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Texas Franchise Tax Earned Surplus Throwback Held UnconstitutionalIn a case in which Strasburger & Price, LLP represented Home Interiors
& Gifts, Inc. ("Home Interiors") a Texas Court of Appeals has ruled that
the Texas franchise tax earned surplus throwback provision as applied to
Home Interiors unconstitutionally burdens interstate commerce in violation
of the Commerce Clause of the United States Constitution. Home InteriorsHome Interiors is a Texas corporation that manufactures and purchases
home decor products, accessories, and gifts, and then wholesales them to
independent contractors throughout the country. During the periods in
issue, approximately 90% of Home Interiors' sales were to customers
outside of Texas. The Texas Franchise TaxThe Texas franchise tax is imposed on corporations for the privilege of
doing business in Texas. The tax is in effect the greater of a 4.5% tax on
"net taxable earned surplus" or a .25% tax on "net taxable capital." Net
taxable earned surplus and net taxable capital are apportioned to Texas on
the basis of the ratio of a corporation's gross receipts generated in
Texas to its world-wide gross receipts. Texas' Throwback ProvisionsFor purposes of determining these apportionment ratios, Texas adopted
two different provisions that treat sales of tangible personal property
shipped from Texas to customers outside of Texas as though the sales were
made to customers in Texas. These are known as the "throwback" provisions.
To apportion net taxable capital, sales are thrown back to Texas if the
corporation is not "subject to taxation" in the purchaser's state. Tex.
Tax Code §171.103(1). To apportion net taxable earned surplus, sales are
thrown back to Texas if the corporation is not "subject to any tax on, or
measured by, net income" in the purchaser's state. Tex. Tax Code
§171.1032(a)(1). P.L. 86-272The court explained that the different standards for throwback were
adopted because Texas sought to tax income from sales to customers in
states that were prohibited by Public Law 86-272 from imposing an income
tax on the seller. Public Law 86-272 [15 U.S.C. §381(a)] was adopted by
Congress in 1959 to create minimum standards for business activity in a
state before that state may impose a tax "on, or measured by, net income." Commerce Clause RequirementsA state tax on interstate commerce must be fairly apportioned. The U.S.
Supreme Court has held that a tax is fairly apportioned if it is both
"internally consistent" and "externally consistent." To be internally
consistent, a tax, if hypothetically adopted by all states in which
interstate commerce is conducted, must impose no greater burden on
interstate commerce than would be imposed by the same tax on commerce
occurring solely within the taxing state. Oklahoma Tax Comm'n v. Jefferson
Lines, Inc., 514 U.S. 179 (1995). The court ruled that the earned surplus
throwback provision requiring Home Interiors to "throwback" out-of-state
sales in computing the earned surplus portion of the Texas franchise tax
violates the fair apportionment requirement because it causes the tax to
be internally inconsistent. Internal Consistency TestApplying a hypothetical standard under which all states are assumed to
impose a tax similar to the Texas franchise tax, the court reasoned that
an interstate corporation could be subject to tax on its taxable capital
in every state in which it established substantial nexus, as well as a tax
on 100 percent of its earned surplus in Texas, while a corporation
operating only in Texas would be subject to tax only on the greater of its
taxable capital or earned surplus. The additional tax burden on
corporations operating in interstate commerce violates the Commerce
Clause. Home Interiors & Gifts, Inc. v. Strayhorn, Tex.
Ct. App., No. 03-04-00660-CV, 7/28/05. Potential Refund OpportunityOn September 22, 2005, the court overruled a Motion for Rehearing filed by the Comptroller in this case. The Comptroller may appeal the decision to the Texas Supreme Court. Pending a final decision in this case, businesses subject to the Texas franchise tax should consider filing protective claims for refund. Likely candidates for refunds under this case include businesses that:
However, all taxpayers that have paid increased Texas franchise tax due to earned surplus throwback might consider whether a protective refund claim should be filed.
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