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Iowa Decision Upholds Tax Assessment Against Out-of-State Franchisor
The Iowa Supreme Court recently issued a decision holding that the state of Iowa has the authority to impose its income tax on out-of-state franchisors based solely on the use of their intangible property by franchisees located in the state. The court's decision in KFC Corporation v. Iowa Department of Revenue (No. 09-1032, 2010 WL 5393506 (Iowa Dec. 30, 2010)) is expected to lead to increased enforcement efforts in Iowa, and perhaps other states. Franchisors should therefore be aware of this case and the impact that it could have on them in Iowa and in other states across the nation.
The KFC case involved an assertion by the Iowa Department of Revenue that KFC was responsible for paying corporate income tax in the state based solely on its receipt of royalties from franchisees in the state. In June 2009, an Iowa District Court upheld the state's imposition of tax, and KFC appealed the decision to the Iowa Supreme Court. The Iowa Supreme Court heard oral arguments in May 2010 and issued its determination on Dec. 30, 2010.
The principal issue in KFC was whether the state of Iowa could impose its corporate income tax on KFC ' a company with no employees or business locations in the state ' based solely on KFC's receipt of royalties from franchisees located in Iowa. KFC argued that it was not subject to that tax because it did not have the necessary “nexus” with the state that was required under the Commerce Clause of the U.S. Constitution. KFC based its argument upon Supreme Court precedent holding that the Commerce Clause required that an out-of-state party have a physical presence in a state for that party to be subject to that state's tax.
The department argued that KFC was subject to income tax in Iowa because it derived income from franchisees in the state. It further argued that the state could impose its income tax on KFC regardless of KFC's lack of physical presence in the state, noting that the Supreme Court decisions cited by KFC involved sales and use taxes and thus should not apply to the state's income tax. The department also relied upon case law from other states that supported its position that “economic nexus” was sufficient under the Commerce Clause when evaluating the imposition of a state income tax.
The court's decision contained a thorough and careful analysis of the U.S. Supreme Court's jurisprudence regarding the limits on state taxation imposed by the Commerce Clause. Based upon that analysis, the court issued two holdings with respect to the Commerce Clause issues raised by the parties. First, in an unexpected and unique ruling, the court held that KFC's licensing of its trademarks to its Iowa franchisees was the “functional equivalent” of a physical presence in the state. Therefore, according to the court, KFC would have been subject to income tax in the state regardless of whether a physical presence was required. Second, notwithstanding its first ruling, the court held that the physical-presence test did not even apply. The court held that “by licensing franchises within Iowa, KFC has received the benefit of an orderly society within the state and, as a result, is subject to the payment of income taxes that otherwise meet the requirements of the dormant Commerce Clause.”
Analysis and Impact
The KFC court's rejection of the physical-presence test for purposes of the state's income tax was consistent with actions taken by other state courts in recent years and was not unexpected. Since 2005, a growing number of state courts have held that the Commerce Clause of the U.S. Constitution does not require a person or entity to have a physical presence in a state before that state can impose its income tax on that person or entity. Further, the Supreme Court has declined to review any of those cases.
One aspect of the decision that was unexpected, however, was its holding that the physical-presence test was met by KFC despite its lack of a true physical presence in the state. As noted above, the court held that KFC's licensing of its intangible property to Iowa franchisees gave it the functional equivalent of physical presence in the state. This functional equivalency test goes beyond case law from the Supreme Court or other states and is of questionable basis.
KFC's rejection of a physical-presence standard for purposes of state income taxation is consistent with state-court decisions in cases across the nation. Although those cases have not involved franchise relationships, they have established a body of law upon which states can rely upon in seeking to enforce their income taxes against out-of-state franchisors. Thus, in addition to expecting enforcement actions against franchisors by the Iowa Department of Revenue, franchisors should expect that other states' revenue authorities will begin to take action as well. Franchisors should be aware of this trend and determine a strategy for analyzing and responding to this development.
KFC has 90 days to appeal the Iowa Supreme Court's decision to the U.S. Supreme Court. Unfortunately, the U.S. Supreme Court has declined the opportunity to review several similar cases in recent years, and thus it appears unlikely that it will review this case even if KFC does appeal. If KFC does not appeal, or if KFC's appeal is not accepted by the Supreme Court, the Iowa Supreme Court's decision will stand. The Iowa Department of Revenue would thus be able to proceed in assessing the state's income tax against out-of-state franchisors with franchisees in the state.
