News Briefs

Franchisor Tax Nexus Case Reaches Iowa Supreme Court

In a case with potentially significant implications for taxation of franchisors, the Iowa Supreme Court heard oral arguments on May 20 in KFC Corporation v. Iowa Department of Revenue. “A victory by the state would represent an extension of [Geoffrey v. South Carolina Tax Commission, 313 S.C. 15 (1993), and other similar] cases because KFC Corp. involves licensing agreements between unrelated parties,” said Bruce Ackerman, of counsel, Faegre & Benson LLP (Minneapolis), who is not involved in the litigation. “The KFC case could result in a landmark decision for states attempting to impose income tax on out-of-state franchisors and other similarly situated taxpayers. This would be the first contemporary case to reach a state supreme court and directly address the franchisor-franchisee relationship.”

The issue is whether Quill Corp. v. North Dakota, 504 U.S. 298 (1992), will dictate the case or whether the court will follow the Geoffrey line of cases in holding that Quill does not limit the state's power in this area. Quill held that the Commerce Clause of the U.S. Constitution barred states from imposing a use-tax collection obligation on out-of-state corporations that had no physical presence in the taxing state ' that the corporations lacked the “substantial nexus” with the state that was required under the Commerce Clause. But states have not stopped seeking to capture that tax revenue, and Geoffrey has been their opening to argue that they can impose an income tax on an out-of-state licensor whose only connection with the state is the receipt of royalties from use of its intangible property in the state.

In June 2009, in KFC Corporation v. Iowa Department of Revenue, an Iowa District Court upheld the state's imposition of a corporate income tax on KFC based on its receipt of royalties from franchisees in the state. “The court held that the Commerce Clause of the U.S. Constitution did not require a taxpayer to have a physical presence in Iowa to establish a 'substantial nexus' in the state for purposes of corporate income tax,” said Adam B. Thimmesch, associate, Faegre & Benson. “The district court cited to the Geoffrey line of cases to support its decision.”

KFC appealed to the state supreme court. “KFC forcefully argued that Quill should apply to Iowa's corporate income tax and that the Geoffrey line of cases had been improperly decided,” wrote Ackerman and Thimmesch after watching the oral argument. “The state appeared content to rely on the Geoffrey line of cases during its argument.”

However, Ackerman and Thimmesch said that KFC ran into skepticism from the court. “The court stated that it struggled with the notion that the Commerce Clause protected KFC from taxation in the state even though KFC earned significant income in Iowa that was dependent upon the state's provision of protections and benefits to its franchisees (e.g., roads, courts, etc.). KFC responded by arguing that those indirect benefits were received by many out-of-state (or out-of-country) entities whose products or customers happened to be sold or located in Iowa. According to KFC, if the court applied that type of indirect-benefit analysis, 'everyone would be taxable everywhere,'” they wrote.

If the court decides in favor of Iowa, other states will likely be emboldened in seeking to collect income taxes from franchisors, said Thimmesch. Franchisors that have not been filing returns in the state could be liable for taxes, interest, and penalties, he added. “We would advise franchisors to discuss this issue with their tax advisers and to determine how they will respond in the event of an adverse decision, especially if they operate in Iowa, do not file returns in the state, and have not already been contacted by the state,” he said.

If KFC Corp. is decided favorably for KFC, the case may discourage actions by other states against out-of-state franchisors, Ackerman added. “Franchisors should keep in mind, however, that other states will not be bound by KFC Corp. and other state taxing authorities may attempt to obtain a more favorable ruling in their state courts,” he said.

Franchisee-Employee Status Unresolved As Judge Dismisses Claims in Awuah v. Coverall

In a three-week trial, U.S. District Court Judge William G. Young dismissed all claims filed by three Massachusetts franchisees of Coverall North America, Inc., who were claiming status as employees of the franchisor. However, the judge's decision did not reflect a reversal of his decision in March 2010 that found that Coverall franchisees are, in fact, employees under Massachusetts law. The judge's finding in March, combined with his comment that likened franchising to a Ponzi scheme, raised concerns among franchisors about massive increases in their liability for many actions by franchisees and employees of franchisees.

