Assume you have never set foot in a particular state. Let’s say that state is Iowa. But you do business with a party in Iowa – a party that has contracted for the right to franchise your business concept in Des Moines, Iowa. The Iowa party sends you weekly royalties based on its sales from its Des Moines location.
Can the state of Iowa tax you on the royalties you receive? What’s more, can the state of Wisconsin tax franchisors who receive royalties from franchisees located in places like Madison or Milwaukee?
Yes, and yes – at least under existing law as interpreted by the Iowa Supreme Court and the Wisconsin Department of Revenue.
In KFC Corp. vs. Iowa Department of Revenue, the Iowa Supreme Court held that the state of Iowa could assess income taxes against franchisors (such as Kentucky Fried Chicken) that did not have a physical presence in Iowa, but which received royalties from franchisees who used the franchisor’s intangible property (e.g., trademarks) in Iowa. The Iowa Supreme Court held that physical presence was not required for the state of Iowa to impose income tax on revenues arising from the use of a franchisor’s intangibles in Iowa. By licensing franchisees in Iowa, the Court held, KFC had received the benefit of “an orderly society within the state” and thus Iowa met the constitutional requirements of nexus needed to assess income tax against KFC.
KFC appealed the decision to the U.S. Supreme Court, claiming that KFC’s business operations lacked sufficient nexus with Iowa to give the state jurisdiction to impose the tax. But last fall, the U.S. Supreme Court declined to review the case. As a result, the Iowa Supreme Court’s ruling stands.
The Wisconsin Department of Revenue (WDOR) appears to be asserting a position akin to Iowa’s on taxation of franchisors: that sufficient nexus exists for the department to assess income taxes against franchisors who receive royalties from Wisconsin-based franchisees, even if the franchisor does not have a significant physical presence in the state. Recently, counsel to a national franchisor posted an inquiry on the ABA Forum on Franchising’s listserv, asking if any listserv members had challenged the WDOR’s theory of nexus for taxing franchisors. According to the post, WDOR has asserted that the mere signing of the franchise agreement in Wisconsin provided sufficient nexus for Wisconsin income tax to be assessed against the out-of-state franchisor.
We asked WDOR whether the department takes the position that Wisconsin can impose an income tax on out-of-state franchisors as to royalties received from Wisconsin franchisees. WDOR declined to comment on current enforcement strategies, but provided the following analysis:
In Wisconsin, royalties and other gross receipts received for the use or license of intangible property (including patents, copyrights, trademarks, trade names, service names, franchises, licenses, etc). are sourced to Wisconsin if the purchaser or licensee: (1) uses the intangible property in operating their business in Wisconsin, (2) is billed for the purchase or license in Wisconsin, or (3) has their commercial domicile in Wisconsin.
There appears to be no reported decision in which either the Wisconsin Tax Appeals Commission (WTAC) or an appellate court considered whether Wisconsin has sufficient nexus to tax royalties of franchisors with little or no physical presence in the state. But although the WTAC or a Wisconsin court facing the issue may consider the Iowa Supreme Court’s KFC decision, neither would be required to follow KFC or accept its rationale. Given the amounts potentially at stake, odds are that a WDOR assessment that asserts that Wisconsin has nexus to impose income tax on an out-of-state franchisor will be challenged and wind its way through the Wisconsin appellate courts.