applies to “income” taxes. Pursuant to the Compact the term “income tax” includes a tax “arrived at by deducting expenses from gross income, one or more forms of which expenses are not specifically and directly related to particular transactions.” Tex. Tax Code § 141.001, art. II(4). The Texas Court of Appeals focused on this point, and used the Black’s Law Dictionary “plain meaning” of the term “net income”—i.e., “the excess of all revenues and gains for a period over all expenses and losses of the period”—to determine whether the Franchise Tax was in fact an income tax. The appellate court explained that taxable margin starts with “total revenue” (in general, all of a business’s gross receipts) and then is computed in one of four ways: (1) by taking 70 percent of total revenue; (2) by subtracting costs of goods sold (“COGS”) from total revenue; (3) by subtracting compensation from total revenue; or (4) by subtracting a flat $1 million from total revenue. The Court found that none of these methods fell within the definition of “net income” and, thus, the Franchise Tax is not an income tax to which the Compact or, its three factor election, applies.
In its Petition for Review to the Texas Supreme Court and later Reply Brief on the Merits, Graphic Packaging asserted that the Franchise Tax plainly meets the broad definition of an income tax under the Compact because the tax base begins with gross revenue and allows for the deduction of expenses (i.e., COGS or compensation) that are not tied to particular transactions. The state countered that the Texas Legislature expressly provided when it enacted the 2006 version of the Franchise Tax that the Franchise Tax is not an income tax and that the Franchise Tax base—margin—is substantially different from net income.
Briefing in Graphic Packaging Corp. was completed in April, and the litigants now await the Supreme Court’s decision on whether to accept the case for review. The ultimate resolution of the Graphic Packaging case will carry repercussions that extend far beyond the parties in the case. A long list of taxpayers have filed similar “Compact election” lawsuits seeking refunds using a three-factor apportionment method. Furthermore, if the Franchise Tax is declared to be an income tax, P.L. 86-272 will shield certain companies engaged solely in protected solicitation and ancillary activities from Texas taxation. Currently, P.L. 86-272 and its jurisdictional protections do not apply to the Texas Franchise Tax because P.L. 86-272, like the Compact, applies only to “net income” taxes. See Tex. Admin. Code 3.586(e). Thus, a declaration that the Franchise Tax is an income tax would represent a major change for many companies operating in Texas.
However, the question of whether the Franchise Tax is an income tax may become purely academic in the near future, at least with respect to prospective taxation. While there have been calls for reform since shortly after the new Franchise Tax was enacted in 2006, there is now a growing movement in the Texas Legislature to eliminate the Franchise Tax altogether. Separate bills have recently passed the Texas Senate (S.B. 17, on March 21, 2017) and the House of Representatives (H.B. 28, on April 28, 2017). H.B. 28, the most recent bill, calls for a gradual phase-out of the Franchise Tax beginning in 2020. While the two chambers have yet to reconcile their legislation, at this point, no proposals have been made to replace the Franchise Tax with some other type of tax on business activity. However, given the state’s need for revenue and the history of the Franchise Tax in its various forms, we would not rule out the possibility of another incarnation of a Texas tax on business earnings in the future.