Defined “Applicable Year” Tax Rate Governs Both Base and Actual Net Operating Profit in Tobacco Settlement Profit-Adjustment Calculations

Commentary on State of Texas v. R. J. Reynolds Tobacco Company, No. 25-40233 (5th Cir. Sept. 1, 2026) (per curiam) (not designated for publication).

I. Introduction

This appeal arises out of Texas’s long-running tobacco settlement litigation. In 1998, Texas reached a settlement agreement with multiple tobacco companies to recover smoking-related healthcare costs. A later “2001 Stipulation of Amendment” (the “2001 Amendment”) governs the ongoing computation of annual payments.

The narrow dispute: how to compute “Base Net Operating Profit” (a synthetic profit benchmark tied to 1997 cigarette profits) when the maximum federal corporate income tax rate changes. After the 2018 reduction of the federal corporate tax rate from 35% to 21%, the parties’ readings diverged:

• Texas (and the district court): “Base Net Operating Profit” is effectively fixed at $3.1151 billion (subject only to inflation adjustment), so the benchmark does not shift with later-year tax rates.
• Tobacco companies: because the agreement’s profit formula uses the “maximum marginal federal corporate income tax rate … in effect on December 31 of the Applicable Year,” the benchmark must be recalculated each “Applicable Year” using that year’s tax rate, for both Base and Actual Net Operating Profit.

The Fifth Circuit reversed, holding that the agreement requires using the tax rate in effect on December 31 of the “Applicable Year” for the profit computation—including when computing the base-year benchmark used for comparison.

II. Summary of the Opinion

III. Analysis

A. Precedents Cited

Although this is a contract-interpretation dispute under Texas law, the opinion is methodical in grounding each interpretive move in established Texas authority.

1) De novo review and objective intent

• Tawes v. Barnes, 340 S.W.3d 419, 425 (Tex. 2011): cited for the proposition that construction of an unambiguous contract is a question of law reviewed de novo. This frames the appellate posture: the Fifth Circuit owes no deference to the district court’s reading if the contract is unambiguous.
• Forbau v. Aetna Life Ins. Co., 876 S.W.2d 132, 133–34 (Tex. 1994): cited for the “primary concern” of giving effect to the written expression of the parties’ intent, considering the contract as a whole, and giving effect to each part without isolating provisions. The court uses this to resist Texas’s attempt to elevate a single illustrative sentence ($3.115 billion) over the definition-driven machinery elsewhere in the text.
• 14 Tex. Jur. 3d Contracts § 228: invoked for the objective-intent principle (objective manifestations govern over subjective intent). This supports the court’s refusal to adopt a reading that would treat the base benchmark as “fixed” when the written definitions point to an annually varying tax-rate input.

2) Extrinsic evidence, ambiguity, and interpretation

• Nat'l Union Fire Ins. Co. of Pittsburgh v. CBI Indus., Inc., 907 S.W.2d 517, 521 (Tex. 1995): cited to distinguish permissible use of extrinsic evidence to interpret language reasonably susceptible to a meaning, from impermissible use to contradict unambiguous text. The Fifth Circuit ultimately finds no ambiguity after applying interpretive rules, thereby cutting against a construction that would rely on external understandings.
• Universal C.I.T. Credit Corp. v. Daniel, 243 S.W.2d 154, 157 (Tex. 1951): provides the operative ambiguity test—ambiguity exists only if applying interpretive rules leaves “genuinely uncertain” which meaning is correct. The court uses this to conclude the agreement is not ambiguous once defined terms and the modifier canon are properly applied.

3) Defined terms control (and courts must honor them)

• 14 Tex. Jur. 3d Contracts § 246: cited for the strong rule that parties’ stipulated meanings for terms control over ordinary definitions, and courts “have no authority” to ascribe a different meaning.
• Provident Life and Accident Ins. Co. v. Knott, 128 S.W.3d 211, 219 (Tex. 2003): reinforces that when terms are defined, those definitions control because they reflect party intent and are integral to contract interpretation. This buttresses the central holding: the defined “Applicable Year” must be applied as written to the tax-rate input.

