New York Law Could Affect Franchisor Tax Obligations

New York State recently enacted legislation that imposes new and unprecedented tax filing obligations on franchisors whose franchisees do business in New York.

The rules, which were enacted on April 7 as part of an Education, Labor and Family Assistance Bill, require extensive sales and use tax information reporting with respect to franchisees and impose penalties on franchisors for the failure to provide such information.

The new provisions, which amend sections 1136 (Returns) and 1145 (Penalties and Interest) of Article 28 of the New York tax law, represent an effort by New York to ensure franchisees are properly remitting both sales and use tax to the New York Department of Taxation and Finance.

Department Requesting Names of New York-Based Franchises

In letters being sent to many franchisors, the department explains it is requesting from franchisors the names of all their New York-based franchisees "in an effort to make them [the franchisees] aware of the law change, as well as to give them an opportunity to apply for New York's Voluntary Compliance Program." The letter states the program will allow franchisees to review and correct their New York tax filings "without any penalty or threat of criminal prosecution."

Notwithstanding the provisions' apparent focus on franchisee tax compliance, one (possibly unintended) effect of the law will be that, by complying, franchisors will reveal to the department significant information about their business relationships with franchisees that do business in New York.

Some franchisors have expressed concern that New York may attempt to use this information as a basis for claiming that the franchisors have sufficient "nexus" (i.e., connection) with New York to constitutionally subject themselves to New York use tax collection responsibilities and income tax reporting obligations.

Law Includes Extensive Reporting Obligations

Under the new law and a subsequent taxpayer guidance, franchisors must provide the department with extensive information involving a breakdown of figures on a location-by-location basis. Information must be supplied not only with respect to the franchisor itself, but also with respect to its affiliates and suppliers designated by the franchisor, even if the suppliers are independent from the franchisor.

These requirements will be burdensome and may lead to audits, given the possibility that franchisees may be required to use different reporting systems for the amounts they report to the franchisor and amounts they report to the department.

Annual Information Return

The new law mandates that every franchisor with at least one franchisee required to be registered as a sales tax vendor in New York file an annual information return with the department. This return must set forth: 1) name and address of each franchisee; 2) certificate of authority or federal identification number of each franchisee; 3) gross sales of the franchisee in New York as reported by the franchisee to the franchisor; 4) total amount of sales by the franchisor to the franchisee; and 5) any income reported to the franchisor by each franchisee.

Additional Information About Franchisees

The department expanded on the information franchisors must provide in a taxpayer guidance issued on July 7. The guidance states that a franchisor must provide, with respect to each franchisee: 1) both the legal and (if different) DBA name of the franchisee; 2) phone number of the franchisee; and 3) name of the owner of the franchisee (e.g., principal shareholder, general partner). In addition, the guidance requires franchisors to provide the following information with respect to the franchises themselves:

• Beginning date of each franchise
• Physical address of each franchise location
• Mailing address of each franchise location if different than the physical address
• Gross sales in New York state for the period covered by the return for each franchise location, as reported to the franchisor
• Gross sales in New York state for each franchise location as audited by the franchisor, if different than reported by the franchisee
• If known, the amount of New York State sales and local sales tax collected at each franchise location for the period covered by the return
• Amount of royalty payments made to the franchisor with respect to each franchise location
• Royalty percentage of gross sales reported for each franchise location (or describe the method of royalty computation if other than gross sales)
• Amount of sales made to each franchise location by the franchisor or companies affiliated with the franchisor
• Amount of sales made to each franchise location by any supplier designated by the franchisor

After Initial Returns, Information Will Be due Annually

The first information returns required by the new law are due September 20, 2009, and cover the period from March 1 through August 31. The next returns are due March 30, 2010, and cover the period from September 1, 2009, through February 28, 2010. Thereafter, information returns will be due on an annual basis on March 20, and will cover the prior 12-month period extending from March 1 to February 28. Each of these information returns must be filed electronically.

According to the guidance, information regarding the actual filing of the electronic returns will be available on the department's Web site by September 1.

Franchisors Must Share Reported Information With Franchisees

Franchisors will also be required to provide each franchisee with a statement showing information reported to the department with regard to the franchisee.

The statement must be given to each franchisee on or before March 20 of each year. The statement due to franchisees on or before March 20, 2010, must also include information provided to the department by the franchisor on its own information return that was due on or before September 20, 2009.

No Specific Form for Statements

According to the guidance, statements sent to each franchisee may be in a summary format. However, they must include the identifying information pertinent to the franchisee, gross sales of each franchise location of the franchisee, royalty payments made with respect to each franchise location, and sales made to the franchisee for each franchise location as reported by the franchisor to the department.

There is no specific form for the statement, but the department must be able to verify it was sent to each franchisee in a proper and timely manner.

Penalties Imposed for Failure to File, Incorrect Information

If a franchisor fails to provide the information required by Section 1136 to the department with respect to any franchisee, files incorrect information with the department, or fails to provide a franchisee with the required information, a penalty of $500 is imposed for ten or fewer failures, and a penalty of up to $50 is imposed for each additional failure. If the information return is late, a penalty of up to $2,000 may be imposed.

