Franchising

Every franchisor, as defined by [the New York Franchise Act] that has at least one franchisee [again as defined by the New York Franchise Act] [must file such an annual information return]. The return must include the gross sales of the franchisee in this State reported by the franchisee to the franchisor, the total amount of sales by the franchisor to the franchisee, and any income reported to the franchisor by each franchisee…. The returns required…must also include [as to each New York franchisee] the name and address, and the certificate of authority or federal identification number, and any other information required by the Commissioner…

Any person required to file a return [as provided above] must, on or before March 20th, give to each [franchisee] about whom information is required to be reported in the return the information pertaining to that person.

In turn, Section 1145 of the New York Tax Law was amended to provide penalties for franchisors that fail to file the new annual information returns specified above—or that file the required return in circumstances where such return “…fails to include any…information that is true and correct.”

These amendments to the New York Tax Law take effect immediately and provide that the first information return required thereunder will be due on or before Sept. 20, 2009 (covering March 1 to Aug. 31, 2009); the next return is required to be filed on or before March 20, 2010 (covering Sept. 1, 2009 to Feb. 28, 2010); and, thereafter, the annual return must be filed on March 20 of each succeeding year and must cover the four sales tax quarterly periods immediately preceding such date.

The New York State Department of Taxation and Finance wasted no time effectuating this new franchisor reporting requirement. In a letter dated May 27, 2009, addressed to many franchisors (presumably those registered under the New York Franchise Act), the department stated that it:

So there you have it.

Every franchisor having New York franchisees will have to report such franchisees’ reported gross revenues to the New York State Department of Taxation and Finance so that it may compare same with revenue figures reported by such franchisees in their New York tax returns and, if the latter are found to underreport revenues, pursue such franchisees through audits and resulting civil—or even criminal—actions.

As we said, this legislative amendment to the New York Tax Law is unprecedented. Neither the federal government nor the taxing authority of any other state has ever imposed such a franchisee gross revenue reporting requirement upon franchisors. However, unfortunately, with more and more states confronting significant deficits and thus desperate to collect every penny owed from taxpayers, we imagine many other states, and perhaps even the Internal Revenue Service, will follow New York’s lead by enacting similar franchisor reporting requirements.

Consequences

New York’s new franchisor reporting requirement has already been characterized as a “tax nightmare,” one that will be borne principally by New York franchisees. While some franchisees may underreport their gross revenues to their franchisors, they do so at great risk. If substantial underreporting is detected by a franchisor, whether in the course of a financial audit or otherwise, then significant ill effects may be suffered by the franchisee: complete loss of the subject franchise and the franchise’s investment therein. It is the specter of complete investment loss that most often overrides a franchisee’s inclination to underreport revenues to its franchisor (and thus retain the royalties that otherwise would have been payable thereon). And franchisees know that even beyond the traditional financial audit, franchisors in each sector have a plethora of means available to ascertain what franchisee gross revenues truly are versus what is reported to the franchisor—knowledge that again militates against franchisee underreporting.

However, in contrast to complete loss of franchise and investment therein, franchisees underreporting gross revenues to taxing authorities have only the inchoate fear that such underreporting will lead to a tax audit and consequential fines and penalties (in addition to taxes due), with criminal proceedings reserved only for the most serious revenue underreporting. No loss of franchise; no total loss of investment in the franchise; and, franchisee knowledge that only a small percentage of tax returns are ever subjected to an audit may leave many franchisees to engage in what is charitably referred to “tax avoidance” by underreporting their gross revenues to federal and state taxing authorities.

Under New York’s recent Tax Law amendment, however, such underreporting will almost automatically generate an audit and resulting fines, penalties and payment of amounts due. This could lead to the absurd consequence of franchisees being placed at a competitive disadvantage to their non-franchised, tax underpaying competitors. And could also lead to the result that small entrepreneurs may intentionally avoid franchising in favor of independently owned businesses whose revenues are not subject to second party (i.e., franchisor) reports to the government.

Franchisors, too, do not have much to cheer about. First, their franchisees are about to be in an uproar over what they will perceive as franchisor interference in their relations with New York taxing authorities. Notwithstanding the fact that it is the New York Legislature itself that mandated such franchisor reporting of franchisee gross revenues, nevertheless the resentment this will foster among franchisees and the perception that their franchisors are reporting on them to the New York State Department of Taxation and Finance can prove markedly disruptive to franchisor-franchisee relations.

