State of Washington Asserts Nexus over Out-of-State Franchisors

The State of Washington has recently begun taking steps to collect tax from out-of-state franchisors that derive income from sources within the state. This action continues a trend that has emerged in recent years as many states seek out new sources of revenue to help balance state budgets. The action in Washington is based on a new law that explicitly imposes its Business & Occupations (B&O) tax on certain taxpayers (including out-of-state franchisors) that do not have a physical presence in the state. Instead of a physical presence, the new law identifies a taxpayer's economic presence in the state as the basis for imposing the B&O tax.  Franchisors with franchisees located in Washington will need to determine whether this new law applies to them and how they will respond if it does.

Tax Based on Taxpayers' "Economic Presence"

The new law in Washington imposes the state's B&O tax on taxpayers whose property or payroll in the state, or receipts from sources within the state, exceed certain limits regardless of whether or not the taxpayers have a physical presence in Washington. Specifically, the new law applies to any business that, during any calendar year, has:

(1)        More than $50,000 of property in the state;

(2)        More than $50,000 of payroll in the state;

(3)        More than $250,000 of receipts from the state; or

(4)        At least 25% percent of its total property, payroll, or total receipts in the state.  

Out-of-state franchisors who receive more than $250,000 of royalties (or other similar payments) from Washington franchisees in a year will thus likely fall within the new law. 

The New Law Applies only to Certain Types of Income, Including Franchise Royalties

Franchisors that satisfy any one or more of the four tests mentioned above are required to file returns and pay the B&O tax on their gross receipts from "apportionable activities" for periods beginning after June 1, 2010. Apportionable activities under the new law include the receipt of royalties for the use of intangible property, including copyrights, patents, licenses, franchises, trademarks, trade names, and similar items. Apportionable activities also include other service-type activities. Franchisors therefore will need to evaluate how their income is classified under Washington law. 

Income from activities other than apportionable activities will be subject to the B&O tax only if the franchisor has a physical presence in the state. (This dual system of taxation means that a franchisor may be subject to the Washington B&O tax on some but not all of its income depending on its connection with the state.) There is no mechanical test for whether a taxpayer has a physical presence in the state. However, the Washington Department of Revenue's administrative rules provide that physical presence "need only be demonstrably more than a slightest presence." 

Physical presence is generally found through the presence of a taxpayer's property or employees in a state (even on a very limited or sporadic basis). Physical presence is also found, however, if the taxpayer engages in activities in the state through an agent or other representative (including an independent contractor) that are "significantly associated" with the taxpayer's "ability to establish and maintain a market" in the state. In the franchise context, this could be evinced by field visits in Washington or the use of independent contractors to provide services to franchisees in the state.   

Franchisors Who Receive Notices from Washington Should Carefully Evaluate Their Washington Presence

We are aware that franchisors (and taxpayers in other service industries) have begun receiving notices from the State of Washington, asking them to comply with the new law. Franchisors who receive such notices are being given relatively little time to respond. Therefore, franchisors who are not able to determine the applicability of the new law to their business before receiving such a notice will need to do so quickly after that time. 

We suggest that franchisors with any connection to Washington take a proactive approach in evaluating the applicability and impact of this new law before they are approached by the state. A franchisor that fails to comply with the new law may face significant penalties and interest on any unpaid amounts. Our franchise and tax teams stand ready to assist you in any way possible—including determining whether this new law applies to you, whether your income is subject to tax based upon a physical-presence standard or an economic-standard, and what business classifications and tax rates may apply to your income. We can also help you assess the best course of action for responding to this new law. 

The Washington Law Reflects a Growing Trend; Franchisors Should Develop a State-Tax Strategy

In recent years, states have been increasingly aggressive in pursuing new sources of tax revenue. The new Washington statute is not unique. Similar statutes imposing economic-nexus standards have been enacted in other states, including California, Colorado, Ohio, and Oklahoma. These statutes eschew a physical-presence requirement and require only a taxpayer's "economic presence" in the state. Although the constitutionality of those statutes is questionable, many state taxing agencies have previously obtained judicial decisions upholding their attempts to tax out-of-state entities based on an economic-nexus concept. Those cases have generally involved state-tax planning mechanisms that the courts refer to as tax-avoidance schemes or "shams," or have involved taxpayers that aggressively marketed their services directly to individuals in the taxing state. As such, those cases are factually very different from the facts presented by a franchisor-franchisee relationship. On Thursday, December 30, 2010, however, the Iowa Supreme Court issued a decision specifically upholding the imposition of the state's income tax on an out-of-state franchisor based solely on an economic-nexus concept. (For coverage of this case, follow the article link on the left.) Based on that decision and the earlier decisions that have involved non-franchise relationships, franchisors can expect Washington to aggressively enforce its new law.

In light of the increased attention that states are paying to out-of-state franchisors, it is important that franchisors act purposefully in developing a comprehensive state-tax strategy. Franchisors may be able to mitigate the adverse impact of negative state-tax determinations through proper planning and, in some cases, modifications of franchise agreements. 

Disclaimer: The information provided herein is general in nature, is not complete, and may not apply to a taxpayer's specific situation. Taxpayers should consult with their tax advisors regarding their tax needs.