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Texas Supreme Court denies use of compact’s three-factor formula for determining franchise tax apportionment

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The Texas Supreme Court held on December 22, 2017 that a taxpayer may not elect to use the equally-weighted three-factor apportionment formula provided by the Multistate Tax Compact (Compact), and must use a single receipts factor to compute its franchise tax. In reaching its decision, the Court chose not to address the issue of whether the franchise tax was an income tax, as defined in the Compact, and instead based its holding on a finding that Texas’ membership in the Compact does not prevent the state legislature from requiring a taxpayer to use only the single sales factor formula when apportioning its tax base to Texas.1

Background Multistate taxpayers are required to apportion their business revenue among the states in which they do business. Such taxpayers conducting business in Texas are subject to the franchise tax and, under Tex. Tax Code Ann. Sec. 171.106, must use a single factor apportionment formula which compares the taxpayer’s gross receipts derived from its business done in Texas to its gross receipts everywhere. Texas also adopts the Compact, codified in Tex. Tax Code Ann. Sec. 141.001, which historically has provided a three-factor formula consisting of equally-weighted property, payroll and sales factors, for apportioning “business income” for an “income tax.” Under the Compact, a taxpayer may elect to apportion its income via the Compact formula in lieu of the state-prescribed apportionment formula. These provisions are contained in Articles III.1 and IV of the Compact.2

Graphic Packaging Corporation (Graphic), a multistate taxpayer headquartered outside Texas, sells packaging for consumer products throughout the United States. Based on its activities, Graphic was subject to the franchise tax and, under Tex. Tax Code Sec. 171.106, was required to apportion its tax base (“margin”) to Texas using an apportionment formula solely based on the receipts factor. Graphic initially filed its 2008 and 2009 franchise tax reports using an apportionment formula based solely on the receipts factor. Subsequently, Graphic filed amended 2008 and 2009 reports and an original 2010 report applying the Compact’s three-factor apportionment formula. In support of this filing position, Graphic argued that since the franchise tax was essentially an income tax, Graphic was eligible to elect to use three-factor apportionment under the Compact. Since Graphic did not own or operate any manufacturing operations in Texas and only engaged in retail and wholesale activities in Texas, the use of the Compact election would allow it to reduce its Texas apportionment factor.

The Texas Comptroller denied Graphic’s refund requests and assessed a deficiency for 2010 on the grounds that the Compact election was unavailable under the franchise tax. Graphic’s refund claims were denied and the assessment upheld at the administrative level, a Texas district court and the Texas Court of Appeals.

Texas Supreme Court Did Not Address Characterization of Franchise Tax At the outset of its analysis, the Texas Supreme Court provided an in-depth review of the Texas Court of Appeals’ decision.3 The Court explained that three issues were before the appeals court, the first of which was whether the franchise tax is an “income tax” under the Compact’s definition which would invoke the Compact’s election and apportionment provisions. If the franchise tax were determined to be an income tax, then two additional issues would arise: (1) whether Tex. Tax Code Ann. Sec. 171.106 precludes a taxpayer from using the Compact’s three-factor formula, and (2) whether Texas’ membership in the Compact prevents the Texas legislature from requiring a taxpayer to use only the single-factor formula to apportion its tax base. Because the Texas Court of Appeals determined that the franchise tax was not an income tax, it did not address the two remaining issues.

The Texas Supreme Court undertook a detailed review of whether the franchise tax should be characterized as an income tax. Graphic argued that the franchise tax had to be characterized as either an income tax or a gross receipts tax, and given that binary choice, the income tax characterization for purposes of the Compact was more appropriate. The Texas Comptroller (along with the Texas Court of Appeals) characterized the franchise tax as a hybrid tax, one that had characteristics of an income tax and a gross receipts tax, which could not be considered an income tax under the Compact. Ultimately, the Texas Supreme Court concluded that it would not decide the issue of whether the franchise tax was an income tax in its opinion, but instead would address the two issues not considered by the appeals court.

Does State Law Preclude Use of Compact’s Three-Factor Formula? The Court first turned to the issue of whether Tex. Tax Code Sec. 171.106 precludes a taxpayer from using the Compact’s three-factor apportionment formula for purposes of the franchise tax. Tex. Tax Code Ann. Sec. 171.106(a) provides that:

Except as provided by this section, a taxable entity’s margin is apportioned to this state to determine the amount of tax imposed under Section 171.002 by multiplying the margin by a fraction, the numerator of which is the taxable entity’s gross receipts from business done in this state, as determined under Section 171.103, and the denominator of which is the taxable entity’s gross receipts from its entire business, as determined under Section 171.105. [emphasis added]

Resolution of this issue turned on whether the Compact election contained in Tex. Tax Code Ann. Sec. 141.001 could be harmonized with the apportionment formula contained in Tex. Tax Code Ann. Sec. 171.106(a). The Court held that it could not.

