Vol. 14 No. 2 | Spring 2011


Message from the Chair

2011 Nominating Committee Selected

34th Annual Forum on Franchising: Flying the Flag of Franchising

FDA Publishes Proposed Regulations on Menu Labeling Requirements

State Taxation of Royalties on Out-of-State Franchisors Continues: KFC Corp. v. Iowa Department of Revenue

From Darkness to Light: A Survey of How Franchise Lawyers Weathered the Recession and Some Thoughts on the Road Ahead

NASAA Project Group Seeks Input on Multi-Unit Franchising

New Location for California Department of Corporations' San Francisco Office

Become a California Board Certified Franchise and Distribution Specialist!

New Books from the Forum on Franchising


Max Schott, II (2013)
Gray Plant Mooty
Minneapolis, MN

Associate Editors
Glenn J. Plattner (2011)
Bryan Cave
Santa Monica, CA

Kristy L. Zastrow (2012)
Dady & Gardner
Minneapolis, MN

Beata Krakus (2013)
Hemker & Gale
Chicago, IL

Forum on Franchising
American Bar Association
321 N. Clark Street
Chicago, IL 60654

Ronald K. Gardner

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 Case

The 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 Standards

The 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.

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III. KFC Decision

As a prelude to its ruling in KFC Corp., the Iowa Supreme Court framed its task as follows: "Our function is to determine . . . how the United States Supreme Court would decide this case under its case law and established dormant Commerce Clause doctrine." KFC Corp., 792 N.W. 2d at 322. Instead of adopting the state court rationale of Geoffrey and Lanco that Quill's physical presence standard simply did not apply to income taxes, the Iowa court instead held that Iowa's taxation of the out-of-state franchisor satisfied the physical presence test.

As such, the court concluded that the franchisor's intangibles "utilized in a fast-food business by its franchisees that are firmly anchored within the state, would be regarded as having a sufficient connection to Iowa to amount to the functional equivalent of 'physical presence' under Quill." Id. at 324 (emphasis added). The court's rationale in this regard arguably constitutes an impermissible expansion of the boundaries of the Supreme Court's physical presence standard, since in Quill, the Supreme Court illustrated physical presence by noting that "whether or not a State may compel a vendor to collect a sales or use tax may turn on the presence in the taxing State of a small sales force, plant, or office." Quill, 504 U.S, at 315. Thus, by formulating its own "functional equivalent of physical presence" test, the Iowa court created a realm of uncertainty around the income tax nexus implications of contractual arrangements between out-of-state taxpayers and in-state businesses.

The Iowa court, however, did not rely solely on its novel extension of Quill's physical presence test. In addition, the court concluded that "even if the use of intangibles within the state in a franchised business does not amount to 'physical presence' under Quill," Iowa can still properly subject the out-of-state franchisor to Iowa's income tax. KFC Corp., 792 N.W. 2d at 328. In this regard the court held that when "a company earns hundreds of thousands of dollars from sales to Iowa customers arising from the licensing of intangibles associated with the fast-food business, we conclude that the Supreme Court would engage in a realistic substance-over-form assessment that would allow a state legislature to require the payment of the company's fair share of taxes without violating the dormant Commerce Clause." Id. at 315.

Accordingly, KFC's receipt of royalties from its Iowa franchisees using KFC's intangibles was, in the court's view, sufficient justification for the imposition of Iowa corporate income tax. The court further concluded that Iowa's taxation of KFC did not violate the specific provisions of Iowa law and associated administrative regulations treating the royalties as Iowa source income of the franchisor.

On March 16, 2011, the United States Supreme Court granted an application to extend time to file a writ of certiorari filed by KFC the previous day, so this may be the case in which the United States Supreme Court finally addresses the question of whether Quill extends to state income tax nexus. The Iowa Department of Revenue has indicated that it expects a decision in the fall of 2011 as to whether the Supreme Court will accept the KFC case.

IV. What Should Franchisors Do Now?

We anticipate that the Iowa Department of Revenue will continue to identify and contact out-of-state franchisors regarding Iowa corporate income tax filing obligations, and we do not believe that the Department will reverse course absent acceptance of the case by the United States Supreme Court and a subsequent ruling that is favorable to KFC. There is no statute of limitations for taxpayers who have failed to file prior returns. See Code of Iowa Section 422.25. As a result, franchisors who have received royalties from Iowa franchisees and have not previously filed Iowa returns are subject to tax assessments, plus applicable interest and penalties, for as far back as such income was received.

Iowa also offers a voluntary disclosure program under which taxpayers who voluntarily come forward and identify themselves to the Department of Revenue may obtain some measure of relief from prior tax liabilities. See Iowa Administrative Code Rule 701-3.1(5) indicating that for taxpayers who seek voluntary disclosure, "the maximum prior years for which the department will generally audit and pursue settlement and collection will be five years." In addition, the Department has the discretion to waive prior period penalties, although the terms and conditions of any individual settlement are made "on a case by case basis." See Iowa Administrative Code Rule 701-3.1(5).

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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 franchisees.

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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: 1938-3231

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