High Court Declines to Review Iowa’s Taxation of Franchisor With No Physical Presence In State

This posting was written by Pete Reap, Editor of CCH Business Franchise Guide.

A national franchisor of fried chicken restaurants has been denied U.S. Supreme Court review of a decision by the Iowa Supreme Court, rejecting the franchisor’s argument that a physical presence within the State of Iowa was a prerequisite to the state’s imposition of income tax on the franchisor (KFC Corp. v. Iowa Department of Revenue, Business Franchise Guide ¶14,518).

Specifically, the Iowa court held that a physical presence was not required under the dormant Commerce Clause of the U.S. Constitution in order for the Iowa legislature to impose an income tax upon revenue earned by an out-of-state restaurant franchisor arising from the use of the franchisor’s intangibles by franchisees located within the state.

By licensing franchises within Iowa, the franchisor received the benefit of an orderly society within the state and, as a result, was subject to the payment of income taxes that otherwise met the requirements of the dormant Commerce Clause.

Background

The dispute began when the Iowa Department of Revenue issued the franchisor an assessment in the amount of $284,658 for unpaid corporate income taxes, penalties, and interest for 1997, 1998, and 1999. The franchisor, a Delaware corporation with its principal place of business in Kentucky, owned no restaurant properties in Iowa and had no employees in Iowa.

All of the franchisor’s franchisees in Iowa were independent businesses that licensed their use of the franchisor’s trademark and related system.

The franchisor protested the assessment of the income tax, arguing that, in Quill Corp. v. North Dakota (504 U.S. 298, 1992), the U.S. Supreme Court held that a use tax could not be imposed on a foreign corporation that had no physical contact with the taxing state. Further, the Quill Court did not limit its holding to use taxes, the franchisor pointed out.

Opinion Below

This situation differed from Quill, where the only presence in the state except for "title to a few floppy diskettes" resulted from the use of U.S. and common carriers, because this case involved the use of the franchisor’s intangible property in the state to produce royalty income, according to the Iowa court.

Forced to predict whether the U.S. Supreme Court would extend the physical presence requirement imposed by Quill on use taxation to prevent a state from imposing an income tax based on revenue generated from the use of intangibles within the taxing jurisdiction, the Iowa Supreme Court held that it would not.

Physical Presence Test

The use of a physical presence test limited the power of a state to tax out-of-state taxpayers, but it did so in an irrational way, according to the court. In today’s world, physical presence was not a meaningful surrogate for the economic presence sufficient to make a seller the subject of state taxation. Instead, physical presence often reflected more the manner in which a company did business rather than the degree to which the company benefited from the provision of government services in the taxing state.

Extension of the physical presence approach of Quill would be an incentive for entity isolation in which potentially liable taxpayers could create wholly-owned affiliates without physical presence in order to defeat potential tax liability, the court reasoned.
The court doubted that the U.S. Supreme Court would want to extend such form-over-substance activity into the income tax arena where "substance over form has been the traditional battle cry."

Moreover, Iowa’s taxation of the franchisor’s royalty income was most consistent with the prevailing substance-over-form approach embraced in most of the modern cases decided by the Supreme Court under the dormant Commerce Clause, according to the court.

Petition for Review

The franchisor contended that review was warranted because of the acknowledged division among the states over whether a state may impose taxes other than sales or use taxes on an out-of-state business with no physical ties to the state. With the decision below, 16 state appellate courts have divided over whether the physical presence requirement in Quill applied to state income and franchise taxes.

The courts of three states concluded that that a taxing state could not impose an income or franchise tax on an out-of-state business unless it maintained a physical presence in the taxing state, and the courts of the remaining 13 states reached a different conclusion, the franchisor noted. The conflict among the states was “entrenched” and would not be resolved absent review by the Supreme Court.

The franchisor also attacked the merits of the Iowa court’s ruling, arguing that the U.S. Supreme Court has never sustained a state tax in the absence of an in-state physical presence by the taxpayer. Underpinning the Iowa court’s ruling was the idea that the Commerce Clause treated sales and use taxes differently than income and franchise taxes. However, the Supreme Court had never drawn such a distinction, according to the franchisor, and had long held that there be a substantial nexus between a state and an out-of state business before any tax could be levied.

In fact, no decision of the U.S. Supreme Court had ever sustained a state tax imposed on an out-of-state business that had no in-state presence in the taxing state. It was only the Iowa court below, along with 12 other state courts, that had reached a contrary conclusion.

The franchisor further argued that continued state court repudiation of the physical presence requirement adversely affected the entire United States economy and had international implications. The issue at stake was estimated to be worth billions of dollars annually in taxes and would be left to a patchwork of state courts to decide until the High Court “provided a uniform understanding of the scope of the Commerce Clause.”

Until the U.S. Supreme Court reviews the issue, a foreign business with no physical presence in the U.S. could be subject to state taxation, even though the foreign business was exempted from federal income taxes by tax treaties that normally required a physical presence in the country.

The petition in KFC Corp. v. Iowa Dept. of Revenue, Dkt. No. 10-1340, was denied by the Supreme Court on October 3, 2011.

Further details regarding the Iowa Supreme Court decision appear in a January 4, 2011 Trade Regulation Talk posting (“Iowa May Tax Royalties to Out-of-State Franchisor Having No Physical Presence in State”).

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.