Specifically, the Court held that reading the Compact to provide an alternative method of apportioning margin could not be reconciled with the limiting language contained in Tex. Tax Code Ann. Sec. 171.106(a). This provision sets forth the gross-receipts formula as the sole apportionment method for the franchise tax, but also provides certain specifically enumerated circumstances under which a taxpayer can deviate from this formula.5 The introductory language of Tex. Tax Code Ann. Sec. 171.106(a) clearly provides that the gross receipts formula is the sole apportionment method “[e]xcept as provided by this section.” Thus, while Tex. Tax Code Ann. Sec. 171.106 provides several alternative apportionment formulas that may be used in specific circumstances, the Compact election is not one of them.

The Court explained that when there is an irreconcilable conflict between statutes, the rules of statutory construction, as codified in the Texas Code Construction Act, provide that the later-enacted and more specific legislation controls. While the Compact was enacted by Texas in 1967, the “except as provided” clause contained in Tex. Tax Code Ann. Sec. 171.106(a) was added in 1991. Furthermore, the relevant provision of the Compact deals with an election applicable to state “income taxes,” while Tex. Tax Code Ann. Sec. 171.106 specifically relates to the method of apportioning margin for the franchise tax. As a result, the Court held that Tex. Tax Code Ann. Sec. 171.106 provides the exclusive formula for apportioning the franchise tax and, by its terms, prohibits the taxpayer from using the Compact’s three-factor formula.

Texas’ Membership in Compact The Court then addressed the issue of whether Texas’ membership in the Compact prevents the Texas legislature from requiring a taxpayer to use only the single-factor apportionment formula. Resolution of this issue turned on the determination of whether the Compact was a binding contract.

Graphic contended that the Compact is a binding agreement under which Texas and the other “party states have voluntarily and contractually agreed to cede their sovereignty as to its subject matter.” As a result, member states cannot “legislate inconsistently” but must either keep the entire Compact or repeal the Compact as a whole. Conversely, the Comptroller argued that the Compact is in the nature of an advisory compact containing model laws, rather than a binding regulatory compact creating reciprocal obligations among the member states. The Comptroller argued that Graphic’s interpretation of the Compact as a “binding limitation on the state’s taxing power” would make the Compact unconstitutional in many current and former Compact states, as well as in Texas. In support of its position, the Comptroller cited to a series of decisions in other states that have rejected arguments similar to that raised by Graphic.6

Rejecting Graphic’s contention, the Court held that the Compact is not a binding regulatory compact because it lacks the features identified by the U.S. Supreme Court as necessary to create a binding regulatory compact: (1) the establishment of a joint regulatory body; (2) state enactments that require reciprocal action to be effective; and (3) the prohibition of unilateral repeal or modification of their terms.7

Applying these criteria, the Court noted that the Compact does not create a regulatory body, but instead creates the Multistate Tax Commission, a body that, in the words of the Commission itself, does not possess regulatory authority. Furthermore, the Compact does not require state reciprocal action for its substantive terms to take effect. Specifically, a Compact state may allow taxpayers to elect to use its apportionment formula irrespective of how other states tax or apportion that income or whether those states are even Compact members.

Turning to the final requirement, “conditional consent” that prohibits members from unilaterally repealing or modifying their participation, the Court explained that while the Compact does not explicitly allow a member state to unilaterally modify its participation, it does not prohibit a member from doing so. The Court explained that Compact states have read this silence to allow them to change the Compact’s provisions under their state laws and noted that only five of the current Compact member states (Alaska, Hawaii, Kansas, Montana and North Dakota, as noted by the Multistate Tax Commission) require the use of the Compact’s equally-weighted three-factor apportionment formula.

The Court also addressed whether Tex. Tax Code Ann. Sec. 171.106 violates the Contract Clause as an unconstitutional impairment of the Compact’s apportionment provisions. The Court determined that the member states did not intend for Articles III.1 and IV to be “immutable, binding contractual terms” whose provisions could not be modified except by withdrawal. The Court then embarked on an analysis that laid forth a series of factors leading to the conclusion that states did not intend for the Compact to be a binding reciprocal agreement. Specifically, the Court held that the unmistakability doctrine, the lack of express restrictions in the Compact on the member states’ power to delete or amend Articles III.1 and IV, the preexisting provisions found in many member states’ constitutions that prohibit contractual suspension of the taxing power, the members’ historical intent to preserve their sovereign tax powers, and the Compact’s other provisions, such as the severability clause, all supported a finding that Compact member states did not intend for Articles III.1 and IV to be “immutable, binding contractual terms.” As a result, the Court concluded that the legislature was empowered to enact Tex. Tax Code Ann. Sec. 171.106 as the exclusive method to apportion the franchise tax, and this provision did not violate the Contract Clause or otherwise adversely impact the operation of the Compact.

