In Universal Frozen Foods Co. v. Rylander, No. 03-01-00646-CV, 2002 Tex. App. LEXIS 3455 (Tex. App.-Austin 2002, no pet. h.), the Austin Court of Appeals sustained the additional Texas franchise tax imposed under § 171.0011 of the Texas Tax Code, the so-called "Exit Tax." The decision is the latest round in a series of taxpayer challenges to the this controversial assessment on companies that cease doing business in the state.
The Exit Tax and Recent Taxpayer Challenges
Section 171.0011 of the Texas Tax Code states that "[a]n additional tax is imposed on a corporation that for any reason becomes no longer subject to the earned surplus component of the tax, without regard to whether the corporation remains subject to the taxable capital component of the tax." The Exit Tax is equal to 4.5 percent times net taxable earned surplus (i.e., generally, net income) earned by a corporation since the day it last computed its Texas franchise tax liability.
The Legislature enacted the Exit Tax, presumably, to prevent income earned in Texas from escaping taxation as a result of the somewhat unique manner of computing the franchise tax. Since 1992, a corporation subject to the franchise tax is required to compute: 1) tax due on its net taxable capital; and 2) tax due on its net taxable earned surplus. A corporation calculates its tax base based on its prior accounting year. However, the corporation pays the franchise tax for the privilege of engaging in business during the current year.
To illustrate, assume that a corporation is doing business in Texas during 2002. The corporation has a calendar year end. In calculating its 2002 Texas franchise taxes, the corporation computes the tax base based on its previous accounting year, January 1, 2001, through December 31, 2001. It pays the franchise tax based on its 2001 operations, for the privilege of engaging in business in Texas during 2002. The return and the tax are due, unless otherwise extended, on or before May 15, 2002.
Now, suppose the corporation in the example dissolves or ceases to do business in Texas on December 31, 2002. After December 31, 2002, the corporation will no longer be subject to the Texas franchise tax. It will not owe any franchise taxes for the privilege of engaging in business in Texas during 2003 because it didn’t engage in any business in Texas in 2003. If not for the Exit Tax, all of the income earned by the corporation in Texas from January 1, 2002 (the day after the last day on which it computed franchise taxes) through December 31, 2002, would escape taxation. In this example, the Exit Tax would apply to that income.
Taxpayers and tax practitioners have complained about the Exit Tax since it was enacted. One of their chief complaints has been that the Exit Tax results in double taxation. Using the facts in the example above, the corporation paid for the privilege of engaging in business in Texas in 2002 (for all of the year) when it filed its regular 2002 franchise tax return. When it filed its 2002 return, it paid for the right to earn all of the income that it actually earned in Texas during 2002. Under the Exit Tax, as the argument goes, it is being forced to pay for the privilege of earning that income a second time. Faced with this perceived double taxation, many taxpayers faced with the Exit Tax have asked why they should be forced to pay for the same privilege twice.
These growing complaints about the Exit Tax resulted in a flood of recent judicial challenges to the Exit Tax. However, the courts, thus far, have sustained the tax.
Strike One: The B&A Marketing decision
Rylander v. B&A Marketing Co., 997 S.W.2d 326 (Tex. App.-Austin 1999, no pet.) was one of the first Exit Tax cases to reach the Austin Court of Appeals. In B&A Marketing, a calendar year end taxpayer that had dissolved challenged the Exit Tax, in part, as an unconstitutional double tax. The Court disagreed, and sustained the tax. The Court reasoned:
First, the additional tax does not constitute double taxation. The additional tax is a tax on profits earned in Texas but not subject to the state’s franchise tax. Although the tax is essentially an income tax, it is not improper that the statute is included in the Franchise Tax Act.
B&A Marketing, 997 S.W.2d 326, 334.
Strike Two: The Beall Brothers decision
Rylander v. 3 Beall Brothers 3, Inc., 2 S.W.3d 562 (Tex. App.-Austin 1999, pet. denied) was the next Exit Tax case to reach the Court. Bealls operated department stores in Texas. Bealls used a fiscal year accounting period ending on the Saturday nearest to January 31. Thus, for the privilege of engaging in business in Texas during the 1993 calendar year, Bealls paid the Texas franchise tax based on its operations from February 3, 1991, to February 1, 1992. Bealls was merged into another corporation on August 2, 1993. Under the Exit Tax, because it had adopted a non-calendar accounting year end, Bealls owed taxes based on the income it earned in Texas from February 2, 1992, through August 2, 1993, an eighteen month period.
