Federal law preempts Texas franchise tax on airline revenue

The AHTA and Texas franchise tax statutes

In 1973, Congress enacted the AHTA to prohibit state and local governments from imposing an additional layer of taxation upon passengers. The AHTA, codified under U.S.C. Sec. 40116(b)(4), provides, in pertinent part, that a state or local government “may not levy or collect a tax, fee, head charge, or other charge on . . . the gross receipts from” air commerce or transportation. It should be noted that states and localities are not preempted from imposing other taxes such as income, franchise, property, and sales and use taxes upon air commerce or transportation.³

A taxpayer’s Texas franchise tax liability is determined by a three-step process: (1) calculation of the entity’s margin (total revenue minus permitted deductions); (2) apportionment of margin to Texas; and (3) subtraction of other allowable deductions.⁴ Total revenue is determined effectively by adding together specific line items from the taxpayer’s applicable federal return and making specific additions and subtractions (e.g., subtracting bad debt expense). Total revenue is then reduced by the greater of $1 million, cost of goods sold, compensation, or 30% to arrive at the taxpayer’s margin.⁵

Consideration and confirmation of AHTA preemption doctrine

The Court of Appeals began its analysis by examining prior cases, including Aloha Airlines where the U.S. Supreme Court determined that the AHTA preempted Hawaii’s property tax equaling 4% of the yearly gross income of airline businesses.⁶ There, the U.S. Supreme Court held that Hawaii’s categorization of the tax as a property tax rather than a gross receipts tax did not matter as the purpose and effect of the tax was to impose a levy upon the gross receipts of airlines and was therefore preempted by the AHTA.

The Court of Appeals also examined the Air Transport Association decision by a New York appellate court, wherein New York imposed a 0.75% tax on an airline’s “gross earnings” from in-state sources.⁷ There, the “gross earnings” calculation included various components including air carriage revenue. In this case, the New York appellate court held that the AHTA preempted the tax on the basis of gross receipts from air transportation being included in the “gross earnings” calculation. Notably, the New York Court of Appeals (the state’s highest court) affirmed this decision, and the U.S. Supreme Court did not grant certiorari.

For the case at hand, the Texas Court of Appeals began by noting that the Comptroller did not directly address Taxpayer’s “as applied” challenge. Instead, the Comptroller asserted that the Texas franchise tax is not similar to the other state taxes preempted by the AHTA as the nature of the Texas franchise tax does not seek to tax overall revenue.

The Comptroller posited that Aloha Airlines imposes a “purpose and effect” test which requires an inquiry into whether the overall structure of the tax qualifies as an impermissible tax under the AHTA.⁸ However, the Court of Appeals disagreed that Aloha Airlines created such a test and instead found that the “purpose and effect” test merely served as a lens to assess whether the practical effect of a tax resulted in an impermissible gross receipts tax on air commerce or transportation.

The Court of Appeals then addressed the Comptroller’s claim that the general availability of deductions within the calculation of total revenue differentiates the franchise tax from a gross receipts tax. Here, the Court rejected the Comptroller’s argument and found that as those deductions to total revenue did not apply to Taxpayer’s transportation revenue, the general availability of deductions and exclusions does not prevent the application of that the AHTA.

The Court of Appeals highlighted that the Comptroller previously ruled the AHTA preempts sales tax as applied to gross receipts from the sales of skydiving jumps⁹ and noted that the Texas sales tax also permits various deductions and exclusions from gross receipts.¹⁰

The Court of Appeals then addressed the Comptroller’s additional claims that the availability of the compensation deduction and the apportionment factor prevent the AHTA preemption of the franchise tax.¹¹ The Court rejected the Comptroller’s general premise that only gross receipts taxes on specific revenue streams are preempted by the AHTA, in highlighting the New York franchise tax at issue in Air Transportation Association as imposed on “gross earnings” included various components including gross receipts on air transportation revenue.

Further, the Court of Appeals found that general availability of the compensation deduction does not save the franchise tax from AHTA preemption, as Taxpayer’s taxable margin did not utilize compensation and ultimately contained transportation revenues in the total revenue calculation. Finally, the Court found that apportioning the franchise tax did not stop the AHTA from applying, as the Court pointed to a case requiring the preemption of the Hawaii excise tax by the AHTA even though that tax contained an apportionment factor.¹²

Ultimately, the Court of Appeals concluded that as applied to Taxpayer’s 2015 franchise tax report, the AHTA preempts the Texas franchise tax insofar as it is imposed on or measured by the gross receipts from Taxpayer’s transportation revenues.

Commentary

This decision emphasizes the importance of narrowly tailoring arguments when pursuing refund claims. Here, Taxpayer focused solely on an “as applied” challenge to specific transportation revenue based on Taxpayer’s facts and circumstances, under which no deductions were applicable to transportation revenue. The posturing in this case can be contrasted with other recent examples where a taxpayer sought a refund claim based on a generalized statutory interpretation.¹³

Further, this decision illustrates how taxpayers can consider arguments outside of the realm of the state statutory framework. In certain cases, courts have been receptive to federal preemption principles applied to reduce taxpayers’ tax burdens. As an example, the Illinois Appellate Court recently held that Chicago’s Amusement Tax, as applied to patrons purchasing tickets for a taxpayer’s historical architectural river and lake boat tours in Chicago, was preempted by the Maritime Transportation Security Act of 2002.¹⁴

This decision also highlights the long-debated issue of whether the franchise tax should be viewed as a gross receipts tax, an income tax, or whether that determination should be made on a taxpayer-by-taxpayer basis. In a prior decision, in Graphic Packaging, the Texas Supreme Court held that the Multistate Tax Commission three-factor election was not applicable to the Texas franchise tax, requiring use of a single sales factor explicitly required under the franchise tax. In doing so, the Court considered whether the Texas franchise tax is an income tax for purposes of the Multistate Tax Compact.

While impliedly endorsing a lower court’s decision on the matter that the franchise tax is not an income tax for purposes of the Compact, the Court did note the variety of potential deductions available to a taxpayer under the Texas franchise tax (e.g. 30% of total revenue). However, the Court did not consider whether that determination can change on an “as applied” basis.¹⁵

Accordingly, the holding of Graphic Packaging may be in tension with the holding of American Airlines given that the Court of Appeals in American Airlines held the franchise tax functioned “as applied” to Taxpayer as a tax on gross receipts.