This week’s decision by the United States Supreme Court to decline review of KFC Corp. v. Iowa Department of Revenue is almost certain to be received by other states as a tacit approval of the imposition of state income taxes on out-of-state franchisors, even where franchisors do not have property or employees in the state.

Earlier this week, the United States Supreme Court denied KFC Corporation’s petition for certiorari in KFC Corporation v. Iowa Department of Revenue. The Iowa Supreme Court ruled late last year that the Iowa Department of Revenue could impose state income tax on out-of-state franchisors that do not have an in-state physical presence.1

Though the United States Supreme Court has repeatedly held that a business must first have a physical presence in the state before the state can require the business to collect sales and use taxes on transactions with in-state residents (National Bellas Hess2 and Quill3), the U.S. Supreme Court has declined to adopt a physical presence standard for the imposition of state income taxes. In recent years, some states have begun to impose state income taxes on out-of-state businesses that often do not have a physical presence in the state.

The degree to which states pursue and collect income taxes on out-of-state franchisors has varied, but the states have become increasingly aggressive. At the front of this movement is Iowa Department of Revenue, and the Supreme Court’s decision to deny KFC’s petition for certiorari is likely to encourage other states to follow Iowa’s lead.

In 2001, the Iowa Department of Revenue issued KFC Corporation an assessment of $284,658.08 for unpaid corporate income taxes, penalties and interest. KFC argued that the Department of Revenue could not lawfully impose the state income tax because KFC had no physical presence in Iowa. All KFC restaurants in Iowa are franchised, and KFC has no property or employees in Iowa. The Department of Revenue contended that no physical presence is needed where a franchisor licenses intellectual property that generates income from within the state based on the operations of its franchisees.

On December 30, 2010, the Iowa Supreme Court upheld Iowa’s right to impose the state income tax on out-of-state franchisors based on two lines of reasoning. First, the court doubted that the U.S. Supreme Court would extend the “physical presence” rule to taxes other than sales and use taxes. The court observed that “‘physical presence’ in today’s world is not ‘a meaningful surrogate for the economic presence sufficient to make a seller the subject of state taxation’” and ruled that by licensing franchises within Iowa, KFC “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 Commerce Clause” (that is, the taxes must be non-discriminatory and fairly apportioned).

Alternatively, the Iowa Supreme Court ruled that the “physical presence” test the U.S. Supreme Court outlined in Quill (if applied to state income tax) was met by KFC’s licensing of its intellectual property to its franchisees for use within Iowa to produce income. In Quill, the state sought to impose a tax on an out-of-state vendor based solely on the in-state presence of “a few floppy diskettes” owned by the vendor. The Iowa Supreme Court found that the use of KFC’s intangible property within Iowa amounted to “far greater involvement with the forum state” than the “slightest of presence” found in Quill. The court also cited pre-Quill case law as establishing the right of a state to impose a state income tax on an out-of-state entity based on that entity’s use of intangibles within the state to generate revenue.

This week’s decision by the United States Supreme Court to decline review of KFC Corp. v. Iowa Department of Revenue is almost certain to be received by other states as a tacit approval of the imposition of state income taxes on out-of-state franchisors, even where franchisors do not have property or employees in the state.

Franchisors should be aware of and consider strategies for dealing with potential state income tax liabilities. Franchisors should consider including tax gross-up provisions in their domestic franchise agreements, which are commonly included in international franchise agreements. Including this type of provision can effectively shift the tax liability imposed by the states back to the franchisee. Alternatively, franchisors should consider increasing marginally the royalty rate payable by franchisees located in states that impose income taxes on out-of-state franchisors.