News and Insights

Earned Surplus Throwback Takes a Hit From the Texas Court of Appeals

Tax Development Aug 07, 2005

On July 28, 2005, the Third District Court of Appeals (the "Court") issued an Opinion in Home Interiors & Gifts, Inc. v. Strayhorn, No. 03-04-00660-CV, 2005 Tex. App. LEXIS 5908 (Tex. Ct. - App. July 28, 2005) reversing the district court's grant of summary judgment to the Comptroller. The primary issue involved is whether the earned surplus throwback provision of the Texas franchise tax unconstitutionally burdens interstate commerce as a result of unfairly apportioning the tax base.

The throwback provision in Texas Tax Code Sec. 171.1032(a)(1) includes sales of tangible personal property shipped from Texas into other states as Texas receipts to apportion net taxable earned surplus if the taxpayer is not subject to any tax on, or measured by, net income in another state. The Court concluded that the interplay of the earned surplus and taxable capital components of the franchise tax, coupled with the workings of Public Law 86-272, resulted in a hypothetical risk of constitutionally impermissible multiple taxation. The Court's reasoning was that sales to another state might be included in Texas receipts if the taxpayer is not subject to an income-based tax in the other state due to Public Law 86-272, but was still subject to a tax on its capital in the other state. Thus, the Court found that due to such a hypothetical scenario, an interstate corporation could be subject to tax that an intrastate corporation would never bear. In essence, the interstate corporation could be subject to both the earned surplus tax in Texas and the taxable capital tax in another state, while a purely intrastate company would never be taxed on both. As a result, the earned surplus throwback provision was held by the Court not to be internally consistent. As a further result, the Court held that the earned surplus throwback provision of the Texas Tax Code did not meet Commerce Clause fair apportionment requirements laid down by the United States Supreme Court in the controlling case of Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). The Court suggested that a prospective credit or other curative action by the legislature could correct the flaw.

It is likely that the Comptroller will file a petition for review with the Texas Supreme Court. Consequently, the resolution of the matter may not yet be final. However, for any report year for which limitations may run in the interim, a protective refund claim should be filed to preserve the issue.