“The jury did not get to decide on the merits of the case; it was thrown out only on technical grounds,” said Shannon Liss-Riordan (Lichten & Liss-Riordan, P.C., in Boston), attorney for the franchisees. “Two were thrown out because franchisees had signed releases, and the other had passed the statute of limitations. Several times during the trial, the judge repeated that his ruling on summary judgment stands [that the franchisees can be considered employees in Massachusetts].”

Liss-Riordan has refiled for class certification under state law for recognition of the franchisees as employees and a national class action for unfair and deceptive trade practices. As of press time, Judge Young had not made a decision on class certification.

“The issue isn't franchising in general. There are many ways to be a franchisor in Massachusetts that are not like what Coverall has done,” said Liss-Riordan. “But Coverall obtained the contracts and then delegated the work to 'franchisees,' just like a company would delegate work to its employees. Basically, the franchisor was acting as if it could put the 'franchise' label on the relationship and avoid designation as an employee relationship.”

Meanwhile, Coverall noted in public statements that the franchisees failed to present proof that they had suffered any damages as a result of the alleged misclassification and that it is considering filing for attorneys' fees and costs.

MD Amends Franchise Law to Get Rid of First Personal Meeting Requirement

Effective on Oct. 1, 2010, the Maryland Legislature amended ' 14-223 of the Maryland Franchise Law to change the timing for delivery of the Franchise Disclosure Document (“FDD”) from “10 business days” to “14 calendar days” before a prospective franchisee pays any money or signs an agreement related to the franchise sale. In addition, the Maryland amendment replaces the “first personal meeting” requirement with a requirement that the franchisor deliver the FDD “upon the prospective franchisee's reasonable request.” The Maryland amendments make Maryland's franchise delivery rule consistent with the FTC's 2007 Amended Franchise Rule.

Franchisor Tax Nexus Case Reaches Iowa Supreme Court

In a case with potentially significant implications for taxation of franchisors, the Iowa Supreme Court heard oral arguments on May 20 in KFC Corporation v. Iowa Department of Revenue . “A victory by the state would represent an extension of [ Geoffrey v. South Carolina Tax Commission , 313 S.C. 15 (1993), and other similar] cases because KFC Corp. involves licensing agreements between unrelated parties,” said Bruce Ackerman, of counsel, Faegre & Benson LLP (Minneapolis), who is not involved in the litigation. “The KFC case could result in a landmark decision for states attempting to impose income tax on out-of-state franchisors and other similarly situated taxpayers. This would be the first contemporary case to reach a state supreme court and directly address the franchisor-franchisee relationship.”

The issue is whether Quill Corp. v. North Dakota , 504 U.S. 298 (1992), will dictate the case or whether the court will follow the Geoffrey line of cases in holding that Quill does not limit the state's power in this area. Quill held that the Commerce Clause of the U.S. Constitution barred states from imposing a use-tax collection obligation on out-of-state corporations that had no physical presence in the taxing state ' that the corporations lacked the “substantial nexus” with the state that was required under the Commerce Clause. But states have not stopped seeking to capture that tax revenue, and Geoffrey has been their opening to argue that they can impose an income tax on an out-of-state licensor whose only connection with the state is the receipt of royalties from use of its intangible property in the state.

In June 2009, in KFC Corporation v. Iowa Department of Revenue, an Iowa District Court upheld the state's imposition of a corporate income tax on KFC based on its receipt of royalties from franchisees in the state. “The court held that the Commerce Clause of the U.S. Constitution did not require a taxpayer to have a physical presence in Iowa to establish a 'substantial nexus' in the state for purposes of corporate income tax,” said Adam B. Thimmesch, associate, Faegre & Benson. “The district court cited to the Geoffrey line of cases to support its decision.”