The aggregate of these penalties cannot exceed $10,000 for any reporting period. These penalties may be abated if the failure to comply with them was entirely due to reasonable cause and not willful neglect.

IFA Requests Reporting Extension

In a letter to the department dated July 20, 2009, the International Franchising Association (IFA) noted that New York's reporting requirement posed a number of challenges for franchise systems and requested that the first reporting date be extended from September 20 until December 31 and that subsequent reporting dates be extended to no sooner than ninety days after the close of the reporting period.

As a result of the IFA letter, the department is contacting a number of franchisors in an effort to understand what data is currently shared by franchisors and their New York franchisees. It is not yet clear whether the department will extend the September 20, 2009, or March 20, 2010, due dates prescribed by Section 1136, or if the department will make any other modifications to the guidance.

Right to Impose Tax Obligations Based on Economic Nexus, Not Physical Presence

Apart from being concerned about the difficulties of complying with the requirements of the New York information reporting law, a number of franchisors are concerned the new law may lead to efforts by New York (and perhaps other states) to impose use tax collection obligations on franchisors with respect to items sold to their franchisees and income tax return filing obligations on the part of franchisors with respect to franchise fees that are received with respect to the operations of their franchisees. The right of New York or any other state to impose these obligations on a franchisor depends on whether the state has jurisdiction over the franchisor for sales and use or income tax purposes.

Gross Receipts Tax

The ability of a state to tax the income of an out-of-state business with no physical presence in that state is currently a hotly contested area of tax law. Several cases decided by the New Mexico Court of Appeals in 1979 held that the state could impose its gross receipts tax on out-of-state franchisors without a physical presence in the state. See AAMCO Transmissions, Inc. v. Tax'n and Rev. Dep't, 600 P.2d 841 (N.M. Ct. App. 1979); Baskin-Robbins Ice Cream Co. v. Rev. Div., Dep't of Tax'n and Rev., 599 P.2d 1098 (N.M. Ct. App. 1979); Am. Dairy Queen Corp. v. Tax'n and Rev. Dep't, 605 P.2d 251 (N.M. Ct. App. 1979).

Sales and Use Tax

Subsequent to these cases, the United States Supreme Court reaffirmed its earlier decision in National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967), that states could not impose sales and use taxes on out-of-state entities unless they had a physical presence in the state. See Quill v. North Dakota, 504 U.S. 298 (1992). While the facts in Quill are different than those involved in a franchisor-franchisee relationship, it appears that if a franchisor does not have a physical presence in New York, the state would have difficulty imposing a use tax collection obligation on that franchisor.

Income Tax Obligation Based on Licensing of Intangible Property

The Supreme Court has not clarified whether the physical-presence rule of National Bellas Hess and Quill applies only to sales and use taxes or whether it also applies to state income taxes. A number of state courts, however, have held that states can constitutionally tax the income of out-of-state taxpayers whose only connection with the state is the licensing of intangible property to in-state licensees. See e.g., Geoffrey, Inc. v. South Carolina Tax Comm'n, 437 S.E.2d 13 (1993); Kmart Properties, Inc. v. Tax'n & Rev. Dep't of New Mexico, 131 P.3d 27 (N.M. Ct. App. 2001); A-F Trademark, Inc. v. Tolson, 605 S.E.2d 187 (N.C. Ct. App. 2004); Geoffrey, Inc. v. Oklahoma Tax Comm'n, 132 P.3d 632 (Ok. Ct. Civ. App. 2006); Lanco, Inc. v. Director, Div. of Tax'n, 908 A.2d 176 (N.J. 2006); Bridges v. Geoffrey Inc., 984 So 2d 115 (La. Ct. App. 2008); Geoffrey, Inc. v. Comm'r of Rev., 899 N.E.2d 87 (Mass. 2009).

In addition, an Iowa District Court recently upheld the Iowa Department of Revenue's imposition of corporate income tax on an out-of-state franchisor with no physical presence in the state. See KFC Corp. v. Iowa Dep't of Rev., No. CV 7466 (Polk Cty. D.C. June 5, 2009). The court held that the franchisor's receipt of royalties that were based upon its franchisees' gross revenues derived in the state gave the franchisor sufficient nexus with the state to meet the demands of the United States Constitution. The taxpayer appealed this decision to the Iowa Supreme Court on July 1, 2009. Franchisors should be aware that this is a very important case and its impact, whichever way it is decided, may extend beyond Iowa to other states.

States Becoming More Aggressive in Asserting Taxing Authority

In recent years, the United States Supreme Court has denied several requests to clarify this area of the law (including denying review of many of the cases noted above). This has caused many states to become more aggressive in asserting taxing authority over out-of-state entities. Franchisors should be aware of this development in the law and monitor their potential exposure to income tax in states in which their franchisees operate.

Please call us if you have any questions about your filing obligations under the New York law or about your sales and use or state income tax filing obligations in general.