Home Interiors—More Work for the Texas Legislature?

In Home Interiors & Gifts, Inc. v. Carol Keeton Strayhorn, Comptroller of Pub. Accts. of the State of Texas, Dkt. No. 03-04-00660-CV, 7/28/2005, the Texas Court of Appeals struck down the “throwback provision” as applied to the earned surplus calculation of the Texas franchise tax. The court ruled that the provision violated the judicial doctrine of “internal consistency” and, thus, resulted in an unconstitutional burden on interstate commerce.

Background

Franchise tax: The Texas franchise tax is a “privilege tax” imposed on corporations and limited liability companies that either do business in Texas or are registered to do business there. The tax is comprised of two parts: the capital tax and the earned surplus tax. The tax is calculated on each part; if the earned surplus tax exceeds the capital tax, the excess is added to the capital tax; see TX Tax Code Ann. 171.001(a)(1) and 171.002(b). The effect is to pay the greater of the two taxes.

The capital tax is based on the corporation’s stated capital and surplus (essentially, its equity) and taxed at 0.25%, while the earned surplus tax rate is 4.5% and is based on the corporation’s Federal taxable income (with certain adjustments). Using gross receipts as a single apportionment factor, the corporation’s net taxable capital and net taxable earned surplus are then calculated by dividing the gross receipts generated in Texas by worldwide gross receipts.

Throwback provision: Home Interiors addressed the application of the “throwback provision” in determining Texas gross receipts. In general, this provision requires sales of tangible personal property shipped from Texas to out-of-state purchasers to be thrown back to Texas when determining the gross receipts allocated to that state; see TX Tax Code Ann. 171.103(1). Whether a sale is thrown back depends on which portion of the franchise tax is being calculated. For taxable capital purposes, the sales are thrown back if the corporation is not subject to tax in the purchaser’s state. For taxable earned surplus purposes, sales are thrown back if the corporation is not subject to any tax on, or measured by, net income, without regard to whether the tax is imposed; see TX Tax Code Ann 171.1032(a)(1).

By enacting the earned surplus throwback provision, Texas intended to tax sales to other states that would otherwise escape tax under P.L. 86-272. Congress enacted P.L. 86-272 to prevent a state from imposing a tax on interstate commerce generated by an out-of-state corporation, unless minimum standards of business activity were present. It states that the mere solicitation of orders in a state does not generate sufficient business activity to impose a net income tax on those sales. A net income tax is defined as any tax imposed on, or measured by, net income; see 15 USC Section 383.

Case

Facts: Home Interiors & Gifts, Inc. (Home Interiors) is a multilevel marketing company in the business of purchasing home decor products, accessories and gifts and wholesaling them to independent contractors (displayers). Home Interiors’ net profits stemmed for the sale of decor products and marketing materials to displayers. The taxpayer’s operations are primarily confined to Texas, but its products are sold to displayers located in all 50 states. The displayers are not employees and receive no benefits; the taxpayer has no contact with their retail clients and does not install or repair products outside of Texas.

The parties stipulated that these activities met P.L. 86-272’s standards in all but 14 states. The Texas Comptroller agreed that gross receipts from sales to those 14 states should not be thrown back to Texas.

The taxpayer sued for refunds of Texas franchise tax it paid, under the theory that the throwback provision causes the franchise tax to (1) be unfairly apportioned, (2) discriminate against interstate commerce and (3) be unfairly related to services provided by Texas and, thus, result in an unconstitutional burden on interstate commerce. After the refund was denied, the taxpayer sued in district court, which granted summary judgment for the state; the taxpayer appealed.

Analysis: In Complete Auto Transit, Inc. v. Brady, 430 US 274 (1977), the Supreme Court developed a four-prong test to determine whether a tax will survive an argument that it is an undue burden on interstate commerce:

1. Is the tax applied to an activity with a substantial nexus with the taxing state?

2. Is the tax fairly apportioned?

3. Does the tax discriminate against interstate commerce?

4. Is the tax fairly related to the services provided by the state?

The Texas court focused on whether the tax was fairly apportioned; it analyzed whether the state was taxing only its fair portion of an interstate transaction. This, in turn, hinged on whether the tax was “internally” and “externally” consistent; see Oklahoma Tax Comm’n v. Jefferson Lines, Inc., 514 US 175 (1995) and Goldberg v. Sweet, 488 US 252 (1989). The internal consistency test assumes that every state imposes a tax identical to the one in question; if interstate commerce bears a burden not also borne by intrastate commerce, the tax is not internally consistent.

The court then compared the hypothetical results of a corporation like the taxpayer, but which resides in Texas and has sales only in Texas, to a corporation like the taxpayer that resides in Texas, but makes sales both in and out of that state. In the first case, the corporation would only be subject to tax in Texas. In the latter case, P.L. 86-272 would protect the corporation from income tax in other states, but not from capital tax in those states. Under the hypothetical test of identical state statutes, gross receipts from out-of-state sales would be gross receipts in both Texas and the other states for purposes of determining the capital tax. If both corporations had the same earned surplus and the same taxable capital (equity) and paid tax on earned surplus, the taxes on the corporation with interstate activity would be higher, because it would also be subject to a capital tax in the other state(s).

Holding: The court ruled that because an interstate corporation could be subject to a tax that the intrastate corporation would not bear, the Texas franchise tax lacked internal consistency for taxpayers that are affected by the throwback rule and pay tax on earned surplus.

Repercussions

The Texas Comptroller’s Office has not announced an intention to appeal the Home Interiors decision. Tax advisers should stay tuned for any announcements and new procedures issued by the Comptroller’s Office as to this decision, which may affect filing refund claims. Absent a ruling overturning the decision, Home Interiors should provide authority to seek refunds in appropriate cases. If the Comptroller does appeal, practitioners should consider filing protective refund claims before the expiration of any statute of limitations.

The court also provided the Texas Legislature with a means to cure the problem, by suggesting that interstate corporations receive a franchise tax credit to offset any taxes assessed on capital by state(s) that threw back receipts to Texas. It has been widely publicized that the Texas Legislature recently ended a third special session without enacting legislation to reform the state’s school financing system. Several of the defeated proposals would have altered or closed certain perceived franchise tax “loopholes.” The Home Interiors decision has now added to the legislature’s workload.

From Gary J. Voth, CPA, J.D., PKF of Texas, P.C., Houston, TX