The most recent challenge to the Texas franchise tax system comes up short on today’s orders list. That was the only decision issued by the Court; it did not grant review in any new cases.
, No. 12-0518
Divided 6-2, the Texas Supreme Court upheld the state franchise tax (now known as the “margins tax”) against a constitutional challenge brought by Nestle.
Justice Hecht’s majority opinion contains a detailed explanation of the formula behind the franchise tax (as well as its history in Texas). For purposes of this case, the key step of the formula is a choice between a 0.5% tax rate (applied to retail and wholesale operations) and a 1.0% tax rate (applied to everyone else).
The core of Nestle’s argument was that the tax unfairly set its tax rate at 1% because of its out-of-state manufacturing operations, rather than 0.5% based on what it actually did inside Texas (distribute products it made elsewhere).
Nestle manufactures and distributes food and beverages in the United States. Although Nestle’s business in Texas is confined to wholesale and retail activities, its manufacturing business in other states subjects it to the 1% Texas franchise tax rate, rather than the lower 0.5% rate applicable to wholesalers and retailers.
Nestle challenged this tax under four constitutional provisions: (1) the requirement of the Texas Constitution that taxes be “equal and uniform”; (2) the Equal Protection Clause; (3) the Due Process Clause; and (4) the dormant Commerce Clause.
Equal and Uniform
The Texas Constitution, like that of many other states, requires that property and occupation taxes be “equal and uniform” on all items similar to one another. The Texas Supreme Court has, traditionally, deferred to the legislature about how to classify items as similar or dissimilar.
The State argued that the Legislature’s classifications should be subjected only to a rational-basis test, among the lowest levels of constitutional scrutiny. The Court today rejects that formulation, instead reaffirming the limits on the Legislature’s choices in tax policy:
The Legislature may pursue policy goals through tax legislation, but only goals related to the taxation. The franchise tax may be used to advance policies relating to doing business in Texas, but it cannot be used, for example, to circumvent the requirement that the ad valorem property tax be based strictly on property value. Further, tax classifications must not only be rational but must attempt to group similar things and differentiate dissimilar things. Further, the franchise tax’s classifications must relate to differences in doing business that affect the value of the privilege.
Ultimately, however, the Court concluded that the distinctions drawn by the Legislature were sensible enough. (The Court’s explanation was that “the Legislature could conclude … a taxpayer’s Texas business would benefit from its manufacturing activity out-of-state.”) The Court thus concluded that the Legislature’s structuring of the franchise tax was reasonably related to its object of having equal and uniform taxation.
Dormant Commerce Clause
Nestle argued that the Texas franchise tax discriminated against it for being an out-of-state manufacturer and thus violates the U.S. Constitution’s “dormant Commerce Clause” — a prohibition on individual states discriminating against interstate commerce without the permission of Congress.
Examining this case, however, the Texas Supreme Court held that what mattered was that Nestle was a manufacturer — that is, the nature of its business — not that those facilities were located out of state.
The Court noted that an in-state manufacturer would pay the same rate as Nestle, and that an out-of-state wholesaler would pay the lower rate. So the discrimination being made was not against out-of-state companies but rather between two different lines of business, which does not offend the Commerce Clause.
When the federal Due Process Clause is applied to taxation, the concern is with notice and proportionality — is the State trying to tax something beyond its reach?
Here, the Court asked whether “the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state.” In concluding that the Legislature had not overstepped its bounds, the Court looked to a 1939 decision of the U.S. Supreme Court, Ford Motor Co. v. Beauchamp, which had approved taxes based on corporate property outside of a state (here: the manufacturing process) if that property was “correlated in use” to property taxed within the state (here: the goods being distributed).
Because Nestle’s out-of-state manufacturing activities were related to the very goods it was shipping inside Texas, the Court rejected Nestle’s arguments that Texas had overstepped the limits set on the power of individual states by the Due Process Clause.
When invoked in tax cases, the Equal Protection Clause usually asks whether the classifications drawn between taxpayers furthers some legitimate legislative purpose. Because the Court had already analyzed this question in terms of Texas’s stricter state-law limit on “equal and uniform” taxes, the outcome was clear:
“Nestles concedes, and we agree, that a failure of its challenge based on the Equal and Uniform Clause forecloses its Equal Protection challenge.”
The dissenting opinion
Justice Willett and Justice Lehrmann joined a short dissent from the Court’s opinion, repeating their view , No. 11-0589 that the Court does not have jurisdiction to consider this type of “direct appeal” mandamus action.