United States: Iowa Supreme Court Hears Oral Arguments in Tax Case Impacting Franchisors

On May 20, the Iowa Supreme Court heard oral arguments in KFC Corporation vs. Iowa Department of Revenue, a case that could have a substantial financial impact on franchisors across the nation.

In KFC Corp. the state of Iowa has asserted that KFC Corporation is subject to Iowa corporate income tax based solely on the fact that it received royalties from franchisees in Iowa. The state cited Geoffrey v. South Carolina Tax Commission and related cases in support of its position. However, a victory by the State would represent an extension of those cases because KFC Corp. involves licensing agreements between unrelated parties.

The KFC case could result in a landmark decision for states attempting to impose income tax on out-of-state franchisors and other similarly situated taxpayers.

Background on State Tax Nexus

Historically, many franchisors have reported and paid income taxes only in states in which they have a physical presence. This practice is based on a 1992 U.S. Supreme Court case, Quill Corp. v. North Dakota, which held that the Commerce Clause of the United States Constitution barred states from imposing a use-tax collection obligation on out-of-state corporations that had no physical presence in the taxing state. The Court held that such corporations did not have the "substantial nexus" with the state that was required under the Commerce Clause.

Since Quill, many state taxing authorities have argued that the physical-presence requirement enunciated in that case applied only to state sales and use taxes. Taxpayers, on the other hand, have read Quill to apply to state income taxes as well.

The first major case to address these conflicting interpretations was Geoffrey, which was decided by the South Carolina Supreme Court in 1993, shortly after the Quill decision. In Geoffrey, the South Carolina Supreme Court sided with the state in a case involving the licensing of trademarks by a licensor to a related licensee. The Geoffrey court held that the U.S. Constitution did not prevent the state from imposing income tax on an out-of-state licensor whose only connection with the state was the receipt of royalties from its subsidiary for use of its intangible property in the state.

A number of state courts have decided cases that are similar to Geoffrey since 1993, including several in recent years. The vast majority of those cases have been decided in favor of the state taxing authorities, and the U.S. Supreme Court has repeatedly declined taxpayer requests to review those decisions. This, in turn, has led state taxing authorities to become increasingly aggressive in asserting nexus over out-of-state entities.

KFC Corporation v. Iowa Department of Revenue

In June 2009, an Iowa District Court upheld the state's imposition of tax on KFC based on its receipt of royalties from franchisees in the state. The court held that the Commerce Clause of the U.S. Constitution did not require a taxpayer to have a physical presence in Iowa to establish a "substantial nexus" in the state for purposes of corporate income tax. The District Court cited to the Geoffrey line of cases to support its decision. KFC appealed the District Court's decision to the Iowa Supreme Court, which, following the submission of briefs by KFC and the state, heard oral arguments in the case last week.

The overall tone of the Iowa Supreme Court in the oral arguments was one of skepticism as to KFC's claim that Quill should control its analysis. The Court specifically highlighted Quill's less-than-enthusiastic adoption of the physical-presence test. In turn, KFC pointed out that the Quill court did evaluate and affirm the adoption of that test and that Quill is the U.S. Supreme Court's latest ruling on this topic.

The Court stated that it struggled with the notion that the Commerce Clause protected KFC from taxation in the state even though KFC earned significant income in Iowa that was dependent upon the state's provision of protections and benefits to its franchisees (e.g., roads, courts, etc.). KFC responded by arguing that those indirect benefits were received by many out-of-state (or out-of-country) entities whose products or customers happened to be sold or located in Iowa. According to KFC, if the Court applied that type of indirect-benefit analysis, "everyone would be taxable everywhere."

Throughout its arguments, KFC forcefully argued that Quill should apply to Iowa's corporate income tax and that the Geoffrey line of cases had been improperly decided. KFC thus urged the Court to follow the pragmatic result reached in Quill and to reverse the decision below.

During the state's argument, the Court asked it to respond to KFC's assertions that a ruling in the state's favor would require a wide range of out-of-state entities and individuals with little or no connection to Iowa to pay taxes in the state. The state responded merely by commenting that other potential applications of the decision were not before the court and declined to opine as to how far it could assert nexus under its reading of the Commerce Clause. The state appeared content to rely on the Geoffrey line of cases during its argument.

It is difficult to determine how the Court will decide the case based solely on the oral arguments. The Court seemed hesitant to accept that KFC could be exempt from Iowa tax merely because it did not have a physical presence in the state. However, KFC continually reminded the Court of the immense difficulties that abandoning Quill could create for taxpayers across the nation.

What Is Next for Franchisors?

The Iowa Supreme Court's determination in KFC Corp. will significantly impact franchisors (and other taxpayers) across the nation regardless of its result. If the case is decided adversely to KFC, franchisors with franchisees in Iowa may face aggressive enforcement actions by the state to collect income taxes (including interest and penalties) from the franchisors for prior years. If a franchisor has not been filing returns in the state, it could be liable for taxes going back as many years as it has had franchisees located in the state. The Department of Revenue could also adopt a shorter look-back period, but that is unknown at this time.

Franchisors should also expect the impact of the decision in KFC Corp. to extend beyond Iowa. Other states will likely aggressively pursue collection actions against franchisors—if they are not already doing so—if the State of Iowa is successful in KFC Corp. Franchisors should consider how they will handle such actions and whether they wish to be proactive in reaching out to state taxing authorities before they are contacted. Many states have voluntary disclosure programs pursuant to which taxpayers can limit the number of years of exposure and potentially limit interest and penalties on any underpayments tax.

On the other hand, if KFC Corp. is decided favorably for KFC, the case may discourage actions by other states against out-of-state franchisors. The Geoffrey line of cases would then be easily distinguishable by franchisors and states may be reluctant to take an aggressive stance in light of that decision. Franchisors should keep in mind, however, that other states will not be bound by KFC Corp. and other state taxing authorities may attempt to obtain a more favorable ruling in their state courts. Further, states with Geoffrey decisions already on the books will likely view KFC Corp. as immaterial to their own taxing authority.

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