The Iowa Supreme Court recently affirmed the power of states to impose income taxes on royalties paid by franchisees to out-of-state franchisors.  In a unanimous decision handed down on December 30, 2010, Iowa’s highest court concluded that such royalties do not violate the Commerce Clause of the United States Constitution or Iowa law.

At issue was a 2001 ruling from the Iowa Department of Revenue that KFC Corporation owed income taxes to Iowa on royalties its independent Iowa franchisees paid to KFC for the use of its intellectual property, including the KFC trademark and related system.  KFC argued that its receipt of royalty income was not subject to tax by the state of Iowa because KFC had no physical contact with or physical presence in Iowa.

Following a lengthy review of constitutional law on this matter from the United States Supreme Court and many other state supreme courts, the Iowa Supreme Court concluded that physical contact or presence was not required for the imposition of income tax upon royalties paid from franchisee to franchisor.  Specifically, the Court found that the use of KFC’s intangible intellectual property by its franchisees within the physical confines of the state of Iowa presents "a sufficient connection to Iowa to amount to the functional equivalent of ‘physical presence’".

Of interest to some readers of this blog may be that this case also highlights the necessity of carefully following legal procedure.  In addition to the tax assessment itself, KFC had also appealed the imposition of penalties for non-payment of the assessment.  KFC argued that it had a good-faith basis to challenge the assessment and, as such, should not have been assessed penalties.  The Court, however, concluded that KFC had waived this issue when it failed to file a motion for rehearing before the Iowa Department of Revenue.  A harsh result indeed.

As Fox Rothschild has noted in the past, outside of the franchise-specific context, other state supreme courts have held that taxes must be paid by out-of-state companies on profits earned from economic activity within the state, even if the economic activity had no connection with a physical presence in the state.  Despite occasional efforts in Congress to require a bright line "physical presence" test prior to the imposition of state taxes, no such bills have been passed in the five years.  Moreover, given the reality of tight budgets and strained finances in most states, it is highly likely that other states will follow Iowa’s lead and explicitly require the payment of income taxes on the royalties franchisors receive for the use of their intellectual property.

This information does not constitute legal or tax advice.  You should, of course, consult an attorney or tax adviser regarding any taxation issues you might have, as each situation is unique.