Adam B. Thimmesch is a lawyer in Faegre & Benson LLP's franchise industry group and focuses his practice on tax issues. He can be reached at [email protected] or at 612-766-7920.
The Iowa Supreme Court recently issued a decision holding that the state of Iowa has the authority to impose its income tax on out-of-state franchisors based solely on the use of their intangible property by franchisees located in the state. The court's decision in
The KFC case involved an assertion by the Iowa Department of Revenue that KFC was responsible for paying corporate income tax in the state based solely on its receipt of royalties from franchisees in the state. In June 2009, an Iowa District Court upheld the state's imposition of tax, and KFC appealed the decision to the Iowa Supreme Court. The Iowa Supreme Court heard oral arguments in May 2010 and issued its determination on Dec. 30, 2010.
The principal issue in KFC was whether the state of Iowa could impose its corporate income tax on KFC ' a company with no employees or business locations in the state ' based solely on KFC's receipt of royalties from franchisees located in Iowa. KFC argued that it was not subject to that tax because it did not have the necessary “nexus” with the state that was required under the Commerce Clause of the U.S. Constitution. KFC based its argument upon Supreme Court precedent holding that the Commerce Clause required that an out-of-state party have a physical presence in a state for that party to be subject to that state's tax.
The department argued that KFC was subject to income tax in Iowa because it derived income from franchisees in the state. It further argued that the state could impose its income tax on KFC regardless of KFC's lack of physical presence in the state, noting that the Supreme Court decisions cited by KFC involved sales and use taxes and thus should not apply to the state's income tax. The department also relied upon case law from other states that supported its position that “economic nexus” was sufficient under the Commerce Clause when evaluating the imposition of a state income tax.
The court's decision contained a thorough and careful analysis of the U.S. Supreme Court's jurisprudence regarding the limits on state taxation imposed by the Commerce Clause. Based upon that analysis, the court issued two holdings with respect to the Commerce Clause issues raised by the parties. First, in an unexpected and unique ruling, the court held that KFC's licensing of its trademarks to its Iowa franchisees was the “functional equivalent” of a physical presence in the state. Therefore, according to the court, KFC would have been subject to income tax in the state regardless of whether a physical presence was required. Second, notwithstanding its first ruling, the court held that the physical-presence test did not even apply. The court held that “by licensing franchises within Iowa, KFC has received the benefit of an orderly society within the state and, as a result, is subject to the payment of income taxes that otherwise meet the requirements of the dormant Commerce Clause.”
Analysis and Impact
The KFC court's rejection of the physical-presence test for purposes of the state's income tax was consistent with actions taken by other state courts in recent years and was not unexpected. Since 2005, a growing number of state courts have held that the Commerce Clause of the U.S. Constitution does not require a person or entity to have a physical presence in a state before that state can impose its income tax on that person or entity. Further, the Supreme Court has declined to review any of those cases.
One aspect of the decision that was unexpected, however, was its holding that the physical-presence test was met by KFC despite its lack of a true physical presence in the state. As noted above, the court held that KFC's licensing of its intangible property to Iowa franchisees gave it the functional equivalent of physical presence in the state. This functional equivalency test goes beyond case law from the Supreme Court or other states and is of questionable basis.
KFC's rejection of a physical-presence standard for purposes of state income taxation is consistent with state-court decisions in cases across the nation. Although those cases have not involved franchise relationships, they have established a body of law upon which states can rely upon in seeking to enforce their income taxes against out-of-state franchisors. Thus, in addition to expecting enforcement actions against franchisors by the Iowa Department of Revenue, franchisors should expect that other states' revenue authorities will begin to take action as well. Franchisors should be aware of this trend and determine a strategy for analyzing and responding to this development.
KFC has 90 days to appeal the Iowa Supreme Court's decision to the U.S. Supreme Court. Unfortunately, the U.S. Supreme Court has declined the opportunity to review several similar cases in recent years, and thus it appears unlikely that it will review this case even if KFC does appeal. If KFC does not appeal, or if KFC's appeal is not accepted by the Supreme Court, the Iowa Supreme Court's decision will stand. The Iowa Department of Revenue would thus be able to proceed in assessing the state's income tax against out-of-state franchisors with franchisees in the state.
Adam B. Thimmesch is a lawyer in
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