The franchise industry is waiting anxiously to see if the U.S. Supreme Court will weigh in this year on a 10-year-old case involving KFC Corp. and the question of whether a state has the right to tax franchise companies located outside its borders.
The eventual outcome of the lawsuit, which hinges on a tax bill proffered by Iowa’s Department of Revenue to the Louisville, Ky.-based quick-service chicken chain, could solve two points of contention: First, the establishment of the “nexus,” or connection between a franchisor and franchisee, a linkage that could make an out-of-state franchisor liable for taxes on royalty revenue paid by Iowa franchisees, and second, whether a potential flood of hefty tax bills could be levied against franchisors nationwide as states, hungry for new revenue sources, follow Iowa’s lead.
The Iowa case “is a revenue grab combined with a misunderstanding of the business model of franchising,” said Wayne Weikel, director of state government affairs for the International Franchise Association, or IFA. “It’s also a new interpretation of what we believe existing law says.”
The lawsuit, filed a decade ago by the Iowa Department of Revenue against KFC Corp., sought $284,658 in unpaid taxes, penalties, and interest for the years 1997-1999, claiming that royalty payments received from Iowa KFC franchisees were subject to income tax.
KFC protested the action, arguing it lacks any physical nexus to its Iowa franchisees because it neither owns property nor employs anyone in the state. Two Iowa courts, however, have sided with the department of revenue on the grounds that KFC Corp.’s income from royalties is derived from Iowa customers, and that those sales would not occur without the state’s “protection of the Iowa marketplace.” In 2009 Iowa’s appellate court further concluded that the traditional test of “physical presence” is not required to establish nexus when the state taxes on an out-of-state business’s income.
The appellate court also determined that KFC franchisees’ use of KFC Corp.’s intangible assets, such as trademarks and recipes, constituted sufficient nexus to make those royalties taxable under Iowa regulations. The court said that because KFC owns and maintains control of its intangibles and the quality of goods sold under its brand, it was indeed connected to its franchisees’ activities.
KFC Corp. appealed to the U.S. Supreme Court in December 2010. The IFA in June filed an amicus brief urging the Supreme Court to hear the case and overturn the Iowa Supreme Court’s ruling or risk stifling the development of franchise businesses.
“The lower court’s ruling, if upheld, would have a devastating impact on job creation and economic growth by franchise businesses and would cause a decline in job growth and economic activity in a sector responsible for one out of every eight jobs,” said IFA president and chief executive Steve Caldeira. “Granting the petition of KFC is important and necessary to protect the settled interests of thousands of franchisors, hundreds of thousands of franchisees, millions of individuals employed by them and trillions of dollars of economic impact that franchising provides to the U.S. economy.”
The High Court has yet to determine whether it will hear the case. KFC declined to comment for this story.
Clarification, please
Legal experts say they are hoping that if the High Court hears KFC’s appeal, a decision — favorable or otherwise — would clarify franchise regulations that have grown cloudy as that business model has evolved.
KFC’s defense is ultimately rooted in the Commerce Clause of the U.S. Constitution, the aim of which is to keep states from unduly restricting interstate commerce, according to observers. Hugh Goodwin, partner at DLA Piper in Silicon Valley, Calif., said part of the company’s argument centers on whether Iowa has the right “to reach out and tax a company that has no buildings or employees in the state. If such laws place a burden on an out-of-state company, you could argue that they’re burdening its ability to conduct business.”
Robert Zarco, a Miami-based franchisee attorney with the firm of Zarco Einhorn Salkowski & Brito, believes Iowa, like many states, ultimately is seeking new sources of income in its maneuvers against KFC Corp. Like other states hurt by the economic downturn, he sees Iowa as recognizing “a source of revenue that’s been untapped in the past. States need cash, and this is a revenue grab, … so why not attack large American corporations?”
While Goodwin agreed Iowa is looking for income in suing KFC Corp., he said, in fairness to Iowa, part of what it wants to recover is tax revenue deducted from KFC franchisees’ tax returns.
“What’s happening is franchisees with out-of-state franchisors deduct their annual royalty payments as a business expense, which ultimately reduces their Iowa tax liability,” he said. “The state is looking for a way to turn that around.”
Attorney John Fitzgerald, co-chair of the franchise and distribution practice at Gray Plant Mooty in Minneapolis, said his franchisor clients are frustrated by the Iowa decisions.
“Their initial reaction is to not only call it ridiculous, they’re asking, ‘Why would I ever want to go to Iowa and do business if this is what I have to face?’” he said. He added that some of his clients are taking a pragmatic approach and recognizing that the court’s decision “may be a business reality that affects their future growth plans and financial models, as well as the costs and expenses related to them.”
But Fitzgerald insists it needn’t be that way and is optimistic that if the Supreme Court hears the case, the nation’s judiciary will better understand the franchising business.
“I often think that if we could do a better job of educating the judiciary, a lot of these cases would just go away,” he said. “Our lawyers spend a lot of time explaining [franchise law] in case briefs and to judges who don’t truly understand it. The fact is there is no franchise court where these laws are discussed regularly.”
Goodwin agreed, saying the courts too commonly misunderstand that “franchisors and franchisees conduct interrelated activities, but that they are not related entities. Each is out to operate their business themselves and be profitable, and without common directors or shareholders. They’re separate corporations.”
Should the Supreme Court refuse to hear KFC Corp.’s appeal, Zarco envisions “a wave of litigation” will follow as other states begin examining their own laws to determine if they, too, can tax franchisors. Goodwin foresees “more of a creep toward the courts,” since such issues tend to move slowly through legal and legislative channels. Fitzgerald is more in the middle, betting state taxing authorities will be emboldened by such an outcome.
“I can’t imagine all the taxation authorities in other states aren’t watching this like a hawk right now,” he said.
In the meantime, his firm is counseling its franchisor clients to prepare for a negative outcome should KFC Corp.’s appeal not get a hearing.
“We know the big franchisors are looking at this because they have internal staffs to do that,” he said. “But it’s definitely something all franchisors of every size should have on their radar.”
In addition to filing the amicus brief on behalf of KFC, the IFA also is working for passage of federal legislation commonly known as the Business Activity Tax Simplification Act, or BATSA, that it believes would help all franchise businesses. The bipartisan legislation was introduced in 2003 by Reps. Bob Goodlatte, R-Va., and Bobby Scott, D-Va., to bring greater clarity to state nexus standards for franchised businesses seeking compliance with tax laws. According to the IFA, the bill pushes for a “bright-line” physical presence standard to help eliminate gray areas that sometimes render state income-tax rules unpredictable.
“States are trying to double dip on franchise operators in this case,” said IFA spokesman Matt Haller. “And what concerns everyone is that there are multiple cases we’re watching. There is a lot to be concerned about.”