Commentary For those who have followed the litany of cases on this subject throughout the United States, the Texas Supreme Court’s decision contains few surprises, and a lack of positive news for taxpayers that had filed refund claims with the Texas Comptroller claiming the Compact election. Disappointingly, the Court sidestepped the issue of whether the franchise tax is an income tax under the Compact as it has so avoided in past decisions.8 Instead, the Court addressed the issues not resolved at the appellate level,9 likely providing taxpayers a level of finality on this issue, unless an appeal is taken by the U.S. Supreme Court.

Barring U.S. Supreme Court review, the Texas Supreme Court’s decision calls into question whether we will see any more litigation on the Compact election provision. The issue of whether taxpayers are allowed to elect to use the Compact’s equally-weighted three-factor apportionment formula gained prominence several years ago after the California Court of Appeal’s 2012 taxpayer-favorable decision in Gillette.10 However, since that time, as noted by the Court in its decision, several state courts11 consistently have rejected taxpayer arguments that they could make the Compact election, under carefully crafted rationales. The Multistate Tax Commission’s own views on this issue as laid out in amicus curiae briefs12 and the U.S. Supreme Court’s denial of petitions for certiorari in two cases on this issue13 effectively appear to have ended taxpayers’ challenges in this area for the foreseeable future.



1Graphic Packaging Corp. v. Hegar, Texas Supreme Court, No. 15-0669, Dec. 22, 2017.
2Article IV.9 of the MTC historically provided that all business income be apportioned to the state using a three-factor formula. It was amended in 2015 to provide that each state define its own factor weighting fraction, with a suggestion that the recommended fraction include property, payroll and double-weighted sales.
3Graphic Packaging Corp. v. Hegar,471 S.W.3d 138 (Tex. Ct. App. 2015). For a discussion of the appellate decision in this case, see GT SALT Alert: Texas Appeals Court Denies Use of Compact’s Three-Factor Formula As Revised Texas Franchise Tax Is Not Considered an Income Tax.
4The status of the franchise tax, and any state tax that may be construed to be an income tax, is an oft-litigated controversy and can impact the availability of a resident credit for tax due to another state, addback to federal taxable income as an income tax, the application of sales factor throwback provisions, P.L. 86-272 nexus protection and financial statement presentation.
5Exceptions to the general formula are listed in TEX. TAX CODE ANN. § 171.106(b)-(h) and are available only to select taxpayers, including those deriving income from the sale of certain services to a regulated investment company or retirement plan, banking corporations, broadcasters, Internet hosts, entities treating loans and securities as inventory, and those performing certain services in a defense economic readjustment zone
6Gillette Co. v. Franchise Tax Bd., 363 P.3d 94 (Cal. 2015), cert. denied, 137 S. Ct. 294 (2016); Kimberly-Clark Corp. v. Comm’r of Revenue,880 N.W.2d 844 (Minn. 2016), cert. denied, 137 S. Ct. 598 (2016); Gillette Commercial Operations N. Am. & Subsidiaries v. Dep’t of Treasury, 878 N.W.2d 891 (Mich. Ct. App. 2015), appeal denied, 880 N.W.2d 230 (Mich. 2016); Health Net, Inc. v. Dep’t of Revenue, No. TC-5127, Oregon Tax Court, Sept. 9, 2015.
7Citing Northeast Bancorp, Inc. v. Bd. of Governors, 472 U.S. 159, 175 (1985).
8See e.g., Allcat Claims Serv., L.P., 356 S.W.3d 455, 470 (Tex. 2011). 9The Texas Court of Appeals had concluded that the franchise tax is not an income tax under the Compact definition, and therefore, the Compact’s three-factor election does not apply. Note that this position differs from the positions in several other states and financial accounting standards treating the franchise tax as an income tax. For a discussion of this issue, see GT SALT Alert: Texas Appeals Court Denies Use of Compact’s Three-Factor Formula As Revised Texas Franchise Tax Is Not Considered an Income Tax.
10Notably, a taxpayer also successfully challenged the ability to elect use of the Compact’s three-factor apportionment formula for purposes of computing its Michigan Business Tax. International Business Machines Corp. v. Department of Treasury, 852 N.W.2d 865 (Mich. 2014), reh’g denied, 855 N.W.2d 512 (2014). Subsequent to the decision, Michigan enacted legislation providing that the Michigan statutes that adopted the Compact were repealed retroactively.
11For a discussion of this issue in other states, see GT SALT Alert: SALT Top Stories of 2015; GT SALT Alert: SALT Top Stories of 2016; GT SALT Alert: Minnesota Supreme Court Denies Use of Multistate Tax Compact’s Equally-Weighted Three-Factor Apportionment Election; GT SALT Alert: California Supreme Court Denies Use of Multistate Tax Compact’s Equally-Weighted Three-Factor Apportionment Election; and GT SALT Alert: Oregon Tax Court Denies Use of Multistate Tax Compact’s Three Factor Apportionment Formula Election.
12See Brief of Amicus Curiae Multistate Tax Commission, Multistate Tax Commission, Aug. 30, 2017.



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