United States: Texas Appeals Court Denies Use Of Compact's Three-Factor Formula As Revised Texas Franchise Tax Is Not Considered An Income Tax

The Texas Court of Appeals has affirmed a trial court's decision that a taxpayer cannot elect to use the equally-weighted three-factor apportionment formula provided by the Multistate Tax Compact, and therefore must use a single receipts factor to compute its Revised Texas Franchise Tax (RTFT).1 The Court concluded that the RTFT is not an income tax under the definition of the Compact, and therefore the Compact's three-factor election does not apply.


Graphic Packaging Corporation (Graphic), a Delaware corporation headquartered in Georgia, sells packaging for consumer products in multiple states, including Texas. Graphic initially filed its 2008 and 2009 RTFT reports using an apportionment formula solely based on the receipts factor. Subsequently, Graphic filed amended 2008 and 2009 reports and an original 2010 report applying an equally-weighted property, payroll, and receipts factor apportionment formula as allowed by 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 greatly reduced its Texas apportionment factor.

The Comptroller denied the use of the Compact's three-factor election under audit for Graphic's 2008-2010 report years. Graphic's refund claims and assessment were combined in a single administrative hearing in which the refund claims were denied and the assessment upheld by the Comptroller. Subsequently, Graphic filed suit against the Comptroller in a Texas district court where, again, the Comptroller prevailed. The district court did not provide reasoning for its decision, and Graphic appealed the case to the Texas Court of Appeals.

Texas' Adoption of the Compact

Texas adopted the Compact on August 4, 1967, and codified this adoption in Chapter 141 of the Texas Tax Code.2 Under the Compact, a taxpayer may elect to use an equally-weighted apportionment formula of property, payroll, and receipts for an income tax as an alternative to a state-prescribed apportionment method. For RTFT reports originally due before January 1, 2008, Texas law specifically stated that the Compact did not apply.3 This specific non-application provision was repealed when the RTFT was enacted for reports due on or after January 1, 2008.

By its own terms, the Compact applies only to an income tax, 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."4

Court of Appeals' Determination of RTFT As a Non-Income Tax

At the Texas Court of Appeals, Graphic contended that the RTFT is an income tax under the Compact's definition, as its margin was calculated using the cost of goods sold (COGS) method, or revenue minus applicable expenses, which meets the definition of net income. Accordingly, Graphic argued that the Compact's three-factor alternative method of apportionment should apply. The Comptroller countered that the single receipts apportionment method was required to be used because the RTFT is not an income tax. Texas law provides that a taxable entity's margin for RTFT should be apportioned based on a single receipts factor.5

The Court began its analysis by reviewing the definition of "income tax" under the Compact, and relying upon the plain meaning of the term "net income" within that definition, as such term was not defined in the Compact. According to the Court, "net income" was appropriately defined as the "excess of all revenues and gains for a period over all expenses and losses of the period."6

The Court then considered the methods available to calculate taxable margin under the RTFT: (i) 70 percent of total revenue; (ii) revenue less COGS; (iii) revenue less compensation; and (iv) revenue less $1 million.7 The Court concluded that 70 percent of total revenue is not tantamount to "net income" and that total revenue less $1 million is not synonymous with deducting expenses from gross income to arrive at "net income." Because the COGS and compensation deductions are limited, the Court likewise found that these methods did not meet the definition of "net income."

Graphic also argued that income tax and gross receipts tax as defined by the Compact are mutually exclusive terms. "Gross receipts tax" is defined by the Compact to mean "a tax other than a sales tax, which is imposed on or measured by the gross volume of business, in terms of gross receipts or in other terms, and in the determination of which no deduction is allowed which would constitute the tax an income tax."8 Graphic reasoned that since the RTFT did not fall under this definition, it must be an income tax. The Court agreed that the RTFT did not fall within the definition of a "gross receipts tax," but rejected the contention that the RTFT had to be classified as an income tax as a result.

Graphic had raised three issues in its original appeal to the state: (i) the apportionment formula under the RTFT9 did not impliedly repeal the Compact's election provision and formula; (ii) if an implied repeal occurred, the repeal was invalid because the Compact is an interstate agreement that is binding on the party states unless and until they withdraw, and (iii) if the Compact's election and formula were not repealed, the RTFT should be considered an income tax under the Compact.

Because Graphic never overcame the "income tax" hurdle, the arguments concerning the application or repeal of the Compact became superfluous and were not considered by the Court in its opinion.

Interestingly, the Court made no mention of the Texas legislature's provision that:

The franchise tax imposed by Chapter 171, Tax Code, as amended by this Act, is not an income tax and Pub. L. No. 86-272 does not apply to the tax.10

The Court also did not reference the Texas Supreme Court's Allcat11 decision. In Allcat, the taxpayer argued that the RTFT was ultimately a tax on individual partners of a partnership and therefore was unconstitutional. The Supreme Court in Allcat concluded that the RTFT was a tax on the entity, not the individuals, and ultimately did not decide on whether the RTFT was considered an income tax.


