U.S. Supreme Court Denies Certiorari in Iowa Tax Case

Last, but certainly not least, franchisors should consider modifying their franchise agreement to address this change in the franchise model. One way of doing so is to include gross-up language requiring franchisees to increase royalties by an amount equal to a franchisor's additional tax burden. This might be done by including language requiring franchisees to “pay such additional royalties so as to make franchisor whole for any additional net tax burden based on economic nexus imposed by the state where franchisee operates.”

Gregg A. Rubenstein is a partner with Nixon Peabody LLP in Boston. He can be contacted at 617-345-6184 or [email protected].

On Oct. 3, 2011, the U.S. Supreme Court denied a petition for certiorari in KFC Corp. v. Iowa Department of Revenue. As a result, the Court has given its silent blessing to extending the “economic nexus” theory to justify states' imposition of tax obligations on out-of-state franchisors with no physical presence there. This will almost certainly result in other states extending their own concepts of economic nexus to reach revenues paid by in-state franchisees to out-of-state franchisors. While the ultimate economic implications for franchisors will depend on their particular corporate structures and where their franchisees are located, this could mark an important change in the economic relationship between franchisors and franchisees throughout the United States.

The Dormant Commerce Clause and Physical Presence Requirement

To understand the concept of economic nexus, one must start with the 1967 decision of National Bellas Hess, Inc. v. Department of Rev. of Ill. (“Bellas Hess“). 386 U.S. 753. Bellas Hess addressed Illinois' attempt to require an out-of-state mail order business to collect and remit sales tax from the Illinois customers to whom it sold product. Id. at 754. As both the Illinois Supreme Court and the U.S. Supreme Court recognized, Bellas Hess' only contacts with Illinois were “via the United States mail or common carrier.” Id. This limited contact, Bellas Hess argued, was insufficient for Illinois to impose any tax obligation pursuant to both the Fourteenth Amendment and the Commerce Clause. Id. at 756. The Court agreed. “In order to uphold the power of Illinois to impose use tax burdens on National in this case, we would have to repudiate totally the sharp distinction which [prior] decisions have drawn between mail order sellers with retail outlets, solicitors, or property within a State, and those who do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business. But this basic distinction, which until now has been generally recognized by the state taxing authorities, is a valid one, and we decline to obliterate it.” Id. at 758. Accordingly, without a physical presence in a state, a corporation could not be held responsible for payment of any state tax.

Not surprisingly, Bellas Hess' physical presence requirement was quickly exploited by other businesses, so that by 1992 the Court was once again called upon to review its decision in Quill Corp. v. North Dakota , 504 U.S. 298. In Quill, which involved an almost identical fact pattern as Bellas Hess, North Dakota argued that the growth of mail order businesses from “a relatively inconsequential market niche” in 1967 to $183.3 billion of annual sales in 1989 and “wholesale changes” in Fourteenth Amendment jurisprudence obviated the need for a physical presence. Id. at 303. The “wholesale change” North Dakota relied upon was the adoption of purposeful availment as the proper standard for Fourteenth Amendment due process concerns. Quill's purposeful exploitation of the North Dakota market, the state argued, was more than sufficient to justify its requirement that Quill collect sales tax from North Dakota customers. Id. at 304.

While recognizing that imposition of tax obligations was now consistent with the Fourteenth Amendment, the Court nonetheless reaffirmed the physical presence requirement pursuant to the Commerce Clause based on businesses' settled expectations from Bellas Hess. Id. at 319. “[T]he Commerce Clause and its nexus requirement are informed not so much by concerns about fairness for the individual defendant as by structural concerns about the effects of state regulation on the national economy. ' Accordingly, contrary to the State's suggestion, a corporation may have the 'minimum contacts' with a taxing State as required by the Due Process Clause, and yet lack the 'substantial nexus' with that State as required by the Commerce Clause.” Id. at 312, 313. This, combined with the importance of stare decisis, led the Court to reaffirm the bright-line physical presence requirement of Bellas Hess.

Emboldened by Quill's reaffirmation of the physical presence requirement, many non-franchise companies established Intangible Holding Companies (“IHC”) for their intellectual property as a means to avoid state taxation. Operating businesses would pay “royalties” to an IHC that generated tax deductions for the operating business, while the income received by the IHC was not subject to tax. Chastened but not defeated by Quill, many states rejected these constructs and adopted the concept of “economic nexus” to satisfy the physical presence requirement ' arguing that actual physical presence was required only in sale and use tax cases. See e.g., Lanco, Inc. v. Director, Div. of Taxation , 908 A.2d 176 (N.J. 2006), cert. denied , 551 U.S. 1131 (2007); A&F Trademark, Inc. v. Tolson , 605 S.E.2d 187 (N.C. Ct. App. 2004), cert. denied , 546 U.S. 821 (2005); Geoffrey, Inc. v. South Carolina Tax Comm'n , 437 S.E.2d 13 (S.C. 1993), cert. denied , 510 U.S. 992 (1993). As the case histories establish, the Supreme Court did not interfere with these efforts.

Iowa Extends Economic Nexus to Franchising

In 2001, Iowa extended the concept of economic nexus beyond IHC structures specifically designed to avoid state taxes to asses KFC for three years of unpaid corporate income taxes, interest and penalties based on the royalties KFC received from its Iowa franchisees. This appears to be the first time a state utilized the economic nexus theory to satisfy the physical presence requirement for a franchise system. Not surprisingly, KFC challenged the assessment, but in 2010 the Iowa Supreme Court approved the application of economic nexus to franchise systems, while “recogniz[ing] that a counterargument could be made that aggressive judicial intervention is required to prevent states from shifting tax burdens onto out-of-state parties who lack political power in the taxing jurisdiction.” 792 N.W.2d 308, 327 (2010). On Oct. 3, 2011, the Supreme Court refused to review the Iowa Supreme Court's decision; other state taxing authorities are almost certain to also extend economic nexus to franchise systems.

While the immediate consequences of the Court's decision are limited to franchisors with franchisees in Iowa, as more states adopt Iowa's approach, franchisors will be expected to file income tax returns in all states where their franchisees are located. This will likely lead to: 1) increased compliance costs, e.g., tax return preparation costs; 2) retroactive tax, interest and penalty assessments with no statute of limitations protection; 3) increases in total state income tax obligations; and 4) possible double taxation of royalties due to their being taxed twice by different jurisdictions.

Equally important is the fact that the ultimate “cost” to franchisors will vary greatly from system to system. This is because franchisors' corporate structure and the residence of their owners will vary how Iowa's approach will affect them.

Recommendations for Franchise Companies

While it will likely take some time for the impact of the Iowa decision to filter through the states, franchisors should consider taking steps now to minimize its impact. One option is litigation outside of Iowa challenging extension of economic nexus to franchising. While certain states are likely eager to jump on the Iowa bandwagon, other states have historically been more loyal to Quill and its physical presence requirement.

Franchisors should also consider lobbying the federal government to end the states' ability to assert the economic nexus theory by adopting the Business Activity Tax Simplification Act or other legislation.

Systems with franchisees in Iowa and other states likely to apply economic nexus to franchising may be best served by seeking voluntary disclosure or amnesty deals with states. Such deals typically permit a taxpayer to “come clean” and begin filing tax returns prospectively in exchange for limiting exposure to past tax obligations and abatement of penalties.