Capitol Offenses

Did the state comptroller settle a lawsuit she shouldn?t have?


U.S. Tobacco has been kind to State Comptroller Carole Keeton Rylander. Just prior to this legislative session, her campaign collected $2,500 from the company, the nation’s leading manufacturer of snuff. And Rylander has been kind in return: In her capacity as steward of the state tax code, she brought a measure to the Legislature that would have dramatically increased taxes on U.S. Tobacco’s competitors, which have been slowly chipping away at the company’s virtual monopoly in Texas. When Rylander appeared in the Senate Finance Committee in March to personally explain the need for the bill, U.S. Tobacco could almost smell its market share rising like a freshly baked loaf of bread.

But a funny thing happened on the way to the bakery.

Rylander’s proposal would have changed the way excise taxes are collected on smokeless tobacco (including snuff, chaw, and roll-your-own varieties) from a price-based standard, which is used by most states, to a weight-based standard. Currently Texas tobacco distributors pay a tax equal to roughly 35 percent of the price they pay the manufacturer for the goods. U.S Tobacco’s products include the top-selling Skoal and Copenhagen brands of snuff. Their chief competitors are discount brands, which sell an inferior grade of tobacco at a much cheaper price. This means the excise tax on their brands is much lower, as is the price to the consumer. Switching to a weight-based standard would erase that competitive advantage, forcing distributors to pay much higher taxes on discount brands, and thus forcing the retail price up. Under Rylander’s proposal, taxes on U.S. Tobacco’s products would rise slightly, but taxes on discount brands would skyrocket, almost surely damaging their market share and increasing U.S. Tobacco’s, which already controls 81 percent of the market in Texas. U.S. Tobacco’s effort in Texas is part of a national lobbying campaign to get states to switch to a weight-based standard.

This is where things started getting strange. One reason that Texas needed to switch to a weight-based standard, argued Rylander, was to avoid lawsuits like the one she recently settled with McLane Company, a Temple-based distributor of food and tobacco products founded by Drayton McLane, the billionaire owner of the Houston Astros. McLane sued the Comptroller’s office to recover what the company claimed was an overpayment of excise taxes totaling $26.5 million. The dispute hinged on how the tax should be calculated on products McLane purchased from U.S. Tobacco. Specifically, McLane and the Comptroller’s office could not agree on the definition of “manufacturer’s list price.” The solution, according to Rylander, was to settle with McLane, which the Comptroller did last summer for an undisclosed amount, and to simplify the entire process by switching to a weight-based standard. End of story.

But some legislators detected something rotten about this deal. Drayton McLane is not only one of the richest men in America, he’s also Carole Keeton Rylander’s long-time campaign treasurer, fund-raiser, and political confidant. As recently as last fall, shortly after Rylander agreed to settle the suit, McLane was raising money for her possible race for Lieutenant Governor. (She has since announced she will instead run again for Comptroller.) McLane sold his distributorship to Wal-Mart Stores, Inc. in 1991, but continued to run the company as a Wal-Mart subsidiary until 1995. He remains one of Wal-Mart’s largest shareholders. The amount of money Rylander agreed to give McLane Company has been sealed, but with interest it could be as high as $35 million.

This is not the first time McLane has petitioned the state for a tobacco excise tax rebate. The company has been making the same excise tax argument since 1994. McLane petitioned for and received at least three separate administrative hearings, first before the state treasurer’s office (before that office was abolished), then before the comptroller’s office, headed by then-Comptroller John Sharp. Yet McLane received nothing for its efforts. An administrative law judge ruled against the company each time, most recently on December 17, 1998. But good things come to those who wait. Two weeks after McLane’s final rejection, John Sharp was replaced by Carole Keeton Rylander, and things started looking up. This time the company filed suit in District Court in Austin, making almost exactly the same argument they had made in each of their previous administrative hearings. By the summer of 2000, they had their settlement. The difference, apparently, was Rylander.