Given the potential for significant refunds and tax savings if successful, Graphic is expected to submit a request for rehearing by the Texas Court of Appeals, or appeal directly to the Texas Supreme Court. After considering how courts in other states have ruled on this issue, it would appear that Graphic's chances of obtaining the ability to use the Compact election are relatively slim, even if the RTFT could be characterized as an income tax for purposes of the Compact. By extension, the hopes of many similarly situated taxpayers may hang in the same balance.

In International Business Machines v. Department of Treasury,12 the Michigan Supreme Court ruled in favor of the taxpayer's use of the Compact's three-factor election for purposes of the Michigan Business Tax (MBT). However, the state of Michigan promptly enacted legislation that retroactively repealed the Compact and may have eliminated virtually all rights to refunds.13 This solution, which itself has been challenged,14 may serve as a template for other states to follow in response to adverse decisions in this area. In California, a taxpayer victory in The Gillette Co. v. Franchise Tax Board15 with respect to the applicability of the election for California corporation franchise tax purposes is being challenged at the California Supreme Court, and the very lengthy wait for a decision in this case could imply a potential reversal.16 One distinction between the IBM and Gillette cases, and the Texas Court of Appeals' disposition of the RTFT challenge is that the MBT and the California corporation franchise tax were both classified as "income taxes," a determination that Graphic could not obtain.

It should be noted that the Texas Court of Appeals' classification of the RTFT as something other than an income tax, at least for Compact purposes, differs from the positions in several other states and financial accounting standards treating the RTFT as an income tax.

Many states treat the RTFT as an income tax for state tax addback purposes, meaning that the amount of RTFT deducted on the federal income tax return must be added back to federal taxable income. Further, many states treat the RTFT as an income tax that if paid by a taxpayer, may be eligible as a credit for other taxes paid on a resident return. For example, a credit for the RTFT paid may be taken on individual income tax returns in Kansas,17 Missouri,18 and Wisconsin.19

With respect to financial accounting, the Financial Accounting Standards Board (FASB) concluded that the RTFT should be treated as an income tax for reporting FAS 109 (now ASC 740) Accounting for Income Taxes purposes, as the tax is based upon a "measure of income."20 However, the FASB declined to provide guidance as to the "income tax" status of the RTFT.

The potential characterization of the RTFT as an income tax has additional implications. For example, Public Law 86-272 applies, conceptually and in practice, only to income taxes. Therefore, taxpayers' potential ability to claim P.L. 86-272 protection via the RTFT, which currently does not exist, conceivably could change if Graphic can successfully argue that the RTFT fits within the Compact's definition of income tax.


1 Graphic Packaging Corp. v. Hegar, Texas Court of Appeals, Third District, at Austin, No. 03-14- 00197-CV, July 28, 2015.

2 TEX. TAX CODE ANN. § 141.001.

3 TEX. TAX CODE ANN. § 171.112(g), repealed effective January 1, 2008.

4 TEX. TAX CODE ANN. § 141.001, art. II.4.

5 TEX. TAX CODE ANN. § 171.106.

6 Black's Law Dictionary 1040 (6th ed. 1990).

7 TEX. TAX CODE ANN. § 171.101.

8 TEX. TAX CODE ANN. § 141.001.

9 TEX. TAX CODE ANN. § 171.106(a), which provides: "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.]

10 H.B. 3, Laws 2006, Special Session, uncodified § 21.

11 In Re Allcat Claims Service, L.P., 356 S.W.3d 455 (Tex. 2011).

12 852 N.W.2d 865 (Mich. 2014). For a discussion of this case, see GT SALT Alert: Michigan Supreme Court Allows Multistate Tax Compact Three-Factor Apportionment Election for 2008 MBT Return.

13 Act 282 (S.B. 156), Laws 2014. For further discussion of this Michigan legislation, see GT SALT Alert: Michigan Enacts Legislation Designed to Eliminate Multistate Tax Compact Apportionment Election Refunds Allowed by IBM Case.

14 Yaskawa America, Inc. v. Department of Treasury, Michigan Court of Claims, No. 11-000077-MT, Dec. 19, 2014. For a discussion of this case, see GT SALT Alert: Michigan Court of Claims Upholds Legislation Retroactively Repealing Multistate Tax Compact.

15 209 Cal. App. 4th 938 (2012).

16 Gillette Co. v. Franchise Tax Board, California Supreme Court, No. S206587. Note that the California Supreme Court granted the petition to review this case on January 16, 2013.

17 Opinion Letter No. O-2008-04, Kansas Department of Revenue, Sept. 2, 2008.

18 Letter Ruling No. LR5309, Missouri Department of Revenue, Dec. 12, 2008.

19 Publication 125, Wisconsin Department of Revenue, Nov. 2007.

20 Financial Accounting Standards Board, Minutes of the August 2, 2006 Board Meeting on the Potential FSP: Texas Franchise Tax, Aug. 2, 2006.

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