4) “Surrounding circumstances” and commercial setting (without varying text)

• Hou. Expl. Co. v. Wellington Underwriting Agencies, Ltd., 352 S.W.3d 462, 469 (Tex. 2011): cited for the idea that the parol-evidence rule does not bar considering surrounding circumstances that “inform” but do not contradict the contract. The Fifth Circuit uses this to support the “commercial logic” of its reading—namely, insulating the profit-adjustment mechanism from unrelated tax-driven volatility.

5) Modifier placement and the “last antecedent” doctrine

• Samano v. Sun Oil Co., 621 S.W.2d 580, 581–82 (Tex. 1981): cited for the presumption that modifiers refer to the closest preceding words. This becomes decisive in rejecting Texas’s “absurdity” argument about SEC reporting “for the Applicable Year.”
• Certain Underwriters at Lloyd's of Lond. Subscribing to Pol'y No.: FINFR0901509 v. Cardtronics, Inc., 438 S.W.3d 770 (Tex. App.—Houston [1st Dist.] 2014, no pet.) (quoting Montanye v. Transamerica Ins. Co., 638 S.W.2d 518, 521 (Tex. App.—Houston [1st Dist.] 1982, no writ)): reinforces the “last antecedent” canon as applied in Texas contract interpretation. The Fifth Circuit relies on it to narrow the SEC-reporting modifier to the enumerated settlement-related expense items immediately preceding it, rather than to every component of “operating income.”

B. Legal Reasoning

1) The interpretive pivot: “Applicable Year” is defined and used twice

The court focuses on Appendix A, Subparagraph (C), defining “Applicable Year,” and Subparagraph (B)(ii), defining “net operating profits.”

• For annual payments under paragraph 7, “Applicable Year” is “the calendar year ending on the date on which the payment at issue is due.”
• In the “net operating profits” formula, the tax component is computed using “the maximum marginal federal corporate income tax rate … in effect on December 31 of the Applicable Year” (plus 4.472 percentage points).

Because “Base Net Operating Profit” and “Actual Net Operating Profit” are both computed under the umbrella definition of “net operating profits,” the court reasons that the tax-rate input must be the “Applicable Year” tax rate for both figures. Any approach that “fixes” the base figure at an old tax rate while updating the actual figure’s tax rate would, in the court’s view, violate the agreement’s definitional structure and the directive that the profits determination “shall be derived using the same methodology as was employed” for the 1997 figure.

2) Why the $3.115 billion sentence does not “freeze” the benchmark

Texas’s strongest textual hook was the sentence: “Applying the foregoing definition, the Settling Defendants’ aggregate net operating profits from domestic sales of Cigarettes in 1997 were $3,115,100,000.”

The Fifth Circuit rejects the “freeze” theory for multiple textual reasons:

• The sentence is explicitly introduced as an application of the “foregoing definition.” That definition itself incorporates the “Applicable Year” tax-rate input—so the example cannot override the definition that generated it.
• The agreement’s parenthetical “such rate being 35% as of May 1, 2001” signals that, at the time of drafting, the parties were attentive to the rate in force near execution, not anchored to 1997 as a locked-in tax assumption.
• The opinion notes that the agreement uses the descriptive phrase “aggregate net operating profits … in 1997,” rather than the defined label “Base Net Operating Profit,” weakening the inference that the sentence is a perpetual definitional “fix.”

3) The “absurdity” argument and the last-antecedent solution

Texas argued that applying “Applicable Year” to the base-year calculation would require using SEC-reported figures “for the Applicable Year” (e.g., 2026) to compute a 1997 profit metric—producing a nonsensical result.

The Fifth Circuit resolves this by a targeted grammatical interpretation: the phrase “all as reported to the [SEC] for the Applicable Year” modifies only the immediately preceding list of settlement-related expense items (e.g., “up-front” settlement payments, restructuring charges, discontinued operations, casualty losses), not every earlier component in the operating-income definition. This reading both:

• avoids the purported absurdity; and
• aligns with the stated purpose of the 2001 Amendment—resolving disputes about whether and how settlement-related charges should be included and measured.

