Iowa May Tax Royalties to Out-of-State Franchisor Having No Physical Presence in State

This posting was written by John W. Arden.

The State of Iowa could impose corporate income taxes on royalties paid by Iowa franchisees to Louisville-based KFC, which owned no restaurant properties within Iowa and had no employees within the state, according to the Supreme Court of Iowa.

In 2001, the Iowa Department of Revenue issued an assessment of more than $284,000 for KFC’s unpaid corporate income taxes, penalties, and interest for 1997, 1998, and 1999. KFC filed a protest of the assessment, contending that the royalty income was not subject to taxation by Iowa because it was a foreign corporation that had no physical presence within the state. Such taxation would violate the Commerce Clause and the Iowa tax code, according to KFC.

An administrative law judge disagreed with KFC, holding:

(1) that physical presence is not required to tax corporate income,

(2) that KFC had a sufficient nexus with Iowa to support the tax assessment, and

(3) that the Iowa statute requiring “situs in this state” did not require physical situs, but merely required Iowa to be the place where a right is held to be located in law.

The director of the Department of Revue affirmed the administrative law judge, noting that several states had held that an economic presence satisfied the “substantial nexus” requirement for corporate income tax purposes.

On appeal, the state district court affirmed, finding that “physical presence” was not required under the Commerce Clause and that the income derived from the use of KFC’s intellectual property was taxable under Iowa law.

Dormant Commerce Clause

On review, the state supreme court explained that physical presence “in the narrow sense does not appear as an important factor in cases involving state income taxation.”

However, the U.S. Supreme Court has endorsed the requirement of physical presence in the area of state sales and use taxes, as held in the 1992 decision Quill Corp. v. North Dakota (504 U.S. 298).

Nevertheless, the Iowa high court argued that—in addressing due process questions—the U.S. Supreme Court has eviscerated the formalistic physical presence test in favor of a flexible multifactor minimum contacts test. It maintained that such analysis should extend to Commerce Clause analysis.

Since Quill, the U.S. Supreme Court has “generally avoided Commerce Clause cases involving the authority of states to impose taxes other than sales and use taxes on out-of-state entities with or without ‘physical presence,’” according to the Iowa court.

Geoffrey Case

The court found support for its position in Geoffrey, Inc. v. S.C. Tax Commission (CCH Business Franchise ¶10,319). In Geoffrey, the South Carolina Supreme Court held that state income taxes could be imposed on out-of-state franchisors who earned income from franchisee activities within the state based on the notion that the franchisor’s intangible property had acquired a “business situs” when used by local franchisees.

In making its decision, the South Carolina Supreme Court concluded that the franchisor’s physical presence in the state was not required. It held that “any corporation that regularly exploits the markets of a state should be subject to its jurisdiction to impose an income tax even though not physically present.”

This decision, which was denied review by the U.S. Supreme Court in 1993, has been cited in many state courts considering whether the licensing of intangible property (such as trademarks and business methods) provides sufficient nexus for the imposition of state income tax. These state courts tend to limit Quill to the context of sales and use taxes, the court noted.

In attempting to determine how the U.S. Supreme Court would rule on this case, the Iowa high court held that the dormant Commerce Clause would not be offended by the imposition of state income tax on royalties paid by KFC’s Iowa franchisees. It based its ruling on findings that:

(1) Franchisees' use of the franchisor’s intangible property within Iowa to produce the royalty income was the functional equivalent of “physical presence” under Quill; and

(2) The Court would not have extended the “physical presence” test beyond its “established moorings” in Quill to prevent a state from imposing an income tax based on revenue generated from intangibles within the taxing jurisdiction in light of subsequent developments in the law.

The December 30, 2010 decision is KFC Corp. v. Iowa Department of Revenue. The 40-page opinion will appear in CCH Business Franchise Guide.