Nexus Determines When Out-of-State Franchisors Pay Taxes on Royalties, Franchisee Revenues

This posting was written by Bruce S. Schaeffer of Franchise Valuations, Ltd., co-author of CCH Franchise Regulation and Damages.

“Tax nexus” is a term of art in the field of state and local taxation that applies to the determination of whether or not an out-of-state entity (for example, a franchisor) must file and pay taxes with respect to revenues which are generated within a particular jurisdiction where they have no facilities—although they do have franchisees.

The issue is often confusing but, in fact, there are two separate issues: income tax nexus and sales tax nexus. For both, the ultimate question is what level of “presence” is necessary to establish taxability or nexus? What is a sufficient connection with a state to allow it to fairly impose a levy on operations connected with its territory?

Income Tax Nexus

Since the well-known decision in Geoffrey v. South Carolina (Business Franchise Guide ¶10,319, 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993)) 15 years ago, it has been fairly well-settled law (though nonetheless frequently contested) that “economic presence” is all that is required to yield income tax nexus.

In that case, the taxpayer was a Delaware Corporation in which Toys R Us incorporated its intangibles, including Geoffrey, its trademark giraffe.

The corporation collected royalties from Toys R Us South Carolina operations (where they were deducted for South Carolina income taxes) and reported them in Delaware where there was no income tax, effectively escaping South Carolina’s income taxes completely. It didn’t stand up. South Carolina’s high court said that the presence of the trademark and the royalty source in South Carolina was enough to constitute “economic presence” and render Geoffrey liable for South Carolina income taxes.

Geoffrey went on to fight the same fight in North Carolina a few years ago with the same result —they lost and were assessed interest and penalties too. Last week, another Geoffrey decision was reported in Louisiana, where the corporation made the same claim and lost again and was again assessed interest and penalties. (Bridges v. Geoffrey, Inc., Louisiana Court of Appeal, First Circuit, Number 2007 CA 1063, February 8, 2008.)

Sales Tax Nexus

However, since the 1992 U.S. Supreme Court decision in Quill v. North Dakota (504 U.S. 298), there has been some legitimate question as to whether or not a “physical presence” is required to make an out-of-state vendor liable to collect and pay over sales taxes. (A full listing of the rules in the various states can be found in Byron E. Fox and Bruce S. Schaeffer, CCH Franchise Regulation and Damages, Chapter 6A.)

Proposed Federal Legislation

Within the past few weeks, a bill was introduced in the Senate (a similar bill was introduced last year in the House of Representatives) to restrict tax nexus to situations where the taxpayer actually maintains “physical presence” in the taxing jurisdiction for more than 15 days in a tax year. Under the proposed legislation, taxpayers would not be subjected to either income or sales tax obligations, absent such “physical presence.” It is unlikely that there is a state or local jurisdiction in the country that will not protest this bill and its enormous potential for revenue loss.

Additional information on state and local tax "nexus" problems for franchisors is available in CCH Franchise Regulation and Damages by Byron E. Fox and Bruce S. Schaeffer.