Prudent Planning Helps Minimize State Tax Liabilities
The United States Supreme Court’s decision to decline review of the Iowa KFC case will likely further embolden states to assert income tax nexus against out-of-state franchisors. Wisconsin has stepped up its efforts to tax out-of-state franchisors in recent months and California has for years attempted to require California franchisees to withhold tax amounts from royalty payments to out-of-state franchisors. In some instances, state tax agencies may well be pursuing positions that exceed the limits of their own state laws.
Franchisors can and should challenge unreasonable nexus assertions by state revenue agencies when the state’s position is unwarranted. The changing state tax landscape, however, may force franchisors to deal with complex income tax apportionment and allocation provisions in multiple jurisdictions.
Franchisors that face increased state tax filing obligations in a post-KFC world can still minimize their tax liabilities by understanding the nuances of state income tax apportionment rules and identifying the circumstances where these provisions can be used to the franchisor’s advantage. Highlighted here are a few of the state income tax issues that franchisors may confront in the face of increased filing obligations.
California Permits a Choice of Apportionment Method
California provides choices to franchisors for income tax reporting by offering taxpayers an annual election to apportion income under one of two apportionment methods: single sales or three factor. Recently issued regulations diminish the possibility that California franchisors will face double taxation on designated income streams since income from certain services and royalties paid by non-California franchisees can likely be excluded from the franchisor’s California sales factor. For non-California franchisors with franchisees in the state, the choice of an apportionment method can yield profoundly different results depending on the franchisor’s specific facts and its current profit or loss position. The ability to choose between two income apportionment methods may also provide a non-California franchisor with the opportunity to shift income outside of the state by undertaking, and tracking, services performed for California franchisees from the franchisor’s home state. Although California’s governor and various legislators have in recent years proposed elimination of the annual apportionment method election in favor of mandatory single sales factor apportionment, California’s current law still allows an annual choice of apportionment methods that should be taken advantage of by every taxpayer.
Some States Provide Different Sourcing Rules for Royalty and Service Income
Another tax planning issue that franchisors may need to consider in light of the tax principle employed by most states for “bundled” transactions is the practice of charging non-segregated franchise fees. When taxable items and non-taxable items are both provided for a single price, states generally will impose a tax on the entire charge in the absence of segregation of the charge into its taxable and non-taxable component parts. If a state employs different rules for assigning income from diverse revenue streams–such as the licensing of trademarks or other intangibles, and the provision of services–then itemizing a franchise fee into separate components may create a tax benefit.
Texas treats income from the licensing of intangibles as a Texas receipt for apportionment purposes if the franchisee uses the intangible in the state. Receipts from services performed for Texas franchisees, however, are assigned to the state where the service is performed. If a franchisor charges a single, non-itemized amount to a Texas franchisee for trademark royalties and services performed outside of Texas at the franchisor’s home state location, there is a risk that Texas will adopt an unfavorable apportionment of the entire franchisee fee because the charge includes an element that constitutes a state receipt.
In addition to royalties paid for trademark usage and services, states are also inconsistent in the manner used to source another income stream, revenue generated from the license of computer software. Thus, franchisors who license software to franchisees may be at risk of over taxation. Accordingly, franchisors will need to consider whether the potential state tax benefits in a given case might warrant an increased level of specificity in separating franchisee fees beyond a single, non-itemized charge.
Franchisors can expect to become targets of increased scrutiny by states seeking to enhance revenue collection.
Costs of Performance
Although many states are moving toward market sourcing which assigns franchisor income streams to the franchisee’s state as was the case in KFC, a number of states continue to source income from services based on a “costs of performance” method. This sourcing method considers the costs incurred by the taxpayer in generating a particular income stream as the predominate factor used to assign revenue to a state for taxing purposes. Costs of performance rules and interpretations of those rules, however, vary by state. Under a costs of performance calculation, critical factors in the determination of a franchisor’s state income tax liability might include: the location where costs are incurred to generate revenue, whether services provided in a franchisor’s income producing activity are rendered by employees or independent contractors, and the sufficiency of the taxpayer’s books and records in substantiating the amount and location of incurred costs. Therefore, franchisors should carefully consider how the costs of performance test is applied in any state where the franchisor has nexus that uses this test to calculate the sales factor. States that continue to use some form of a costs of performance analysis in the sourcing of income from services include Massachusetts, Idaho and Oregon.
Special Problems May Arise in States That Have Gross Receipts Taxes
Gross receipts tax states like Washington and Ohio present special problems that arise from the nature of the tax itself. Since gross receipts tax statutes generally do not permit the deduction of expenses in determining the income subject to tax, all amounts received by franchisors from franchisees may be treated as taxable to the franchisor even when the franchisor essentially serves as a “conduit” for ultimate payment to a third party.
This situation occurs when franchisee payments are funneled through a franchisor, but are intended to fund franchisee operating costs such as costs for staffing services that the franchisee provides to customers, or utility or insurance charges negotiated and paid by a franchisor, but are obtained for the benefit of franchisees. In a gross receipts tax state, the state revenue agency may assert that such amounts paid by the franchisee to the franchisor but used to fund the franchisee’s obligations, are taxable to the franchisor without giving credence to the “pass through” nature of the payment. Accordingly, franchisors should carefully evaluate the gross receipts tax laws of states in which they have franchisees. If a particular payment is not in fact being made for activities undertaken by the franchisor as part of the franchisor’s business activities, but instead represents a pass through payment that ultimately accrues to a third-party service provider (like an advertising fund), then franchisors should consider whether or not such an arrangement can be structured to satisfy the state’s statutory provisions that might exclude such amounts from the franchisor’s taxable receipts.
Franchisors can expect to become targets of increased scrutiny by states seeking to enhance revenue collection. Nexus expansion appears almost inevitable given the Iowa KFC decision and the existing economic nexus laws already on the books in many states. As a result, franchisors must be able to navigate the state income tax apportionment rules to which they will be subject, and use these rules to their advantage. In some cases, franchisors may wish to include language in franchise agreements that supports the franchisor’s state tax position. In any case, an awareness of state income tax apportionment rules and how they apply to a franchisor’s particular circumstances will enable franchisors to make prudent decisions about how their operations are structured and documented.
Hugh W. Goodwin is a partner of DLA Piper LLP (US). He can be reached at 650-833-2262 or email@example.com.
This document is for general information purposes only and should not be used as a substitute for consultation with professional advisors. Readers are urged to consult their own tax advisors regarding their specific tax situations.