Second, the cost of franchisors preparing and furnishing such franchisee gross revenue reports (technically “returns”) may prove considerable. Third, for those networks whose franchisees traditionally underreport revenues to taxing authorities, the inability to do so any longer may distress the economics not only of franchisees, but their franchisors as well.

Of further concern to franchisors is the fact that a new type of “tax nexus” is being established. This tax nexus now exists solely by virtue of a franchisor having franchisees within the borders of the State of New York. That franchisor may be from California, China or Timbuktu. But regardless of where such franchisors are situated, New York’s recent amendment to its Tax Law subjects them to the jurisdiction of the New York State Department of Taxation and Finance. Note also that all franchisors are now presumed to have this tax nexus, not just franchisors that register under the New York Franchise Act—again, the sole ground for this new tax nexus is whether, in the words of newly amended Section 1186 of the New York Tax Law, the franchisor “…has at least one franchise” situated in, and thus required to pay business taxes to, the State of New York.

One fear regarding this new requirement that franchisors report their New York franchisees’ gross revenues is unfounded—the fear that such information will be available to the general public (and to competitors). To the contrary, the information reports that franchisors must submit to the New York State Department of Taxation and Finance are deliberately characterized as “returns” which, like any other tax return under the Tax Law, is afforded complete confidentiality (with significant criminal penalties attaching to anyone who intentionally breaches such confidentiality).

How did this amendment to the New York Tax Law requiring franchisors to report their franchisees’ gross revenues come to be without any debate, publicity or opportunity to be heard? In an attempt to ascertain the answer to this question (and to confirm that, indeed, our understanding of the impact of the amended Tax Law is correct in all respects), we communicated at length with an individual who serves in a legal capacity with the New York State Department of Taxation and Finance but who wishes to remain anonymous (since he is not authorized to give public comment on this subject). “That’s a good question,” our source states. “We were expecting a flood of comments in opposition to this amendment to the Tax Law. But nobody ever showed up. Where were you guys? It is not like we kept it a secret or anything. In fact, as you know, from reading the statutory amendment (as quoted above), it specifically makes reference a few times to the New York Franchise Act and repeatedly uses the words “franchisor” and “franchisee.” So we were expecting business and industry to pick up on what was being proposed and, having done so, to flood Albany voicing strong opposition. But nobody ever came.”

Our conversations with the senior official at the New York State Department of Taxation and Finance made one thing clear: the department firmly believes that the new amendment to the New York Tax Law requiring franchisors to report their franchisees’ gross revenues is virtually “…inviolate to judicial attack.” Thus, notes this official, only a legislative amendment removing this newly added franchisor reporting requirement from the New York Tax Law will suffice.

Tax Nexus

This newly established tax nexus comes at a time when the entire subject is in the midst of debate and review. The basics are simple. So called “tax nexus” must exist for a state to impose a tax upon an individual or entity. Conversely, any attempt by a state to tax persons, entities or property that are not within its jurisdiction amounts to a deprivation of property without due process of law in violation of the 14th Amendment of the U.S. Constitution.¹

Similarly, the Commerce Clause of the U.S. Constitution² limits state taxing power and permits state taxation of interstate activity only if such activity has a substantial nexus with the taxing state; is fairly apportioned; is nondiscriminatory against interstate commerce; and, is fairly related to the services provided by the taxing state.³

Traditionally, required tax nexus has always been found to exist between a business entity and its state of incorporation, organization or formation (with some states, such as Delaware, providing income tax exemptions for business entities that do not feature any in-state activity other than incorporation in that state).

Beyond incorporation, a business entity is always deemed to have tax nexus with the state where it has an in-state physical presence (offices, warehouses, real property, resident employees), with some states exempting out-of-state businesses that attend certain in-state trade shows, deliver products via company vehicles or merely feature physical property that remains in transit or employees who travel through the state without performing any other in-state activities.

