Those in the franchising industry have been awaiting a ruling from the Iowa Supreme Court in KFC Corp. vs. Iowa Department of Revenue, a tax nexus case that could have implications for the entire industry. That ruling was finally issued on December 30, 2010, in which the court upheld the state's ability to tax franchisors that do not themselves maintain a physical presence in the state, but that collect royalties from franchised locations in Iowa.
In this case, the Iowa Department of Revenue asserted that KFC Corporation was subject to taxation in Iowa, solely based on the fact that KFC received royalties from franchisees located in Iowa. KFC disputed the finding, and argued that under the Commerce Clause of the United States Constitution, it must have a physical presence in Iowa before it can be subject to a state income tax.
The Iowa Supreme Court acknowledged that KFC did not own any restaurant properties in Iowa, and had no employees in Iowa. However, it conducted a long and detailed analysis of the Commerce Clause and the U.S. Supreme Court's application of this clause in the sales and use tax and state income tax arenas. In its analysis, the court asserted that over time, the application of state taxation has evolved from a formalistic approach requiring a strong and direct presence, to a more practical assessment that looks at substance over form in determining whether a tax is due.
In the end, the Iowa Supreme Court decided that the intellectual property and other intangibles owned by KFC and licensed to its franchisees in the state of Iowa amounted to the functional equivalent of a physical presence in the state. Furthermore, the court found that a traditional physical presence is not required in order for an income tax to be assessed on revenue. Instead the court found that "by licensing franchisees 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."
As a result of this decision, franchisors across the nation need to analyze their activities in Iowa, and determine a strategy for dealing with the Iowa Department of Revenue if taxes have not been paid in this state. Additionally, although this is the first case that has specifically rejected the need for a physical presence to exist, franchisors should be aware of the growing trend of state taxation authorities that are expanding their interpretations of corporate activities that subject entities to sales or corporate income taxes. As a result, we are encouraging our franchisor clients to (i) not ignore the tax letters they received from the states, (ii) recognize the risk that a state tax may be payable in the states from which they receive franchise royalties, and (iii) include a provision in their franchise agreement requiring the franchisee pay this tax (just as a customer is required to pay sales tax associated with the purchase of goods).
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