The court further adds a practical rationale: tying the measurement of these specific charges to SEC reporting promotes consistency and discourages opportunistic accounting, given the regulatory risks of misreporting (with a general citation to 15 U.S.C. § 78m).

4) Ambiguity rejected after applying interpretive rules

Having applied (i) defined-term primacy and (ii) the last-antecedent canon, the Fifth Circuit concludes the contract is not ambiguous under Universal C.I.T. Credit Corp. v. Daniel. That conclusion matters because it forecloses attempts to alter the result by extrinsic evidence under Nat'l Union Fire Ins. Co. of Pittsburgh v. CBI Indus., Inc..

C. Impact

1) Practical consequences for settlement-payment mechanics

The decision reallocates how tax law changes affect the profit-adjustment calculation. Under the Fifth Circuit’s reading:

• The “maximum marginal federal corporate income tax rate” is not a historical constant embedded in the 1997 benchmark; it is an annually updating input for the entire “net operating profits” computation.
• The comparison between “Actual” and “Base” profit becomes more “apples-to-apples” with respect to tax-rate assumptions, reducing windfalls or penalties attributable solely to changes in the federal corporate rate rather than underlying cigarette operating profitability.

2) Drafting and litigation lessons for complex, formula-heavy contracts

Even though the opinion is unpublished, its reasoning is a template for disputes involving:

• Defined terms embedded in formulas: Courts will typically enforce the defined term throughout the formula, including in sub-calculations parties may intuitively view as “fixed.”
• Illustrative numbers vs. operative definitions: “Applying the foregoing definition” examples will rarely trump the definitional text that generates them, especially when the definition includes time-variable inputs.
• Modifier placement: Drafters who intend a trailing phrase to modify multiple earlier clauses should say so explicitly; otherwise, Texas courts may apply the last-antecedent doctrine to limit the modifier.

3) Doctrinal influence in Texas-law contract interpretation

The opinion exemplifies a disciplined, hierarchy-based approach: (1) read the contract as a whole, (2) give primacy to defined terms, (3) apply established grammatical canons, (4) consider commercial context only to “inform” meaning, and (5) declare ambiguity only if uncertainty remains after those steps.

IV. Complex Concepts Simplified

• Base Net Operating Profit vs. Actual Net Operating Profit: “Base” is a benchmark tied to 1997 cigarette profitability (inflation-adjusted); “Actual” is the comparable figure for the year tied to the payment due date. Payments may be adjusted if sales volume falls but profits rise.
• “Applicable Year”: A defined term specifying which calendar year supplies certain inputs. For annual payments here, it is the year ending when the payment is due.
• Why the tax rate matters: The “net operating profits” definition applies a fixed-style tax adjustment: operating income is reduced by a percentage keyed to the maximum federal corporate tax rate (plus 4.472 points). If “Base” and “Actual” use different tax rates, the comparison can be distorted by tax-law changes rather than true operational profitability.
• Parol evidence rule (as used here): Courts may consider context to “inform” meaning but cannot use external evidence to contradict clear contract text. If the contract is unambiguous, the text governs.
• Last antecedent doctrine: A grammatical rule: a trailing modifier generally attaches to the closest preceding phrase, not earlier, more remote phrases—unless the text indicates otherwise.
• “Reverse and remand”: The appellate court set aside the district court’s liability ruling and sent the case back for further proceedings consistent with its interpretation. Because liability was reversed, the court did not decide allocation and pre-judgment-interest issues.

V. Conclusion

The Fifth Circuit’s central contribution is its insistence that the 2001 Amendment’s defined “Applicable Year” governs the tax-rate input in the “net operating profits” formula for both the baseline (“Base Net Operating Profit”) and the comparison-year figure (“Actual Net Operating Profit”). The court treats the agreement’s $3.115 billion statement as an illustrative application rather than a perpetual “freeze,” and it neutralizes Texas’s “absurdity” concern through the last-antecedent doctrine.

More broadly, the opinion underscores that, under Texas law, defined terms and careful grammatical structure can determine the outcome of high-stakes, formula-driven commercial disputes—especially when external economic or legal changes (like tax reform) stress-test older settlement frameworks.