On July 29, 2011, Allcat Claims Services, L.P. (Allcat) and one of its individual partners filed a petition with the Texas Supreme Court seeking a declaratory judgment that the Texas margins tax (TMT) is unconstitutional under the Bullock Amendment of the Texas Constitution. In re Allcat Claims Service, L.P. and John Weakly, No. 11-0589. Tax practitioners have anticipated this challenge since the TMT was first enacted in 2006. The legislature also anticipated this type of challenge and created a special procedure whereby any challenge to the constitutionality of the TMT is filed directly with the Texas Supreme Court for expedited review.1 Regardless of whether the Texas Supreme Court will strike down the TMT in its entirety, the court’s decision could have significant implications for many corporate taxpayers. In this Legal Alert, we summarize the legal issues and ramifications of the Allcat challenge.
Is the TMT Constitutional?
Article VIII, § 24(a) (known as the Bullock Amendment) of the Texas Constitution provides that:
A general law enacted by the legislature that imposes a tax on the net incomes of natural persons, including a person’s share of partnership and unincorporated association income, must provide that the portion of the law imposing the tax not take effect until approved by a majority of the registered voters in a statewide referendum held on the question of imposing the tax [emphasis added].
Texas voters never approved the TMT, and its constitutionality therefore turns on two issues: (1) whether the TMT is an income tax, and (2) whether it is imposed on a natural person’s share of partnership income.
Tax Classification: Is the TMT a Tax on Net Income?
The Texas Constitution does not define the phrase “tax on . . . net incomes,” and Allcat proposes three potential definitions. First, the Multistate Tax Compact (MTC), adopted in full by Texas in Texas Tax Code Ann. § 141.001 and in effect at the time the TMT was enacted, 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 are not specifically and directly related to particular transactions.”2 Under this definition, Allcat argues, the TMT should be classified as a net income tax, because the tax is generally calculated by computing gross income, making specified adjustments, and then deducting either cost of goods sold (COGS) or compensation.3 Both the COGS and compensation deductions include expenses to be deducted from gross income that are not “specifically and directly related to particular transactions.” For example, the COGS deduction includes items such as utility charges, insurance costs, and employee benefits, all of which are general overhead-type costs unrelated to a specific transaction.4 Similarly, the compensation deduction includes administrative or back-office staff salaries unrelated to any particular transaction.
Allcat also references similar definitions of an income tax set forth in Black’s Law Dictionary (income tax is “a tax on . . . total income from all sources minus deductions, exemptions, and other tax reductions”) and by the U.S. Supreme Court5 (income tax is one that taxes profitable businesses more than unprofitable ones), arguing that all of the definitions of “a tax on net incomes” are satisfied.6
Sutherland Observation: The question of whether to characterize the TMT as an income tax has been the subject of substantial debate. Former Texas Comptroller Carole Keeton Strayhorn concluded it was an income tax.7 Also, other states characterize it as an income tax for purposes of determining whether it is deductible for other states’ income taxes (including California, Kansas, Missouri, South Carolina, and Wisconsin).8 And, the Financial Accounting Standards Board (FASB) concluded it is an income tax for financial accounting purposes.9 However, others believe that the TMT is not an income tax, primarily because companies have to pay the tax even in years when no profit is earned. For example, former Comptroller John Sharp, who chaired the Texas Tax Reform Commission, testified that the TMT was not an income tax because a company could lose money and still pay the tax.10
The Attorney General’s litigation strategy appears to be to avoid having the court rule on whether the TMT is a net income tax. Rather, the Attorney General’s response to Allcat’s petition dismisses the issue of whether the tax is an income tax, arguing that it “makes no difference” because the true issue is whether the TMT is a tax “on the net incomes of natural persons” or one imposed on business entities.
Sutherland Observation: A ruling on the issue of whether the TMT is a net income tax could open the door to refund claims by corporate taxpayers claiming protection under P.L. 86-272 or electing to apportion income under the Multistate Tax Compact’s three-factor formula, as discussed below.
Tax Target: Is the TMT a Tax on a Person’s Share of Partnership Income?