U.S. Supreme Court decisions addressing state tax nexus frequently address this issue of “physical presence.” In the landmark decision of Quill Corp. v. North Dakota,⁴ the Court ruled that the Commerce Clause mandated that, absent action by the U.S. Congress to the contrary, a taxpayer must have some physical presence in a state to be subject to collection responsibility for the state’s use tax. Although Quill deals with use taxes, the Supreme Court’s discussion of the general Due Process and Commerce Clause constitutional principles of nexus sheds light on their application to business entity income taxes.

But in 1993, the South Carolina Supreme Court in Geoffrey Inc. v. South Carolina Tax Commission⁵ held that a Delaware holding company that only owned intangible property used in South Carolina was subject to income tax. The court rejected Geoffrey’s claim that it had not purposely directed its activities toward South Carolina’s economic forum and held that by licensing intangibles for use in the state (the famous Toys “R” Us trademark) and receiving income in exchange therefor, Geoffrey had the minimum contacts and substantial nexus with South Carolina required by the U.S. Constitution’s Due Process and Commerce Clauses (with Geoffrey’s receivables held to have a business situs in South Carolina).

While the U.S. Supreme Court denied certiorari in Geoffrey—thus limiting its application to the State of South Carolina—many other states have incorporated by statute or regulation the principles of economic nexus outlined in Geoffrey regarding intangibles in the nature of trademarks and trade names. This trend embraced franchisors and for the first time subjected them to state tax liability only by virtue of licensing their trademarks/service marks to franchisees in the subject taxing states.

Which is why the business community is so strongly behind the proposed federal Business Activity Tax Simplification Act (BATSA), whose goal is to create a national standard of state tax nexus. On Feb. 13, 2009, BATSA was reintroduced in Congress and on March 16 referred to the House Subcommittee on Commercial and Administrative Law. If enacted, BATSA would clarify that no state may impose a business activity tax on any business entity that lacks a physical presence in the taxing jurisdiction and would refine the definition of “physical presence” in a fashion favorable to business interests.

Enactment of BATSA should be the goal of every franchisor. Indeed, a critic of BATSA actually notes that, if the bill is enacted, “A restaurant franchisor like Pizza Hut or Dunkin’ Donuts would not be taxable in a state no matter how many franchisees it had in the state and no matter how often its employees entered the state to solicit sales of supplies to the franchisees or to train the franchisees in company procedures.”⁶

So it is that New York’s recently amended Tax Law, which for the first time anywhere requires franchisors to report to taxing authorities their franchisees’ gross revenues, prompts significant concerns among franchisors and franchisees alike. Only legislative action can negate this overreaching and ill advised Tax Law amendment. But, for the time being, franchisors had best engage in the course of conduct designed to inform their New York franchisees of this legislative amendment; the impact it may or will have on franchisees that underreport revenues to New York State; the fact that such franchisors are now legally required to identify their franchisees and their gross revenues to New York State; and, by deploying a campaign, the fact that it is not their franchisors which created this nightmare for them but, rather, their elected officials in the New York Legislature.

David J. Kaufmann is a senior partner at Kaufmann Gildin Robbins & Oppenheim and wrote the New York Franchise Act.

Endnotes:

1. U.S. Const. Amend. XIV; Miller Bros. Co., v. State of Md., 347 U.S. 340, 74 S.Ct. 535, 98 L.Ed. 744 (1954); People Ex. Rel. Hatch v. Reardon, 184 N.Y. 431, 77 N.E. 970 (1906) aff’d 204 U.S. 152, 27 S.Ct. 188, 51 L.Ed. 415 (1907).

2. U.S. Const. Art. I, §8, cl. 3.

3. Complete Auto Transmit Inc. v. Brady, 430 U.S. 274, 97 S.Ct. 1076, 51 L.Ed. 2d 326 (1977); Huckaby v. New York State Division of Tax Appeals, 4 N.Y.3d 427, 796 N.Y.S.2d 312, 829 N.E.2d 276 (2005), cert. denied, 126 S.Ct. 546, 163, L.Ed. 2d 459 (2005).

4. 112 S.Ct. 1904 (1992).

5. 437 S.E.2d 13 (S.C. 1993).

6. Mazerov, “Proposed ‘Business Activity Tax Nexus’ Legislation Would Seriously Undermine State Taxes on Corporate Profits and Harm the Economy,” Center on Budget and Policy Priorities (July 17, 2008).