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March 1, 2013
Texas’s Contribution To the Gillette Saga
by Jennifer Carr

Full Text Published by Tax Analysts®

By Jennifer Carr

Jennifer Carr is a legal editor of State Tax Notes.

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The ongoing Gillette saga that started in California was the biggest news last year in the world of state and local taxation.1 In addition to California, similar litigation is pending in at least three other states -- Michigan, Oregon, and Texas.2 Michigan is the only one of those other states in which there has been in an opinion on this question.3 In Texas the taxpayer asserting its right to use the Multistate Tax Compact's three-factor formula faces the additional challenge of showing that the state's franchise tax is an income tax for purposes of the compact.4 The taxpayer has a good chance of prevailing on that initial question. However, after that, the taxpayer faces an uphill battle because the compact and franchise tax statutes are incompatible and it seems unlikely that the Texas Legislature intended to bind future legislatures when it adopted the compact. As a result, Texas appears more likely to join Michigan than California in the Gillette cases split.

In Gillette, the California Court of Appeal, First Appellate District, held that the compact was a binding agreement that required member states to offer taxpayers the option of apportioning their income using the equally weighted, three-factor formula. The court further held that although states could unilaterally withdraw from the compact, they could not unilaterally modify its terms. Thus, a California law requiring taxpayers to use a double-weighted sales factor formula did not repeal or supersede the formula provisions in the compact, which are still available to taxpayers. The Franchise Tax Board appealed to the California Supreme Court, which has not decided whether it will hear the appeal. Although the case was pending before the appeal court, the California State Legislature Assembly enacted legislation withdrawing from the compact and thus removing its formula as an option for taxpayers.

In addition to the California opinion that has garnered the bulk of the coverage, the Michigan Court of Appeals has weighed in on the question, though it reached the opposite conclusion. In International Business Machines, the Michigan court held that the Michigan business income tax and modified gross receipts tax apportionment formulas conflicted with the compact's single-weighted three-factor formula. However, the court concluded that rather than being bound by the compact provisions, Michigan was free to enact a conflicting and controlling statute. Because the later state laws could not be reconciled with the compact provision, the court held that the election provision in the compact had been repealed by implication. The Michigan Court of Appeals denied IBM's request to publish the opinion. The Department of Treasury appealed, but the Michigan Supreme Court also has not decided whether it will hear the case.5

Texas Litigation

Graphic Packing Corp. is headquartered in Marietta, Ga. Graphic Packaging and its subsidiaries design, manufacture, and sell packaging for consumer products. The company has only retailing and wholesaling activities in Texas. Graphic initially filed its 2008 and 2009 franchise tax returns using the single-factor apportionment method found in Texas Tax Code section 171.106(a).6 However, for 2010 the company apportioned its income using the three-factor method in the compact. Graphic Packaging filed amended returns for 2008 and 2009 similarly using the three-factor formula. The change decreased Graphic's total franchise tax liability for the three years combined by approximately $540,000. The comptroller denied the changes and refunds, and Graphic requested a hearing. On August 10, 2012, the comptroller issued her decision upholding the refund claim denial.7 The comptroller concluded that taxable entities are required to apportion their Texas franchise tax under the single-factor apportionment formula in section 171.106(a) and may not elect to use the compact formula. That decision was consistent with two rulings issued earlier in 2012.8 Graphic Packaging paid the amount due in the notice and filed suit for a refund in Travis County District Court. According to the plaintiffs' attorney, Jimmy Martens, motions for summary judgment are likely to be filed soon and the case is scheduled for trial in December 2013.

In its complaint, Graphic Packaging raises four counts. First, the company alleges that it properly elected to use the compact's three-factor formula because the compact is part of the Texas Tax Code, and the compact states that a taxpayer may elect to apportion its income in accordance with the three-factor formula. Citing Gillette, Graphic Packaging asserts that compact signatories are obligated to offer taxpayers the three-factor option.

Next, Graphic asserts that the franchise tax meets the definition of an income tax in Texas Tax Code section 141.001 because the tax begins with gross income and provides deductions for expenses unrelated to specific transactions. Graphic Packaging argues that deductions for costs of goods sold and overhead expenses fit the definition. Also, Graphic Packaging asserts that in other circumstances the comptroller has argued that the tax is an income tax. Graphic Packaging also notes that several states have considered the tax an income tax and that the Financial Accounting Standards Board has concluded that the franchise tax is an income tax.

In count two, Graphic Packaging alleges that the single-factor apportionment method, as applied, violates the due process and commerce clauses of the U.S. Constitution "because it attributes to Texas a percentage of income that is out of all appropriate proportion to the business [Graphic Packaging] transacts in Texas." In count three, Graphic Packaging asserts violations of the Texas equal and uniform taxation clause based on the difference between manufacturing and retailing tax rates and its taxation as a retailer even though it conducts manufacturing elsewhere.9 Finally, Graphic Packaging asserts that the comptroller abused her discretion by failing to waive the penalties and interest.