The Bullock Amendment’s second element requires that the tax be imposed on the “net incomes of natural persons, including a person’s share of partnership and unincorporated association income.” Allcat argues that “Texas indirectly imposes the [TMT] on each partner by allocating a share of a partnership’s profits to each partner” under Texas partnership law.11 In this regard, the Texas Revised Partnership Act provides that a partnership interest includes “the partner’s share of profits and losses” and that “[e]ach partner is entitled to be credited with an equal share of the partnership’s profits.”12 Thus, Allcat concludes that because the TMT is paid by the partnership itself, the TMT directly reduces (1) each partner’s distributive share of income in proportion to his/her profit and loss interests in the partnership, and (2) each partner’s values and liquidation rights in the partnership interests.13
The Attorney General counters that the TMT does not run afoul of this element because it “taxes total revenue . . . of ‘taxable entities’ while that revenue is still maintained in the entity’s coffers.”14 Texas law provides that “[a] partnership is an entity distinct from its partners.”15 Under the state’s view, because Texas imposes the TMT on entities and does not follow federal tax law passing through income from a partnership to its partners, the TMT is imposed at the entity level and is not a tax on a “person’s share of partnership . . . income.”16
Potential Outcomes and Their Implications for Corporate Taxpayers
If the court finds that the TMT violates the Bullock Amendment, it has two options. First, the state has argued that if the taxpayer is successful, the court should find that those portions of the statutes which impose the TMT on a natural person’s share of partnership income are unconstitutional and leave the remaining TMT intact.17 Even this “limited remedy” could have significant ramifications.
The most extreme possible outcome of a ruling in favor of the taxpayer would be to strike down the entire TMT as Allcat has requested. This result may occur if the court determines that invalidating a portion of the TMT prevents the TMT from being applied in a manner consistent with the enacting legislature’s intent.18 This happened, for example, with California’s dividends received deduction in the Farmer Brothers and Abbott Laboratories cases.19
Sutherland Observation: The possible invalidation of the entire TMT raises interesting questions. The TMT was enacted by modifying the previous franchise tax, rather than repealing the former tax and replacing it with an entirely new tax. If the TMT’s enacting law (H.B. 3, as modified by H.B. 3928) were found to be unconstitutional in its entirety, then the franchise tax statutes may revert back to the previous Texas franchise tax as it existed prior to the enactment of the TMT. Taxpayers subject to the TMT could file refund claims for any TMT paid, but it would appear that the Comptroller could then recompute and assess taxpayers under the old franchise tax.
Another possibility is that Allcat could simply lose its case on all grounds and the status quo would be maintained. However, if the court finds that the TMT is an income tax, either in striking some or all of the TMT or in ruling against Allcat but finding that the first element of the Bullock Amendment is met, such a ruling will have two potentially significant impacts on corporate taxpayers.
The first and most obvious result would be that taxpayers may claim P.L. 86-272 protection (activities limited to the solicitation of sales of tangible personal property) and file refund claims for all taxes paid under the TMT and cease filing prospectively. The TMT itself states that it “is not an income tax, and P.L. 86-272 . . . does not apply.”20 A ruling by the court that the TMT is, in fact, an income tax would make clear that P.L. 86-272 (which is limited by its terms to income taxes) does apply. Combined groups with members able to claim P.L. 86-272 protection would benefit as well because Texas is a Joyce state,21 which means that only members of the combined group with nexus in the state must include sales in the Texas sales factor numerator of the apportionment calculation.
Another potential impact is that taxpayers could be permitted to make an election to apportion their income using a different and potentially more favorable formula. Texas has adopted the MTC in full, and the statute provides an election for taxpayers to apportion their income to Texas using the MTC’s equally weighted three factor formula rather than the TMT’s single sales factor formula. The MTC election, however, only applies to the TMT to the extent it is an income tax under the definition discussed above. The Comptroller has taken the position that the election “does not apply to the [TMT],”22 because, in the state’s view, the TMT is not an income tax under the MTC definition. However, the court’s possible ruling on this issue could foreclose the Comptroller’s position and allow taxpayers to make the MTC apportionment election.