United States: NM Supreme Court: Gross Receipts Tax Does Not Apply to Certain Trademark License Transactions

There has been much controversy over the last few years concerning the issue of the right of a state to tax out-of-state license and franchise transactions. A recent case in New Mexico may affect that state’s position on the applicability of its gross receipts tax (GRT) to royalties paid under franchise agreements.

The New Mexico Supreme Court, in Kmart Corp. v. Taxation and Revenue Dep’t, No. 27,269, N.M. Sup. Ct. (December 19, 2005) (Kmart), recently reversed the earlier holding of the New Mexico Court of Appeals in Kmart Properties, Inc. v. Taxation and Revenue Dep’t, __ N.M. __, __P.2d__ (Ct. App. 2001), cert. granted, 131 N.M. 564, 40 P.3d 1008 (2002), cert. quashed, __N.M.__, __P.3d__ (2005) (KPI (Court of Appeals)) and found that the GRT did not apply to royalties paid under a trademark license agreement that was entered into outside of New Mexico, even though the trademark licensee conducted activities in New Mexico.

For years, New Mexico has taken the position that the GRT and corporate income tax apply to royalties paid under a license agreement based on sales that occur in New Mexico. This position has been affirmed by the New Mexico Court of Appeals in various holdings, including KPI (Court of Appeals) and, in the franchise context, Sonic Industries, Inc. v. State, 129 N.M. 657, 11 P.3d 1219, cert. granted, 129 N.M. 519, 10 P.3d 843 (2000) (Sonic Industries). Kmart may signal a change in this position.

Based on advice from its accountants, in 1991, Kmart Corporation (Kmart) restructured the ownership of its trademarks, assigning certain of its trademarks to an affiliate, Kmart Properties, Inc. (KPI). KPI then granted Kmart an exclusive right to use the trademarks in exchange for payment of a royalty equal to 1.1 percent of Kmart’s net sales in the United States. KPI was located in Michigan and licensed the trademarks to Kmart, a Michigan corporation, in Michigan. KPI did not file tax returns in New Mexico.

In 1997, the New Mexico Taxation and Revenue Department audited KPI, and for the period from 1991 through 1996, assessed it $748,142 in corporate income tax and $478,099.55 in GRT (plus penalties and interest) based on sales in Kmart’s stores in New Mexico. KPI appealed the Department’s imposition of the taxes to the Court of Appeals.

In KPI (Court of Appeals), the court upheld the imposition of the taxes. The Court of Appeals did not undertake a comprehensive analysis of the applicability of the GRT to the licensing transaction. Instead, it relied on its earlier decision in Sonic that royalties received by a franchisor under a franchise agreement for a Sonic restaurant located in New Mexico were subject to the GRT, even though the franchise agreement was entered into in Oklahoma.

Kmart (which was substituted as a party due to a subsequent merger of KPI into Kmart) appealed to the New Mexico Supreme Court, making various arguments against the imposition of the GRT and corporate income tax to KPI’s receipts under the license agreement, including that the imposition of the taxes was not constitutional.

In its decision, however, the Supreme Court focused on the language of the New Mexico Gross Receipts and Compensating Tax Act (the Act) to determine whether the New Mexico legislature intended for KPI’s receipts to be subject to the GRT. (The Supreme Court quashed the certiorari on the corporate income tax issue and ordered that the KPI (Court of Appeals) opinion be filed, so the Court of Appeals holding in KPI (Court of Appeals) on this aspect of the case is currently the law of New Mexico.)

The court noted that, prior to 1991, the grant of a license to use intangible property was considered a lease under the GRT. This provided the underpinning for three 1979 cases decided by the Court of Appeals upholding the imposition of the GRT in the franchise context when the intangible property was owned by an out-of-state franchisor but used by the franchisee in New Mexico. See Am. Dairy Queen Corp. v. Taxation and Revenue Dep’t, 93 N.M. 743, 605 P.2d 251 (N.M. Ct. App. 1979); Baskin-Robbins Ice Cream Co. v. Revenue Div., Dep’t of Taxation and Revenue, 93 N.M. 301, 599 P.2d 1098 (N.M. Ct. App. 1979); AAMCO Transmissions, Inc. v. Taxation & Revenue Dep’t, 93 N.M. 389, 600 P.2d 841 (N.M. Ct. App. 1979).

However, in 1991, the legislature amended the New Mexico tax laws to provide that "the granting of a license to use property is the sale of a license and not a lease." Further, under the Act, "licensed property can only be subject to the GRT in New Mexico if the license was in essence sold in New Mexico." The court rejected the Department’s argument that the location of the licensed property in New Mexico subjected KPI’s license agreement receipts to the GRT. The court held that, since "all of the critical elements" of the license transaction took place outside of New Mexico, there was no "selling [of] property in New Mexico" and, therefore, the GRT was not applicable to KPI’s receipts under the license agreement.

The Supreme Court’s reference in Kmart to the rationale for the three 1979 franchise decisions and its observation that "we do not perceive any legally significant distinction between franchise fees and trademark licensing royalties" suggest that one might apply Kmart to out-of-state franchise transactions and argue that it effectively overrules Sonic and the earlier franchise cases.

There are two cautionary notes, however. The Kmart court based its holding, in part, on the fact that KPI was located in Michigan and licensed the trademarks in Michigan to Kmart, a Michigan corporation. A question remains as to whether the GRT would apply to royalties paid to an out-of-state franchisor by a New Mexico franchisee, even if the franchise agreement is entered into outside of New Mexico.

Additionally, the Kmart court noted that "all activity related to the License Agreement" took place in Michigan. Although the court appears to be referring to the initial act of entering into the license agreement as the "sale," this is not entirely clear. If the court was also referring to ongoing obligations of KPI under the license agreement, the application of Kmart to a franchise transaction may be in question if the out-of-state franchisor provides some level of "on the ground" support and assistance to the franchisee in New Mexico.

If you have any questions relating to this recent decision, or the general issue of state taxation of franchise royalties paid to out-of-state franchisors, please contact us.

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