Franchisor Nexus Dilemma – Glass Half Empty or Half Full?

It is increasingly apparent that states are eager for revenue and turning to tax “hunting” as a source of funds. Recently, many franchisors were shocked to find that they may have to pay taxes in all states where they have a franchisee—even when they have no physical presence. Nexus rules, somewhat complex and differing state by state, are not a new concept. Nonetheless, many Franchisors now feel these rules have been taken to a whole new level.

Last fall the U.S. Supreme Court refused to hear an appeal of a state Supreme Court ruling in favor of the Department of Revenue. The case involved a Franchisor who sued over a $250,000 income tax bill on royalties paid by a franchisee in that state. This was a big blow to Franchisors—not just because of the ruling in this particular state but because our greatest court is not willing to hear these types of cases. For states that sit on the fence on this issue, this sends a clear message on which side they will likely fall.

History repeating itself?

It has now been a long time since South Carolina took aim at Geoffrey, the intangible holding company that owned and licensed various intellectual property rights for Toys R Us (Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E. 2d 13 (1993)). Geoffrey started the debate over whether or not physical presence is required in order for an out-of-state corporation to be subject to a state’s income tax. In Geoffrey, the South Carolina Supreme Court held that an out-of-state corporation need not be physically present within the state in order to be subject to South Carolina’s income tax jurisdiction. Mere “economic exploitation” would suffice.

Franchisors just want to know…

What is the correct answer in those states that have yet to judicially rule on the issue? There remain many states that have not had this issue work its way through the courts. It appears that franchisors will have to wait for separate decisions in those states.

Not all bad news

Being subject to state income taxation in multiple jurisdictions may not be all bad news. In order to have the right to apportion income (meaning your home state does not tax 100% of a company’s income) a corporation must be subject to tax in at least one other jurisdiction. Depending on the state in which franchisors are domiciled (headquartered), the tax rate may be higher than the state where their franchisees are located. For most franchisors, some out of state rates will be higher and some lower. The point though, is filing in more states could actually result in a lower effective tax rate.

Hmm, now that is another way of looking at the glass half full!