After Home Interiors & Gifts v. Strayhorn, when are a corporation's sales thrown back to Texas for the earned-surplus franchise tax?

Plain-English summary

This is an internal audit-procedure memo (AP 114) to all Comptroller audit staff, changing how the earned-surplus throwback rule is applied after the Texas Supreme Court decision in Home Interiors & Gifts, Inc. v. Strayhorn.

• Old earned-surplus rule. Receipts were thrown back to Texas if the corporation was not subject to a tax on or measured by net income in the destination state — and, critically, prior audit procedure threw the receipts back even if activity there was protected by Public Law 86-272 (which shields mere solicitation of sales of tangible personal property from a net-income tax), so long as the seller had constitutional nexus.
• New rule after the case. Sales protected by PL 86-272 are no longer thrown back for the earned-surplus component. The Comptroller now applies the same constitutional-nexus standard it already used for the taxable-capital component: if the seller has enough contact that the other state could tax it, the sale is not thrown back.
• Still thrown back: sales into states where the seller has no nexus at all continue to be thrown back to Texas.

Refund conditions. Refunds apply to the earned-surplus component only, and the taxpayer bears the burden of proving it was subject to tax (or had protected solicitation) in the other state (Rule 3.357(e)(37)(I)). Merely holding a certificate of authority, or having voluntarily paid tax elsewhere, is not sufficient proof of nexus; the taxpayer must produce actual documentation of solicitation during the relevant accounting period.

Important currency note: This memo describes the pre-2008 franchise tax and its earned-surplus component. The 2007 legislation (House Bills 3 and 3928) replaced that tax with the current margin tax effective January 1, 2008. Treat this as historical guidance and confirm current apportionment and throwback rules.

What this means for you

Corporations that shipped goods from Texas under PL 86-272 protection

If, for open pre-2008 report years, you threw back sales to Texas for earned surplus even though your out-of-state activity was protected by PL 86-272, this memo signals you may have been entitled to a refund — but only with solid documentation of your solicitation activity in those states.

Accountants and auditors

The key takeaway is the alignment of the two components: after Home Interiors, earned-surplus throwback uses the constitutional-nexus test, not the old "subject to a net-income tax" test. Documentation standards are strict — expense reimbursement alone will not substantiate solicitation.

Common questions

Q: What changed after Home Interiors & Gifts v. Strayhorn?
A: Texas stopped throwing back earned-surplus sales that were protected by PL 86-272 in the destination state, matching the constitutional-nexus standard used for taxable capital.

Q: Which sales are still thrown back to Texas?
A: Sales into states where the seller had no nexus of any kind.

Q: Is a certificate of authority enough to prove nexus elsewhere?
A: No. Neither a certificate of authority nor voluntary payment of tax proves nexus; the taxpayer must document actual solicitation in the other state.

Citations and references

Statutes and rules:

• Tex. Tax Code Sec. 171.1032(a)(1) (earned-surplus throwback of receipts to Texas)
• Franchise Tax Rule 3.564 (Taxable Capital: Nexus)
• Franchise Tax Rule 3.554 (Earned Surplus: Nexus)
• Franchise Tax Rule 3.357(e)(37)(I) (taxpayer bears the burden of proving it is subject to tax in the other state)

Case: Home Interiors & Gifts, Inc. v. Strayhorn (Texas Supreme Court).

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200710433L

Original ruling text

AP 114

Date: October 9, 2007
To: All Audit Staff
From: David Rock, Audit HQ
Subject: Earned Surplus Throwback

Audit procedures relating to earned surplus throwback have changed, effective
immediately and retroactive for report periods within statute of limitations,
due to the Texas Supreme Court case Home Interiors & Gifts, Inc. vs. Strayhorn,
et al.

SUMMARY OF NEW AUDIT PROCEDURE

As a result of this court case a number of refunds are expected. Refunds
granted on this issue will be limited to taxpayers with earned surplus
throwback where the taxpayer can prove they had solicitation in the other state
and throwback receipts were reported to Texas for earned surplus franchise tax
for report periods in statute. For those states in which the taxpayer had
people soliciting sales of tangible personal property but were protected by
Public Law 86-272, taxpayers will have to recalculate their franchise tax
liability without throwing sales back for the earned surplus component. Sales
in states in which a taxpayer had no nexus will continue to be thrown back to
Texas for earned surplus apportionment purposes. In other words, we will now,
in effect, apply the same standard for earned surplus throwback that we have
been applying for taxable capital throwback.

THROWBACK DISCUSSION

Taxable Capital
Sales are thrown back if the corporation is not subject to tax in the
purchaser's state. For taxable capital, subject to taxation means
constitutional nexus. Constitutional nexus means the seller does not need to
pay tax to the other state; the seller only has to have enough contact with the
other state so that the other state could tax the seller. If the seller is
doing business or is incorporated in the other state, the seller is subject to
taxation in that state, and therefore, sales of tangible personal property
shipped from Texas to a purchaser in a state in which the seller is subject to
taxation will not be thrown back to Texas. See Rule 3.564, Taxable Capital:
Nexus.

Earned Surplus (old policy)
For earned surplus purposes, sales were thrown back to Texas if the corporation
was not subject to any tax on, or measured by, net income, without regard to
whether the tax was imposed; see TX Tax Code Ann [section] 171.1032(a)(1).
Prior audit procedure dictated if these activities were protected by Public Law
86-272, then the receipts MUST be thrown back to Texas, even if the seller had
constitutional nexus to be subject to a state tax in general. See Rule 3.554,
Earned Surplus: Nexus.

TAXPAYERS QUALIFYING FOR REFUND

• Taxpayer sold tangible personal property that was shipped from Texas to
  purchasers in one or more other states, and

• Taxpayer was protected by PL 86-272 (from a tax on net income in those
  states), and

• Taxpayer reported sales to those states as throwback sales to Texas, for
  apportioning earned surplus.

REFUND COMPONENTS/ISSUES

Excerpt from Rule 3.357(e)(37)(I), "the corporation or limited liability
company has the burden of proving that it is subject to taxation in the other
state." Therefore, the burden of proof is on the taxpayer to produce evidence
to the contrary.

• Home Interiors refunds are applicable to the Earned Surplus component only.

• Merely holding a certificate of authority in another state is not sufficient
  evidence of nexus in another state.

• Proof of payment of taxes to another state is not sufficient evidence of
  nexus in another state (tax may be voluntarily paid without having nexus
  there).

• If solicitation (PL 86-272 guidelines) occurred in other states, supporting
  documentation must exist and be presented to substantiate solicitation in the
  other state (actual documentation for expenses and receipts are required, not
  just the reimbursement of said expenses).

• The supporting documentation of the selling corporation or limited liability
  company must have occurred during the accounting period upon which the report
  year tax is based.

• If no nexus exists in other states, sales will continue to be reported as
  Texas receipts (thrown back to Texas) using the same criteria as used for
  taxable capital.

If you have any questions, contact the Area Manager of Technical Support, the
Franchise Tax subject matter expert in Audit Headquarters, or the Audit
Headquarters Franchise Tax trainer.

As STAR is the Comptroller's research system for Texas tax policy issues,
only tax-specific audit policy memos (AP Memo) are included here. AP memos
not on STAR can be found on Window on State Government on the
Audit Memos web page.