United States: Corporations That Licensed Intellectual Property to Restaurants Deemed Subject to North Carolina Income and Franchise Tax

In a decision that proves North Carolina can tax both the cake and the recipe, the Secretary of the North Carolina Department of Revenue (the "Secretary") found that two nondomiciliary corporations ("Taxpayer 1" and "Taxpayer 2") that licensed secret food recipes, tradenames, trademarks, and other intellectual property to restaurant franchisees in North Carolina were subject to the state’s income and franchise tax. Secretary of Revenue Decision No. 01-550 (N.C. Dep’t Revenue July 1, 2004). The Secretary determined that the taxpayers were doing business in the State, were "excluded corporations," and were subject to penalties for failure to file income and franchise tax returns.

The Taxpayers were engaged in the business of licensing their intellectual property to restaurants under their tradenames, but they did not own or operate any restaurants in North Carolina or have any offices, resident employees, or tangible property in the State. Rather, the Taxpayers licensed their intellectual property to affiliated companies and independent thirdparty franchisees that operated restaurants throughout North Carolina. The trademarks and tradenames were used in the sale and advertising of food products at North Carolina restaurants and appeared on signs, menu boards, paper goods, furnishings, and fixtures at North Carolina restaurants.

Each Taxpayer had a franchise agreement that imposed numerous obligations on its franchisees. Taxpayer 1’s agreement required strict adherence to requirements regarding menu items, advertising, and the restaurant facilities, including the layout of the furnishings and fixtures. Standards governing the quality of the food and service and the use of the trademarks, tradenames, and service marks were also detailed in the agreement, and Taxpayer 1 reserved the right to audit the restaurant. The agreement further provided that any enhancement of the goodwill associated with the use of the intellectual property inured to the benefit of Taxpayer 1. To ensure compliance with its quality standards, Taxpayer 1 had an agreement with one of its affiliates for the affiliate to provide quality assurance services on behalf of Taxpayer 1 to the franchisees. The affiliate provided services to North Carolina franchisees, and the franchisees paid a royalty fee to Taxpayer 1 of 4% of gross revenues for each month the restaurant was in operation.

Taxpayer 2 similarly required that its franchisees operate their restaurants in strict accordance with the standards and specifications of its franchise agreement. Under the terms of the agreement, Taxpayer 2 was to help the franchisee select a suitable location for establishing a restaurant and to provide, at the franchisee’s request, for three days of training for restaurant personnel. Taxpayer 2 could also require structural changes, major remodeling, or renovation of a restaurant. Taxpayer 2’s operating manual provided standards of quality, cleanliness, and service for all food, beverages, furnishings, interior and exterior design, supplies, fixtures and equipment used in connection with the restaurant, and Taxpayer 2 reserved the right to examine the franchisee’s restaurants. The franchise agreement deemed the goodwill arising from the use of the intellectual property to inure to the benefit of Taxpayer 2. Like Taxpayer 1, Taxpayer 2 also had a service agreement with an affiliate for the affiliate to provide quality assurance services on behalf of Taxpayer 2 to its franchisees. These services included ensuring restaurant maintenance, cleanliness, and adherence to store procedures. These services were performed in North Carolina on behalf of Taxpayer 2, and the franchisees paid an initial franchise fee and a 4% service fee per month based on the previous month’s gross sales.

The Taxpayers recorded significant royalty income earned from affiliated companies and thirdparty franchisees in North Carolina. The Taxpayers received more than half of their income from investments in intangible property.

The Secretary determined that the Taxpayers were doing business in North Carolina and, as a result, were subject to corporate income and franchise taxes. Although the Taxpayers argued that they lacked a physical presence sufficient to subject them to taxation, the Secretary concluded that the performance of the quality control activities and other services by the Taxpayers’ affiliates on behalf of the Taxpayers established their physical presence in the State. The affiliates’ services, the Secretary determined, were necessary and vital to the establishment of the Taxpayers’ marketplace in the State. The Secretary further concluded that the Taxpayers continuously and regularly permitted their property to be used in North Carolina for economic gain and that their royalties were dependent upon the use of the property in the state. The Secretary therefore found that the Taxpayers were doing business in North Carolina and were fairly subjected to the corporate income and franchise taxes.

The Taxpayers were also excluded corporations under the North Carolina General Statutes. An "excluded corporation" was defined in North Carolina to be any corporation that received more than half of its ordinary income from "investments in" or "dealing in" intangible property. If the Taxpayers were excluded corporations, they were required to apportion their business income by using the sales factor as provided under the North Carolina General Statutes. The Taxpayers argued that "investments in and/or dealing in" intangibles did not include the activity of licensing intellectual property. The Secretary rejected the Taxpayers’ argument and found that the licensing of intangibles was an "investment in" or "dealing in" intangible property. The Secretary further found that, except for a short-period for Taxpayer 2, more than half of the Taxpayers’ ordinary gross income was from royalties. As a result, the Taxpayers were excluded corporations required to apportion their income using the single sales factor.

Finally, the Secretary determined that none of the penalties imposed on the Taxpayers should be waived. The Secretary found the law clear in North Carolina that a taxpayer that licenses its trademarks for economic gain in the State is doing business for corporate income tax purposes. Finding no special circumstances absolving the Taxpayers from the payment of penalties, the Secretary declined to waive them.

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