Originally published August 3, 2005
In a case in which Sutherland Asbill & Brennan LLP, and Of Counsel, Walter Hellerstein, participated in representing the taxpayer, the Texas Court of Appeals held that the "throwback rule" contained in the Texas franchise tax unconstitutionally burdens interstate commerce as applied to an in-state corporation that sells to mostly out-of-state consumers. Home Interiors & Gifts, Inc. v. Strayhorn, No. 03-04-00660-CV (Tex. Ct. App., July 28, 2005).
The Texas franchise tax is imposed on corporations for the privilege of doing business in the state on the greater of the taxpayer’s taxable capital (i.e., a tax imposed on capital) or net taxable earned surplus (i.e., a tax imposed on net income). Texas also employs a "throwback rule" for the net taxable earned surplus tax component. This apportionment rule provides that gross receipts are thrown back to Texas if the corporation is not subject to tax on, or measured by, net income, in its customer’s state. The purpose of the throwback provisions is to capture and tax income generated from sales destined for states that would otherwise not be taxed. Specifically, the Texas legislation was enacted to prevent income from going untaxed as a result corporations not being subject to tax in other states because of Public Law 86-272, which is a federal law that prevents states from imposing net income taxes on taxpayers that limit their activities to solicitation within the state.
Home Interiors & Gifts, Inc. ("Home Interiors") is in the business of purchasing home décor products, accessories and gifts and wholesaling them to independent contractors. Home Interiors sells a variety of marketing materials to these independent contractors to facilitate retail sales of merchandise. Home Interiors has virtually all of its operations to Texas and has no manufacturing, warehousing or administrative facilities outside of Texas, but did sell products to retailers in all 50 states, Washington D.C. and Puerto Rico. Home Interiors earned 90% of its revenue from sales outside of Texas.
The court prefaced its analysis by articulating the Commerce Clause analysis from Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977) which held that a tax will survive Commerce Clause scrutiny when the tax is applied to an activity with a substantial nexus with the taxing State, that is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State. The Home Interiors & Gifts court focused on the fair apportionment prong of the Complete Auto analysis, which requires the court to determine whether the tax is "internally consistent." The internal consistency test is a hypothetical analysis and requires an assumption that every state imposes an identical tax as the tax being challenged to determine whether the state is taxing more than its fair share. Accordingly, the court reviewed the hypothetical scenario that every state imposed a franchise tax identical to the Texas franchise tax (i.e., a tax on two alternative bases and a sales factor throwback provision). The court compared the burden the Texas franchise tax imposed on a strictly intrastate corporation to that of an interstate corporation under this hypothetical analysis.
In reaching its decision, the court relied on Walter Hellerstein’s treatise (J. Hellerstein & W. Hellerstein, State Taxation ¶ 4.09 (3d ed. 2004)) and a law review article (Walter Hellerstein, Is Internal Consistency Foolish?: Reflections on an Emerging Commerce Clause Restraint on State Taxation, 87 Mich. L. Rev. 138 (1988)). Under the court’s hypothetical analysis, the interstate corporation that manufactures tangible personal property in Texas and sells goods to customers in other jurisdictions would pay the earned surplus tax in Texas on nearly all of its sales (i.e., sales to other jurisdictions will be thrown back to Texas) and pay the taxable capital tax in all other states. However, a similar, but intrastate only company (i.e., a company that manufactures in Texas and sells goods to customers in Texas) would only pay the earned surplus tax on nearly all of its sales and would not pay the tax on capital in Texas or any other state. The application of the throwback provision, the unique features of the Texas franchise tax (i.e., paying the higher of a tax on capital or income) and Public Law 86-272 led the court to determine that the Texas franchise tax impermissibly burdened interstate commerce because it produced a higher tax burden on a company engaging in interstate commerce versus a company engaging in intrastate commerce.
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This article is for informational purposes and is not intended to constitute legal advice.