Bealls filed suit challenging the Exit Tax. Bealls argued, primarily, that the Exit Tax violated its rights to equal protection and equal and uniform taxation under the U.S. and Texas Constitutions, respectively, because a calendar year end taxpayer that had similarly merged on the same date would have only owed taxes on income earned over a seven month period (January 1, 1993, through August 3, 1993).
The Court once again rejected the taxpayer’s arguments and sustained the Exit Tax. The Court distinguished the facts in Beall Brothers from the facts of earlier cases in which the taxpayer had prevailed on equal protection grounds principally because Bealls, and not the Comptroller, had elected to be a fiscal year end taxpayer. According to the Court:
There is no doubt that Bealls’ choice to be a fiscal year taxpayer resulted in a greater additional tax burden to Bealls than would have been assessed had Bealls chosen to be a calendar year taxpayer. Nonetheless, a tax system that results in one party paying a disproportionately higher tax is not inherently unconstitutional so long as the legislation is rationally related to a legitimate governmental goal and the system operates equally within each class. . . . [T]he additional tax applies evenhandedly [within each class] because the amount of tax is always based upon the period of previously untaxed earned surplus. . . . We cannot say that the Comptroller’s decision to assess the additional tax on the period of previously untaxed earned surplus was irrational or unreasonable.
Beall Brothers, 2 S.W.3d 562, 568-70.
Strike Three: The Universal Frozen Foods decision
Universal Frozen Foods was a subsidiary of Universal Holdings, Inc., which itself was a subsidiary of Universal Foods Corporation. Universal Foods Corporation, the group’s ultimate parent, filed a consolidated federal income tax return on behalf of all members of the group. The group used a non-calendar fiscal year end. Universal Frozen Foods was the only member of the group doing business in Texas. As such, it was required to pay Texas franchise taxes on the income it realized from Texas sources.
Universal Frozen Foods ceased doing business in Texas on August 1, 1994, when it was sold and merged into one of the purchasing corporation’s subsidiaries. The parties to the sale and merger elected to treat the stock sale as a deemed asset sale under IRC § 338(h)(10). Thus, for federal income tax purposes, the so-called "old target corporation" was required to recognize, in general, the net built-in gain in its assets.
After the merger, Universal Frozen Foods was no longer subject to the Texas franchise tax. As a result, the Comptroller assessed the Exit Tax against Universal Frozen Foods. The Comptroller included in the assessment the IRC § 338(h)(10) gain.
Universal Frozen Foods protested the assessment on two grounds. First, it claimed that the Exit Tax violated its right to equal protection since it (as a fiscal year corporation) owed more taxes than a calendar year corporation would have owed under otherwise identical facts. The Court rejected the argument, noting that the "first issue appears to be controlled by Rylander v. 3 Beall Brothers 3, Inc., 2 S.W.3d 562 (Tex. App.-Austin 1999, pet. denied)." 2002 Tex. App. LEXIS 3455 *5. Universal Frozen Foods argued that unlike Bealls, it did not select its fiscal year end. Rather, it was forced to adopt a fiscal year end by its parent corporation. The Court rejected the argument, writing that "Universal’s argument overlooks the fact that Universal’s parent has voluntarily made an election and that election was not the result of any agency action by the Comptroller or any other governmental authority." 2002 Tex. App. LEXIS 3455 *8.
Having lost on its first ground, Universal Frozen Foods claimed that the Comptroller had unlawfully included the § 338(h)(10) gain in its taxable earned surplus, when the gain in fact resulted in net income to its parent corporation. Universal Frozen Foods’ rationale, according to the Court, was that its parent corporation ultimately owned all of Universal Frozen Foods’ assets, and so any gain realized in a deemed sale of those assets belonged to the parent corporation. The Court rejected the argument because it contravened § 171.110 of the Tax Code, which prohibits the use of consolidated reporting for franchise tax purposes. Rather, the Court held that Universal Frozen Foods was required to compute its franchise taxes based on its own financial condition. Universal Frozen Foods, admittedly, recognized a gain under § 338(h)(10) on the deemed sale of its assets.
Conclusion
We will have to wait and see if the Universal Frozen Foods case finally puts an end to this issue. However, there are several cases waiting judgment on the issue, and it is possible that any one of them might go forward on different facts.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.