|Vol. 14 No. 2 | Spring 2011|
|INSIDE THIS EDITION|
THE FRANCHISE LAWYER
Gray Plant Mooty
Santa Monica, CA
Kristy L. Zastrow (2012)
Dady & Gardner
Minneapolis, MNBeata Krakus (2013)
Hemker & Gale
321 N. Clark Street
Chicago, IL 60654
|State Taxation of Royalties on Out-of-State Franchisors Continues: KFC Corp. v. Iowa Department of Revenue|
By Hugh Goodwin
DLA Piper (Silicon Valley office)
Will K. Woods
Baker Botts (Dallas office)The Iowa Supreme Court recently upheld a state district court decision imposing income tax nexus on an out-of-state franchisor as a result of the franchisor's receipt of royalties from Iowa franchisees. See KFC Corp. v. Iowa Department of Revenue, 792 N.W.2d 308 (Iowa 2010). The case is significant because it marks the first time a state supreme court has concluded that the in-state use of an out-of-state franchisor's intangibles by a franchisee satisfies the physical presence test by creating the functional equivalent of a "physical presence" in the state sufficient to establish state income tax nexus.I. Facts of the Iowa KFC CaseThe franchisor/taxpayer in KFC Corp. was a Delaware corporation headquartered in Louisville, Kentucky. The franchisor licensed its trademarks and fast food restaurant operating systems to approximately 3,400 restaurants nationwide, including to a number of franchisees in Iowa. All KFC restaurants in Iowa were owned by independent franchisees, and the franchisor did not own any restaurant properties or have any employees in Iowa.In 2001, the Iowa Department of Revenue issued KFC Corporation an assessment of $284,658.08 for unpaid corporate income taxes, penalties, and interest. KFC argued that the Department of Revenue could not lawfully impose the state income tax because KFC had no physical presence in Iowa. To support imposition of the tax, the Department of Revenue contended that no physical presence is needed where a franchisor licenses intellectual property that generates income from within the state based on the operations of its franchisees.After an administrative law judge and the director of the Department of Revenue held in the Department's favor, KFC sought judicial review. The district court ruled in favor of the Department of Revenue, and KFC appealed to the Iowa Supreme Court.II. Income Tax Nexus StandardsThe United States Supreme Court has established a "physical presence" nexus standard as a prerequisite for state taxation of out-of-state taxpayers under the Commerce Clause of Article I of the United States Constitution. See Quill v. North Dakota, 504 U.S. 298 (1992). Quill, however, was a sales and use tax case, and the Court has never extended the physical presence threshold to income tax nexus. In the absence of Supreme Court guidelines for income tax nexus, a number of states courts subsequent to Quill determined that physical presence was not required for income tax nexus. See, e.g., Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993);Lanco, Inc. v. Director, Division of Taxation, 879 A.2d 1234 (N.J. Superior Ct. App. Div. 2005), aff'd, 908 A.2d 176 (N.J. 2006), cert. denied, 551 U.S. 1131 (2007). In both of these cases, out-of-state taxpayers were held to have nexus for state income tax purposes based on the licensing of intangibles to affiliates located in the state.In the wake of Geoffrey, a number of other jurisdictions also adopted income tax nexus standards through case law, rulings and legislation based on the so called "economic nexus" rationale reflected in Geoffrey and Lanco. The cases that authorize economic nexus tests for state income tax purposes, however, have generally been limited to situations that involve the intercompany licensing of intangibles.These intercompany license transactions generate an income tax deduction for the licensee, but if the state only imposes its income tax on those affiliated entities that have a physical presence (in the traditional sense) and, therefore, their own nexus with the state, the licensor would generally avoid income tax liability in the state in which the licensee is located. Thus, part of the underlying justification for decisions like Geoffrey and Lanco was undoubtedly the perceived unfairness associated with generating a state tax deduction from an intercompany payment that essentially did not create an economic loss when taking into account the combined profit and loss of the entire affiliated group of entities.
KFC Corp.marks a departure from these cases in that the franchisor and franchisee are unrelated parties dealing at arms-length where the payment of royalties does not create an intercompany tax advantage.
Therefore, franchisors located outside of Iowa with franchisees in Iowa may wish to consider the merits of initiating a voluntary disclosure filing with Iowa. Taxpayers should be aware, however, that prior contact with the Department renders a taxpayer ineligible for voluntary disclosure. See Iowa Administrative Code Rule 701-3.1(2)(c). Taxpayers filing voluntary disclosure agreements in Iowa should consider whether they are entitled to relief in other states where royalty income was previously reported. Such relief might be obtained through tax credits for the owners of non-C corporation entities or taxable income reductions resulting from the filing of amended returns.In addition to addressing Iowa's KFC Corp. decision, franchisors may face similar issues in other states seeking to tax the franchisor's royalty stream. For instance, under 2010 legislation enacted in Washington, nexus is created for an out-of-state royalty recipient if the taxpayer has more than $250,000 of annual receipts from Washington payors or if at least 25% of the taxpayer's total property, payroll or receipts are from Washington sources. Also, as of January 1, 2011, franchisors are considered to be "doing business" in California for corporate income tax purposes if they receive the lesser of 25% of their total receipts from California sources or more than $500,000 annually. This is in addition to a nearly two year campaign by the California Franchise Tax Board to require franchisees to withhold California tax from royalty payments made to out-of-state franchisors.Finding a solution to the issue of who should bear the burden of the seemingly ever-widening reach of state tax authorities in this area is not always easy. Many franchisors have the contractual right under their franchise agreements to shift the burden of state tax liability to its franchisees through gross-up or tax indemnification provisions. However, shifting the tax burden just because a franchisor has the right to do so might not always be the optimal approach (and, almost certainly, not a welcome approach as viewed by franchisees).On the one hand, it can be argued that the franchisor should not have to bear the burden of new and/or increased state taxes on royalties that erode the economics of the deal that the franchisor negotiated with the franchisee as part of a long-term relationship. Franchisees with one or more outlets in the state are, arguably, in a much better position than the franchisor who has no physical presence in the state to effect changes to state tax policy that may be viewed as more pro-business. On the other hand, depending on the respective sizes of the franchisor and franchisee and the resources available to each, arguments can be made that franchisors are in a better position to bear additional tax liabilities, and franchisees may view having to cover what is, from the state's standpoint, the franchisor's tax liability, as "unfair." The solution in each circumstance requires careful analysis of the franchisor's own tax situation, the rules regarding income apportionment, and the franchisor's relationships with its email@example.com or via fax to 312-988-6030.
The opinions expressed in the articles presented in The Franchise Lawyer are those of the authors and shall not be construed to represent the policies of the American Bar Association and the Forum on Franchising. Copyright 2011 The American Bar Association. ISBN: 1938-3231American Bar Association | 321 N Clark | Chicago, IL 60654 | 1-800-285-2221