KFC appealed to the state supreme court. “KFC forcefully argued that Quill should apply to Iowa's corporate income tax and that the Geoffrey line of cases had been improperly decided,” wrote Ackerman and Thimmesch after watching the oral argument. “The state appeared content to rely on the Geoffrey line of cases during its argument.”

However, Ackerman and Thimmesch said that KFC ran into skepticism from the court. “The court stated that it struggled with the notion that the Commerce Clause protected KFC from taxation in the state even though KFC earned significant income in Iowa that was dependent upon the state's provision of protections and benefits to its franchisees (e.g., roads, courts, etc.). KFC responded by arguing that those indirect benefits were received by many out-of-state (or out-of-country) entities whose products or customers happened to be sold or located in Iowa. According to KFC, if the court applied that type of indirect-benefit analysis, 'everyone would be taxable everywhere,'” they wrote.

If the court decides in favor of Iowa, other states will likely be emboldened in seeking to collect income taxes from franchisors, said Thimmesch. Franchisors that have not been filing returns in the state could be liable for taxes, interest, and penalties, he added. “We would advise franchisors to discuss this issue with their tax advisers and to determine how they will respond in the event of an adverse decision, especially if they operate in Iowa, do not file returns in the state, and have not already been contacted by the state,” he said.

If KFC Corp. is decided favorably for KFC, the case may discourage actions by other states against out-of-state franchisors, Ackerman added. “Franchisors should keep in mind, however, that other states will not be bound by KFC Corp. and other state taxing authorities may attempt to obtain a more favorable ruling in their state courts,” he said.

Franchisee-Employee Status Unresolved As Judge Dismisses Claims in Awuah v. Coverall

In a three-week trial, U.S. District Court Judge William G. Young dismissed all claims filed by three Massachusetts franchisees of Coverall North America, Inc., who were claiming status as employees of the franchisor. However, the judge's decision did not reflect a reversal of his decision in March 2010 that found that Coverall franchisees are, in fact, employees under Massachusetts law. The judge's finding in March, combined with his comment that likened franchising to a Ponzi scheme, raised concerns among franchisors about massive increases in their liability for many actions by franchisees and employees of franchisees.

“The jury did not get to decide on the merits of the case; it was thrown out only on technical grounds,” said Shannon Liss-Riordan (Lichten & Liss-Riordan, P.C., in Boston), attorney for the franchisees. “Two were thrown out because franchisees had signed releases, and the other had passed the statute of limitations. Several times during the trial, the judge repeated that his ruling on summary judgment stands [that the franchisees can be considered employees in Massachusetts].”

Liss-Riordan has refiled for class certification under state law for recognition of the franchisees as employees and a national class action for unfair and deceptive trade practices. As of press time, Judge Young had not made a decision on class certification.

“The issue isn't franchising in general. There are many ways to be a franchisor in Massachusetts that are not like what Coverall has done,” said Liss-Riordan. “But Coverall obtained the contracts and then delegated the work to 'franchisees,' just like a company would delegate work to its employees. Basically, the franchisor was acting as if it could put the 'franchise' label on the relationship and avoid designation as an employee relationship.”

Meanwhile, Coverall noted in public statements that the franchisees failed to present proof that they had suffered any damages as a result of the alleged misclassification and that it is considering filing for attorneys' fees and costs.

MD Amends Franchise Law to Get Rid of First Personal Meeting Requirement

Effective on Oct. 1, 2010, the Maryland Legislature amended ' 14-223 of the Maryland Franchise Law to change the timing for delivery of the Franchise Disclosure Document (“FDD”) from “10 business days” to “14 calendar days” before a prospective franchisee pays any money or signs an agreement related to the franchise sale. In addition, the Maryland amendment replaces the “first personal meeting” requirement with a requirement that the franchisor deliver the FDD “upon the prospective franchisee's reasonable request.” The Maryland amendments make Maryland's franchise delivery rule consistent with the FTC's 2007 Amended Franchise Rule.