But Rylander, who once campaigned as the “World’s Toughest Grandma,” doesn’t seem too concerned about the perception that she gave in too easily in the McLane suit. In fact, in a characteristically brash move, she brought representatives from McLane, along with several other distributors, to Austin to testify on behalf of her excise tax bill. The hearing before the House Ways and Means Committee on April 4 provided some interesting theater. Testifying in support of the House version of Rylander’s bill (H.B. 3382), McLane president Kevin Koch explained that he was present to fulfill a promise he made to the Comptroller during the recent settlement negotiations. Houston Republican Talmage Heflin, a long-time Ways and Means committee member and tax expert, found Koch’s advocacy curious. After all, why did McLane, a distributor, care about the amount of excise tax collected on competing brands? To be sure, as a distributor, the company had to pay the tax, but didn’t they simply pass that cost along to the retailers, who in turn passed it on to the end customers?

“So you do recoup your tax when you sell to the retailer, right?” Heflin asked. But Koch hedged. “I didn’t say that, Representative,” he told Heflin. There followed a 10-minute grilling, in which Heflin attempted to force Koch to admit that excise taxes were just like any other overhead cost, and Koch hemmed and hawed and generally evaded the question (see sidebar). Finally, exasperated, Heflin gave up. “I’m havin’ a hard time understandin’ why you can’t be straightforward with me,” he said.

The answer may lie in the pleadings of McLane’s suit against the Comptroller. Under the state tax code, no taxes can be refunded to a taxpayer who has in turn collected the taxes from another person, unless the taxpayer seeking the rebate has refunded all of the taxes to the person he passed them on to. In other words, if McLane passed on the cost of the excise tax in the form of higher prices to its retailers, it is not entitled to a refund. In that scenario, it would be the retailers (or, as Rep. Senfronia Thompson pointed out at the Ways and Means committee hearing, perhaps the people that actually bought the snuff) that would be entitled to the refund. Accordingly, McLane swore in its pleadings that it did not “collect these taxes from any of its customers by adding the tobacco products tax to the sales prices it charged its customers.” Thus, the company’s lawyers argued, any refund coming was due McLane, not the retailers or the customers.

Rylander apparently found this argument persuasive. Heflin did not.

“You make a profit. You do recover the cost of your taxes when you sell your product, otherwise you wouldn’t make a profit,” he all but shouted at Koch. Later, after Koch slunk away and other distributors came forward to testify, each made a point of telling Heflin that they did, in fact, pass the cost of the excise tax on to the retailers. How could they not? (They did favor an easier system of paying excise taxes, however, and supported Rylander’s bill, which they felt would simplify the system.)

Reached at his Austin office, McLane attorney Gilbert Bernal conceded that the company’s basic argument, rejected three times previously, hadn’t changed in the most recent suit. Still, he dismissed the notion that the change in comptrollers had any bearing on McLane’s ultimate success. Rylander spokesperson Mark Sanders dismissed the conflict of interest argument as well. Sanders told the Observer that the Attorney General’s office advised Rylander to settle. Asked about this version of events, a spokesperson for the AG’s office declined to confirm it, citing “attorney-client privilege.”

In the end, Rylander’s tax revision failed to make it out of committee in either chamber. The big loser was U.S. Tobacco, which had invested in a six-figure lobbying effort. Another loser was the state budget, at least in the short term. In her initial projections, Rylander had counted on collecting an additional $18 million over the next biennium from the bill, which would have created a temporary bubble in the tobacco excise tax revenue. In the long run though, the bill would have cost the state considerably, since the amount of excise tax collected rises with inflation under the current price-based system; it would have been capped under a weight-based system.

The big winner was McLane, which, despite the embarrassing grilling in Ways and Means–and the light shined on a legal maneuver that looked a lot better in the dark–already has its settlement safely in hand. And, of course, the satisfaction of beating one tough grandma.