The first question the court must resolve before it determines the relationship between the franchise tax apportionment formula and the compact formula is whether the franchise tax is an income tax for purposes of the compact.10 The compact provision states that it applies to "any taxpayer subject to an income tax whose income is subject to apportionment and allocation for tax purposes."11 The compact, which was codified in Texas Tax Code section 141.001, defines an income tax 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."12 The franchise tax portion of the tax code contains no definition of income tax.

In addition to the statutory provisions, there is other, largely conflicting, information regarding the franchise tax classification. For instance, section 21 of the 2006 bill that created the current franchise tax stated 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." But when the franchise tax amendment was enacted, Comptroller Susan Combs sent a letter to Attorney General Greg Abbott expressing her opinion that the franchise tax was a tax on the income of natural persons because of its taxation of partnership income and because the tax met the compact definition of income tax. As a result, according to the comptroller, the tax was subject to the requirements of the Bullock Amendment.13 The attorney general appears not to have responded to the comptroller's request for an opinion on the matter. However, in In re Allcat Claims Service LLP, the Texas Supreme Court held that the franchise tax as applied to a partnership was not an income tax on natural persons. The decision did not hinge on whether the franchise tax was an income tax, however. Instead it was resolved based on the court's conclusion that the tax was on the partnership as an entity and not on the individual partners, and thus did not fall within the Bullock Amendment. Thus, Allcat does not resolve the initial issue in this case of whether the franchise tax is an income tax.

However, other entities have concluded that the franchise tax is an income tax. In the minutes of the FASB meeting in August 2006, the board determined following discussions with "national accounting firms and other interested parties" that the franchise tax is an income tax to be counted under Statement 109.14 The board further said that there would not be a diversity of opinion on the matter and thus no project for additional guidance was needed. Also, Graphic Packaging correctly notes that some states consider the franchise tax an income tax for purposes of calculating their state's income tax.15 However, those rulings, like the FASB board meeting minutes, contain little or no analysis of the franchise tax.

The question then is how to reconcile the conflicting information and statutes on this matter. Although the Legislature's statement is among the more persuasive evidence that the franchise tax is not an income tax, it is not dispositive. The Texas court will have to resolve the question for itself. And even though the definition for income tax is found in the compact portion of the Texas Tax Code, it is the only definition for income tax the Legislature has enacted in either relevant section of the code. Thus, it is the best starting point for the statutory analysis of the franchise tax. The franchise tax is calculated by determining an entity's total revenue, which is federal taxable income minus some deductions for items such as bad debt, foreign royalties, and Medicare payments. The taxpayer then deducts either costs of goods sold or compensation paid to its employees. If the margin yielded by either subtraction is greater than 70 percent of total revenue, the taxpayer uses the 70 percent figure. The taxpayer then multiplies that amount by a tax rate of 1 percent if it is engaged in manufacturing or 0.5 percent if it is primarily engaged in retailing or wholesaling.

As seen above, income tax is measured by net income, including tax based on gross income, less expenses not related to a particular transaction. That would appear to apply to the franchise tax because it starts with the taxpayer's gross income and allows a variety of deductions not related to any particular transaction. One potential issue in this analysis is that some taxpayers will deduct 30 percent of their revenue rather than taking deductions based on expenses. However, the deduction is still unrelated to a specific transaction and used only if a taxpayer's other deductions do not get the margin down to at least 70 percent of total revenue. That distinction appears insufficient to get the franchise tax outside the statutory definition for income taxes. As a result, the franchise tax is likely an income tax for compact purposes.

Assuming the court concludes the franchise tax is an income tax, it will then have to determine the effect of the later franchise tax amendments on the codified multistate compact. Because the franchise tax statute in 2006 did not address the compact, the question will be whether the 2006 statute amended or repealed the multistate compact apportionment provision by implication. Although it is clear that the Legislature intended to implement the single-factor franchise tax provision, it is unclear what the Legislature's intent was regarding the existing compact provision. Thus, in order to conclude that the compact provision was amended, the court will have to find that the two provisions are "in irreconcilable conflict" and are "so inconsistent that the passage of the [franchise tax] by necessary implication abrogated [the compact provision.]"16

The court likely will conclude the statutes meet that standard. Both are emphatic and clear in what they require. The compact provision clearly states that a taxpayer may elect to use the three-factor formula to apportion its income. The franchise tax provision clearly requires that a taxpayer apportion its tax using a fraction, "the numerator of which is the taxable entity's gross receipts from business done in this state . . . and the denominator of which is the taxable entity's gross receipts from its entire business." There is no way that both provisions can be in effect. They are in "irreconcilable conflict."

