United States: Iowa Supreme Court Holds that Out-of-State Franchisors with Franchisees in the State are Subject to Iowa Corporate Income Tax

The Iowa Supreme Court handed down its decision in KFC Corporation vs. Iowa Department of Revenue on December 30, 2010, upholding the state's ability to tax out-of-state franchisors that do not have a physical presence in the state. The court held that the State of Iowa has the authority to impose its corporate income tax on franchisors based solely on the use of their intangibles by franchisees located in the state. This decision, although not unexpected, will lead to increased enforcement efforts in Iowa, and perhaps other states. This article provides a brief background on the KFC case, information regarding the KFC decision, advice for franchisors on what to expect from state taxing authorities in light of the decision, and advice for franchisors regarding what actions they should take in response to the case.

Case Background

The KFC case involved an assertion by the Iowa Department of Revenue that KFC was responsible for paying corporate income tax in the state based solely on its receipt of royalties from franchisees in the state. In June 2009, an Iowa District Court upheld the state's imposition of tax, and KFC appealed the decision to the Iowa Supreme Court. The Iowa Supreme Court heard oral arguments in the case in May 2010 and issued its determination on December 30.

Decision Rejects the Physical-Presence Standard for Nexus for Income Taxes

KFC argued to the Iowa Supreme Court that the department's assessment of tax violated the Commerce Clause of the U.S. Constitution. KFC based its argument upon earlier Supreme Court case law finding that the Commerce Clause required that a taxpayer have a physical presence in a state before the state could require the taxpayer to collect and remit the state's sales and use taxes. The department disagreed with KFC's position, arguing that the state could impose its corporate income tax on KFC regardless of KFC's physical presence in the state. The department argued that the cases cited by KFC should be limited to sales and use taxes and should not apply to the state's corporate income tax.

The court's decision contained a thorough and careful analysis of the United States Supreme Court's jurisprudence regarding the limits on state taxation imposed by the Commerce Clause. The court paid special attention to the genesis, application, and impact of the physical-presence standard and found it compelling that the Supreme Court's decisions applying that standard all involved sales and use taxes, and that no Supreme Court decision had applied that standard to cases involving state income taxes. The court also noted independent skepticism about the advisability of a physical-presence test for income taxation and felt that the test "engendered" tax evasion.

Based on its review of the applicable authority, the court came to two important conclusions. First, in an unexpected and unique ruling, the court held that the U.S. Supreme Court would likely find that the intangibles that KFC licensed to its Iowa franchisees "would be regarded as having a sufficient connection to Iowa to amount to the functional equivalent of 'physical presence.'" This functional-equivalency test goes beyond related case law and is of questionable basis. Second, the court held that the physical-presence standard does not apply to Iowa's corporate income tax. The court noted that "physical presence is not required under the dormant Commerce Clause of the United States Constitution in order for the Iowa legislature to impose an income tax on revenue earned by an out-of-state corporation arising from the use of its intangibles by franchisees located with the State of Iowa." The court thus affirmed the district court's decision, noting that "by licensing franchises within Iowa, KFC has received the benefit of an orderly society within the state and, as a result, is subject to the payment of income taxes that otherwise meet the requirements of the dormant Commerce Clause." The decision represents the first contemporary case applying this concept to franchise relationships.

What is next?

KFC has ninety days to appeal the Iowa Supreme Court's decision to the United States Supreme Court. If KFC decides to appeal, the Supreme Court will have full discretion on whether it will review the case. Unfortunately, the Supreme Court has declined the opportunity to review several similar cases in recent years. Therefore, it appears unlikely that the court would decide to review the case even if KFC does appeal.

If KFC does not appeal the case, or if KFC's appeal is not accepted by the Supreme Court, the Iowa Supreme Court's decision will stand. The Iowa Department of Revenue would thus be able to proceed in assessing the state's income tax against out-of-state franchisors with franchisees in the state.

How will KFC impact franchisors with franchisees in Iowa?

If the Iowa Supreme Court's determination in KFC is not overturned by the U.S. Supreme Court, franchisors with franchisees located in Iowa (and who have not been paying Iowa income tax) will likely face aggressive enforcement actions by the state to collect income taxes from prior years (and interest and penalties on those taxes). If a franchisor with franchisees in Iowa has not filed income tax returns in Iowa, it could potentially be liable for taxes in all previous years the franchisor has had franchisees within the state. It is unclear at this point whether the department will limit its look-back period.

