Over the last few years, certain states have increased their efforts to collect income taxes from out-of-state businesses.
Internet sales and transactions involving intellectual property, such as trademarks and copyrights, are now targets in the hunt for additional tax revenue. The issue is one of “nexus” – whether or not an out-of-state company has a presence in the state sufficient to legally obligate the company to pay taxes on income generated from sources within such state. Franchisors have become targets due to the franchise registration process, payment of royalties by franchisees located in a particular state, use of a franchisor’s trademarks and other intellectual property, training and meetings held between representatives of the franchisor with the franchisee in a particular state, and the existence of franchisor-owned equipment and property located in a franchised location within the state. Florida, Hawaii, Iowa, Louisiana, Massachusetts, New Jersey, North Carolina, Oregon, Pennsylvania, South Carolina, and Wisconsin assert that a franchisor has income tax nexus if the franchisor collects royalty fees from a franchisee located in the state.
A brief summary of case law interpreting the “economic nexus” theory is helpful to highlight the uncertainty surrounding the potential tax liability.
Quill Corp. v. North Dakota
In 1992, the United States Supreme Court held in Quill Corp. v. North Dakota, that a corporation must have a physical presence in a state in order for the state to impose sales/use tax liability. This decision did not address income taxes.
Geoffrey, Inc. v. South Carolina Tax Comm’n
In 1993, the South Carolina Supreme Court ruled in Geoffrey, Inc. v. South Carolina Tax Comm’n that Geoffrey, a Delaware corporation with no employees or tangible property in South Carolina, was subject to income tax liability in South Carolina. The Court concluded that: ( i )Geoffrey was a subsidiary of Toys R Us Inc.; (ii) Toys R Us had a physical location in South Carolina; (iii) Toys R Us paid royalties to Geoffrey resulting from operations in South Carolina; and (iv) Geoffrey used intangible personal property located or having a situs in the State of South Carolina that became an integral part of its business. Geoffrey was found liable for several years of income taxes on royalties. The United States Supreme Court rejected a request to consider an appeal of this decision.
KFC Corp. v. Iowa Department of Revenue
In 2010, the Iowa Supreme Court ruled in KFC Corp. v. Iowa Department of Revenue that KFC Corporation, a Delaware corporation with no employees or corporate-owned locations in Iowa, had a substantial nexus to the State because franchisees located in Iowa paid royalty and license income to KFC Corporation for use of its trademarks and franchise system. The Court held that KFC’s intangible property had a substantial nexus to Iowa to amount to the functional equivalent of a physical presence to support the imposition of an income tax. The United States Supreme Court rejected a request to consider an appeal of this decision.
Iowa Department of Revenue ruled against subsidiaries of Jack Daniels and Southern Comfort
In 2011, the Iowa Department of Revenue ruled against subsidiaries of Jack Daniels and Southern Comfort that owned intellectual property related to the sale of the brands in Iowa. Neither entity owned any property in Iowa nor had any employees in the State of Iowa. The Administrative Judge held that because the subject entities received trademark license fees and royalty payments based on net sales of the bottled whiskey in Iowa, the subsidiaries receiving the royalty payments and license fees were subject to the imposition of an income tax, plus penalties and interest dating back six years.
Griffith v. ConAgra Brands, Inc.
In 2012, the Supreme Court of Appeals of West Virginia ruled in Griffith v. ConAgra Brands, Inc. that ConAgra was not liable for net income tax assessments related to royalties earned from the nation-wide licensing of food industry trademarks and trade names. The Court held that there was not a sufficient economic nexus to impose income tax liability because: ( i ) ConAgra did not have a physical location in West Virginia; (ii) ConAgra did not sell or distribute food-related products or provide services in West Virginia; (iii) all products were manufactured by unrelated or affiliated licensees outside of West Virginia; and (iv) ConAgra’s licensees only sold the products to wholesalers and retailers in West Virginia.
In re Washington Mutual, Inc.
In 2012, in the case of In re Washington Mutual, Inc., the U.S. Bankruptcy Court for the District of Delaware held that a holding company that was not domiciled in Oregon, and whose only connection to Oregon was use by its subsidiaries of intellectual property owned by the holding company while they carried on business in Oregon, from which the holding company received no revenue or income, did not have requisite minimum contact with Oregon to impose income tax liability.
Scioto Ins. Co. v. Oklahoma Tax Commission
In 2012, in the case of Scioto Ins. Co. v. Oklahoma Tax Commission, the Supreme Court of Oklahoma ruled that an out-of-state corporation that licensed trademarks and other intellectual property to Wendy’s International that received license revenue derived from sublicensees (franchisees of Wendy’s) who used the trademarks and intellectual property did not have a sufficient economic nexus with the State of Oklahoma to assess income tax on such out-of-state corporation.
Based on the foregoing, there are various factors that a court may consider when determining whether a state may impose new or increased income tax liability on a franchisor under the economic nexus theory. Franchisors should consult with their accountants and legal advisors to assess the potential for “economic nexus” income tax liability in states where the franchisor is receiving any royalty, license or use fees related to intellectual property or intangible property. Until the United States Supreme Court weighs in on this legal issue, franchisors can expect to receive tax assessments from aggressive state departments of taxation looking to impose current and past income tax liability on out-of-state corporations that have no physical presence or employees located in their state.