If this was only a question of Texas statutory interpretation, the court would likely hold that the margin tax statute repealed the compact three-factor provision by implication. However, courts in these cases must also consider the effect of the compact itself on the state's statutory scheme and the Legislature's power to modify it. The two state courts that have considered those questions have reached opposite conclusions, with California deciding that the state could not unilaterally amend the terms of the compact and the Michigan court concluding that the compact was not binding on the state. That decision was based on a Michigan Supreme Court opinion holding that in order to be bound against future unilateral changes, the Legislature must clearly express that intent by using the words "contract" or "covenant."17

Unfortunately, there is little case law indicating how the Texas courts are likely to treat the compact. Searching for the term "interstate compact" in Texas appellate court decisions yields many cases that mention interstate compacts, particularly those regarding children and criminal justice. But there is not much relevant to this question. Also, the appeals courts in the state have not cited the primary cases relied on by the California appeal court in its opinion. There is just not much to go on in the existing case law.

As a result, it is likely that the Texas courts will fall back on the key question in almost all statutory analysis situations -- what was the intent of the Legislature when it enacted the provisions in question, or in this case, joined the multistate compact. In his article, "What Did the MTC Think and When Did They Think It," Billy Hamilton lays out a compelling case that even though the member states wanted to be able to show Congress that they were tackling the problems created by a lack of uniformity in state tax administration, it is highly unlikely that member states would have joined had they thought they were binding their future legislatures to a particular formula.18 And, Hamilton, who was the deputy comptroller in Texas for 16 years, writes that "in 30 years of working around Texas taxes, I never heard anyone in an policy meeting, legislative committee, or any other venue seriously suggest moving to three-factor apportionment." Obviously, that is just one man's opinion, but it is an informed opinion and the evidence Hamilton cites is compelling. The bottom line is that nothing the Texas Legislature has done gives any indication that it believed it was bound by the compact regarding the apportionment formula.

The Gillette saga is just getting started and it is impossible to say exactly how it will ultimately play out. Obviously, consistency among the compact member states is preferable to a situation in which the states treat the terms of their membership differently. That would severely hamper the function and purpose of the compact. The two ways to get consistency would be for the different states courts to reach the same conclusion or for the U.S. Supreme Court to ultimately issue the definitive opinion on the nature of the compact. That is clearly years away and is much more likely to occur if there is a significant split between the states on the matter. Unfortunately, that would likely require a significant period of ambiguity in the meantime. Regardless, the most likely contribution of the current Texas litigation is to add a case to the Michigan column holding that the states are not bound by the compact to refrain from requiring a different apportionment formula.


1 The Gillette Co. et al. v. Franchise Tax Bd., A130803, Cal. 1st App. (Oct. 2, 2012).

2 The Oregon case is Health Net Inc. v. Dep't of Revenue, Case No. 120649D, Ore. Tax Ct.

3 International Business Machines v. Dep't of Treasury, No. 306618, Mich. App. Ct. (Nov. 20, 2012, unpublished).

4 Graphic Packaging Corp. v. Combs, Travis County Dist. Ct.

5 Supreme Court Docket No. 146440.

6 "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."

7 201208576H.

8 201207561H (July 13, 2012) and 201209609H (Sept. 11, 2012).

9 Counts two and three are unlikely to succeed and will not be further discussed. See In re Nestle USA Inc., No. 152-0518, Texas Sup. Ct. (Oct. 19, 2012).

10 That is also potentially a question for some taxes in the Michigan case. However, because the department acknowledged that the business income tax is an income tax, the court concluded there is at least one tax that would fall within the compact's election structure and rendered a decision based on that tax without resolving any other potential income tax questions.

11 Texas Tax Code section 141.001, Art. III.

12 Texas Tax Code section 141.001, Art. II.

13 The Bullock Amendment, found in Texas Constitution, Art. VIII, section 24(a), requires a popular vote to approve a "tax on the net income of natural persons."

14 Statement 109 "establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting for income taxes."

15 Wisconsin Tax Bulletin 156 (Apr. 2008), Missouri Department of Revenue Letter Ruling 5309 (Dec. 2008), and California Technical Advice Memorandum 2011-03 (Apr. 13, 2011).

16 Cluck v. Hester et al., 521 S.W.2d 845 (Texas 1975).

17 See In re Request for Advisory Opinion Regarding Constitutionality of 2011 PA 38, 806 NW2d 683 (Mich. 2011).

18 Billy Hamilton, "What Did the MTC Think and When Did They Think It?" State Tax Notes, Dec. 3, 2012, p. 751.


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