It is also unclear what standard the department will apply when determining whether an out-of-state franchisor has nexus with the state. The KFC court merely held that physical presence was not required "in order for the Iowa legislature to impose an income tax on revenue earned by an out-of-state corporation arising from the use of its intangibles by franchisees located within the State of Iowa." Based on this limited language, however, we expect that the state will assert nexus over (and seek to collect income tax from) any franchisor receiving more than a de minimis amount of income from franchisees located in Iowa. Franchisors will thus need to evaluate whether their circumstances are sufficiently different from those presented by KFC to oppose an action by the state under the KFC case.

How will the Iowa income tax on a franchisor be measured?

The actual tax implications of the KFC decision to a franchisor depend on a number of factors, including the source and types of income of the franchisor and the franchisor's form of organization.

Very generally, a corporate franchisor's Iowa tax will be determined by applying Iowa's graduated corporate income-tax rates to the corporation's Iowa taxable income. A franchisor's Iowa taxable income is generally determined by multiplying the franchisor's total net income by Iowa's single-factor apportionment formula. That apportionment formula is determined by dividing the franchisor's "Iowa sales" by its "everywhere sales." A franchisor's "Iowa sales" will be determined by applying Iowa's source rules to the franchisor's various types of income. Iowa will generally seek to source franchise royalties and licensing fees to Iowa to the extent that they are earned from franchisees within the state.

For a franchisor that is structured as a sole proprietorship, LLC, or partnership, the tax would generally be imposed on the franchisor's owners. The owners' Iowa taxes would be determined by multiplying the Iowa graduated personal income-tax rates by the owners' portion of the franchisor's Iowa taxable income. Unlike a corporate franchisor, the owners of a franchisor taxed as a sole proprietorship or partnership could generally then get a credit against their home states' income taxes for the taxes paid in Iowa.

How will KFC impact franchisors with franchisees in other states around the nation?

We expect that the KFC case will have an impact far beyond Iowa. Franchisors can expect that other states have been following KFC and will view the decision as support for aggressive collection actions against franchisors that have franchisees located within their states. States are facing historic budget shortfalls, and expanding their tax bases is a way to generate additional revenue. This type of expansive enforcement action has been occurring outside of the franchise area for years. For example, states have been successfully assessing their income taxes based upon an economic-nexus concept against intangible holding companies since the early 1990s and more recently against credit card companies in the 2000s.

Franchisors have already seen states taking more aggressive actions against franchisors in recent years. Earlier this year, for example, Washington enacted a new statute that imposes its B&O tax on franchisors based simply upon their receipt of certain levels of royalties from franchisees in the state (for a detailed analysis, follow the article link on the left). This development came soon after new reporting requirements in New York and aggressive collection actions by California. Franchisors should carefully monitor and evaluate state-tax developments to ensure that they are fully aware of their tax obligations.

What should a franchisor do in response to KFC?

Franchisors with franchisees in Iowa should develop a plan for handling potential enforcement actions by the Iowa Department of Revenue if they have not been paying Iowa income tax. Specifically, franchisors should determine whether they will be proactive with the state by entering into Iowa's Voluntary Disclosure Program, or whether they will wait to see if the state contacts them. Generally, participation in the program will limit a franchisor's liability for back taxes, interest, and penalties. However, that program is not available to franchisors once they have been contacted by the department. Franchisors should contact their tax advisors as soon as possible if they would like to evaluate participation in the Voluntary Disclosure Program.

In addition to determining how to respond in Iowa, franchisors should be deliberate in developing an overall state-tax strategy. Franchisors should expect that the action taken by Iowa will be repeated in states across the country as they grapple with their budget deficits. The timing, applicability, and impact of those undertakings will vary. However, franchisors can better understand and limit their potential exposure by taking initiative in this area, from evaluating their past and current business activities and organizational structures to enacting "gross-up" provisions in their franchise agreements.

In the end, the KFC case does not mean that franchisors will be left without tools to defend themselves from state-tax audits. Different states are taking different approaches, each of which provide different risks and opportunities for franchisors. Taking the time to understand these issues and develop a comprehensive strategy today will help lessen the surprise, cost, and burden on franchisors should they be approached by state taxing authorities in the future.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.