Texas Businesses Again Challenge Texas Supreme Court on Franchise Tax

by Janet Elliott, Contributing Writer

AUSTIN (January 17) – Major divisions in the business community are playing out at the Texas Supreme Court as the justices weigh a second case challenging the constitutionality of the franchise tax.

The court heard arguments Jan. 12 in a direct appeal by Nestle and two other companies, who argued that the tax is a confusing mess that fails to treat businesses equally and uniformly. They want the court to order the Legislature to start over.

The franchise tax is the state’s main business tax, passed by the Legislature six years ago in response to a Supreme Court order to improve school funding. It broadened the tax base and was designed to help cover a politically popular one-third cut in the property tax.

The fight among industries that played out behind the scenes at the Capitol flared up last week at the Supreme Court. A small business group wants the tax thrown out while a coalition of manufacturers, oil and gas companies, chemical plants and electric utilities backs the state.

The Nestle case follows a Nov. 28 decision by the Supreme Court that rejected a constitutional challenge from Allcat Claims Service. Allcat had argued that taxing limited partnerships amounts to a personal income tax, banned under the Texas Constitution absent voter approval.

Allcat could pose jurisdictional problems for the latest case, Nestle v. Comptroller Susan Combs, because the court said that issues on the tax “as applied” to individual businesses must start in the lower courts.

Allcat received a lot of media attention because it was the first constitutional challenge and involved the sexy issue of personal income taxes, but Nestle has the potential to throw state finances into a tailspin, said Dale Craymer, president of the Texas Taxpayers and Research Association. Should the court find the tax unconstitutional and order refunds of the more than $20 billion that businesses have paid since the tax went into effect in January 2008, the Legislature would immediately have to meet in a special session to find the revenue.

“The stakes are very high,” Craymer said.

That possibility was on the minds of the justices, who interspersed their questions about the legal issues with questions about the practical impact of such a ruling.

Justice Phil Johnson wanted to know if companies would line up at the Supreme Court or the Comptroller’s Office to seek refunds and Chief Justice Wallace Jefferson asked, “How much money are we talking about?”

Peter Nolan, who represents Nestle USA Inc. and two other companies, said the court could avoid all those concerns by stopping future tax collections but not ordering refunds. He even suggested that the Legislature, which is concerned about the failure of the tax to meet projections, might welcome the court’s guidance.

Nolan, a shareholder in Winstead’s Austin office, told the court that because the tax treats similarly situated businesses so differently, it fails to meet a legal standard that taxation must be related to the privilege of doing business in Texas.

“The franchise tax as a percentage of Texas profits differs between industry groups by almost 3,000 percent,” said Nolan.

The Office of Texas Attorney General Greg Abbott argued that the Legislature has the authority to draw such distinctions as long as there is some plausible reason to do so.

“They can favor one business over another,” said Assistant Solicitor General Rance Craft.

Justice Dale Wainwright asked if the state could decide that all revenue should come from the 100 largest companies operating in Texas.

“I would say yes,” Craft replied.

Richard Farrer, who represents the National Federation of Independent Business, told the court the tax has resulted in slower hiring as businesses not only have to pay new taxes but also employ experts to interpret the provisions. Farrer of Yetter Coleman’s Austin office, said the fact that the revenue is falling short of legislative projections does not make the tax unconstitutional but is “kind of a red flag that there are problems here.”

Craymer said the tax has been raising about $4 billion a year, compared to the predicted $6 billion, partly because of the slower economy but mainly because of flawed legislative projections.

The manufacturers and heavy industry, in an amicus brief written by Austin’s Beatty Bangle Strama, said the restructured tax has succeeded in making the burden borne by most industries more closely parallel their share of the economy. They said what is disguised as a constitutional challenge is “in truth, no more than a complaint about the state’s tax policy, and its effect on … respective bottom lines.”

Under the tax, businesses pay either 1 percent or 0.5 percent on the “margin,” defined as total revenue minus either the cost of goods sold or compensation and benefits. Businesses with less than $1 million in total revenue or those who would owe less than $1,000 in tax are exempted.

Although Nestle engages only in wholesale activities in Texas it pays a higher 1 percent tax rate applicable to Texas manufacturers instead of the 0.5 percent tax on wholesalers because it manufactures products in other states that it sells in Texas.

“Nestle does not receive any benefits from Texas with respect to its manufacturing operations. Nestle receives only the benefits conferred on wholesalers and retailers in Texas. By taxing Nestle based on activities for which Texas confers no benefit, the margin tax violates the Due Process Clause of the United States Constitution,” the company said in its brief.

The other two companies joining Nestle have similar complaints. Switchplate LLC, a Dallas-based global temporary housing company, said it pays an inordinately higher tax because it is not permitted to exclude payments made to contractors from its total revenue payments. NSBMA LP, which rents generators, cooling towers and trailers to construction sites, said it is not permitted to deduct its rental costs as cost of goods sold – resulting in an additional tax burden of nearly $229,000 over three years.

Nolan compared the variations to taxing the home of a dentist differently than the home of a doctor. “They are not taxing value. They are taxing something which is unrelated and that is the fatal flaw,” he said.

Craft said that the standard referenced by Nolan applies only to property taxes.

Craft also argued the case should be dismissed because Nestle willingly paid its taxes. Asked by several justices why Nestle did not pay its taxes under protest or file a refund claim, Nolan said that would have been futile because “the comptroller has been enforcing this law for years.”

Farrer told the court that requiring the claims to start anew in district court means the “bill is just going to grow and grow and grow.”

In an interview after the arguments, Nolan said there is one other point he wished he would have made to the court.

“If equal and uniform means anything, it means you don’t have to hire your own lobbyist to be taxed equally and uniformly.”