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Updated: Texas Supreme Court Hears Franchise Tax Suit

The Supreme Court of Texas heard arguments Tuesday in a case challenging the constitutionality of the state's primary business tax, a case that could have major implications for the way the state funds schools.

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UPDATE, 10:24 a.m.:

A challenge to the state’s primary business tax went before the state’s highest civil court on Tuesday and a decision from those judges could set the course and tone of next year’s legislative session.

Nestle’s lawyers argue that the only way to leave the tax in place would be to disregard the state constitution’s declaration that taxes should be equal and uniform. The state argued that the franchise tax is set up with various classifications and adjustments in order to make sure that it’s equal and uniform. The state’s lawyer told the court that the company would get a windfall if the case went its way, since it would still have the deductions allowed to manufacturers but would not pay the tax at the same rate as other manufacturers.

The court should rule before the end of the year and, importantly, before the beginning of the next regular legislative session. The franchise tax isn’t the state’s biggest source of revenue — that honor goes to the sales tax. But it’s a major one: The comptroller expects the franchise tax to bring in $5.5 billion this year. It was devised in a 2006 special session after several failed attempts to replace the state’s old business tax, and it has been under assault ever since.

That 2006 solution was part of a school finance rewrite that had the state lowering local school property taxes and adding to what the state spends on local schools. If the Supreme Court knocked down the franchise tax, lawmakers would be forced to look for the money somewhere or to rework the school finance formulas and make cuts in education or other state spending.

That’s not the end of the Legislature’s worries on that subject. Several challenges to the state’s school finance system have been combined and set for argument in state district court in October; those are expected to end up, on appeal, before the Supreme Court sometime next year.

Original story:

The Supreme Court of Texas will hear arguments Tuesday in a case that could change the way Texas taxes businesses and has implications for the way the state funds schools.

Food giant Nestle USA and two Texas-based companies, Switchplace LLC and NSMBA Relators, have sued the state, claiming the Texas franchise tax violates the businesses’ constitutional rights on both the state and federal level. The state of Texas, in court documents, disagrees and says it has the authority to apply differing tax rates.

Texas lawmakers revamped the state franchise tax in 2006 when they were overhauling the state's school finance provisions. The revision expanded the kinds of businesses subject to the tax, making eligible companies like Nestle and Allcat Claims, an insurance adjustment firm that also sued the state last year. In the first two years after the revision, the tax brought in nearly $9 billion.

Dale Craymer, president of Texas Taxpayers and Research Association, says the suit boils down to questions over equal treatment.

Craymer explains the franchise tax charges one-half of 1 percent to wholesalers but a full 1 percent to businesses engaged in manufacturing. Nestle, a national manufacturer and wholesaler, does not manufacture anything in Texas, but is still subject to the 1 percent rate.

The company claims the distinction violates equal protection provision in the Texas and U.S. constitutions.

Texas designates Nestle and the other companies in the suit as “unitary entities,” or companies that have various components but operate as one organization. Unitary entities are subject to the 1 percent tax rate under current franchise tax rules that were revised in 2006.

Texas has had a version of the franchise tax since the 19th century. Sometimes called the margins tax, it’s a tax on doing business in Texas. Craymer says the dollars it brings in “generally pale in comparison to property and sales tax” on businesses.

Lawyers for the Texas Attorney General's Office wrote in a brief to the court that Nestle’s equal-protection challenges hinge on an erroneous premise that the franchise tax was solely meant to cover the value of doing business in Texas and that the value should be assessed as if it were property. But, they wrote, the Legislature has wide latitude to create tax classifications. 

According to court documents, the Texas Supreme Court turned down a similar claim by Nestle in January 2012 based on a procedural technicality. 

Though the case may seem arcane, Craymer says it is significant. “The Supreme Court doesn’t have a long history of trying tax cases,” he says. “Every time they do, it makes history.”

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