The New Jersey Tax Court Limits State Taxation Of Royalty Payments

In an October 23, 2003, decision, Lanco, Inc. v. Director, Division of Taxation (No. 005329-970), the New Jersey Tax Court comprehensively reviews the history of state taxation of interstate royalty payments and the constitutional issues involved and limits the right of the state to tax such royalty payments. Though it does come down on the side of the argument that U.S. Supreme Court precedent requires physical contact by a taxpayer with a state as a prerequisite for the state to levy an income tax on royalty income from sources located in the state, the decision is not a clear-cut victory for franchisors.

The concerted effort of state governments to broaden their tax bases has been evident for many years. In recent times, as the soft economy has caused state budget deficits to balloon, that effort has accelerated, and franchisors have been among the targets. In seeking to tax royalty fees (and in some cases advertising fees), the states have relied on a 1993 decision of the Supreme Court of South Carolina, Geoffrey, Inc. vs. South Carolina Tax Commission. Geoffrey also held that neither the due process nor the commerce clauses of the U.S. Constitution banned a state from taxing an out-of-state corporation with no physical presence in the state (i.e., no tangible property or employees located in the state). The court found that the use of the taxpayer’s trademarks — intangible property — by a licensee in the state was a sufficient basis to impose a tax on the royalties paid by the licensee to the taxpayer. The South Carolina Supreme Court rejected the argument that the situs of intangible property (e.g., a trademark) is the domicile of its owner. The International Franchise Association filed a brief amicus curiae in support of the taxpayer’s appeal to the U.S. Supreme Court, but the Supreme Court did not grant certiorari.

The term most commonly used as the prerequisite for state taxation of an out-of-state company is "nexus," meaning the relationship between a taxpayer and a state. There are two limitations on state taxation contained in the U.S. Constitution, one in the due process clause and one in the commerce clause. Nexus has a different meaning in each of those clauses. Under the due process clause, nexus means an intentional effort to exploit the market of the taxing state. Under the commerce clause, nexus means a more than de minimis physical contact with the taxing state, which before Geoffrey meant property or employees located in the state.

In 1992, the U.S. Supreme Court held in Quill Corp. v. North Dakota that a more than de minimis presence by a taxpayer was a prerequisite under the commerce clause (though not under the due process clause) for a state to impose on that taxpayer the obligation to collect use taxes on sales made to purchasers located in the state and shipped by mail or common carrier to the purchaser. This ruling applied to the obligation to collect use taxes, but not to state income, gross receipts, or other types of taxes. Whether Quill applies equally to state income taxes has remained unresolved, but the states apparently believe that the Supreme Court’s denial of certiorari in Geoffrey was a sign that it did not.

In reply to another issue raised by the taxpayer in Geoffrey, the South Carolina Supreme Court held that the state had met its burden under the due process clause, noted by the U.S. Supreme Court in Complete Auto Transit v. Brady, that the tax sought to be imposed bear a reasonable relationship to the services the state furnishes to the taxpayer. The Geoffrey court based this holding on the fact that South Carolina provided a variety of services to the South Carolina licensees of the taxpayers’ trademarks.

Many states have moved to tax royalty income (and in some cases advertising fees) paid by franchisees located in the state to a franchisor that is located outside the state, without regard to any physical presence of the franchisor in the state (i.e., tangible property in the form of franchisor-owned outlets or employees located in the state). Franchisors have maintained that the fact that they do not have a presence in the state bars the state, under the commerce clause, from taxing such royalty income. Because the states have, for the most part, relied on Geoffrey, holding that the use of the franchisor’s trademark in the state is a sufficient basis under the commerce clause for a tax on royalty payments to the out-of-state franchisor, the disputes between franchisors and state tax authorities have not focused on other potential elements of physical contact that might justify a tax even if Quill applied to state income taxes. For example, a franchisor may send employees to the state for periods of several days or weeks to assist franchisees in the development of their outlets, to provide pre- and post-opening training, and to perform periodic inspections. Even if such employee visits are irregular, in the aggregate they may add up to a significant number of days in a year in which a franchisor’s employees are present in the state. This level of contact with a state could meet the more than de minimis test of Quill.

The small amount of tax typically owed by a franchisor, in situations where insufficient contact with the state can be seriously argued, has also contributed to the very small number of contested state tax assessments on franchisor royalty revenue. The amount of tax involved typically does not warrant the cost of disputing the state’s right to impose the tax, particularly in the not uncommon instances in which a state has offered a tax amnesty, agreeing to waive interest and penalties on taxes due for prior years in exchange for the franchisor’s agreement to file a tax return and pay the taxes due for the current and future years and perhaps one or two prior years. As many franchisors have noted, because they can to a large extent reduce the income tax they pay to their state of domicile by the taxes they pay to other states (and state income tax is deductible for federal income tax purposes), the principal burden of state taxation of royalty income is the paperwork required to comply.

Lanco did not involve a franchise relationship. Like Geoffrey, the taxpayer was a company that owned the trademarks of a related group of companies (Lane Bryant stores) and licensed those trademarks to the Lane Bryant stores located in New Jersey. The taxpayer had no tangible property or employees in New Jersey and no other physical contact with the state.

The New Jersey Tax Court reviewed the history of constitutional litigation over state taxation of income earned by out-of-state companies that had no physical contact with the taxing state, including judicial decisions issued since Geoffrey was decided in 1993. The specific focus of the tax court was whether Quill applied to state income taxes as well as to use tax collection obligations. The tax court considered the arguments pro and con and the rulings of several courts since Geoffrey, the majority of which rejected a distinction between different types of tax and held that Quill’s nexus requirement of more than de minimis contact by the taxpayer with the taxing state applied to both income taxes and the collection of use taxes. The tax court noted, and rejected, the argument that has been made to distinguish use tax collection burdens from the payment of income taxes. One such argument is that the collection of use taxes potentially exposes the taxpayer to numerous taxing jurisdictions within each state (e.g., the state and its counties and municipalities), with many variations in tax rules, exemptions, and administrative and record-keeping requirements. It has been argued that the obligation to collect use taxes is, therefore, a far greater burden than filing a single tax return and paying a single tax to the state. The New Jersey Tax Court reasoned that even if such complexity characterized use tax collection, modern data-processing technology narrowed the differences in such burdens.

Though the New Jersey Tax Court held that the commerce clause requires a nexus of the taxpayer to the taxing state in the form of a physical presence, it also rejected the taxpayer’s attempt to invoke the due process clause. Though the court holds that it is unnecessary to reach the due process argument, in dictum it notes that the taxpayer clearly met the due process nexus requirement by purposefully availing itself of the benefits of the economic market in New Jersey.

Lanco is a well-reasoned opinion and may well be persuasive to other courts. However, New Jersey may appeal the tax court decision, and the ultimate value of the decision is therefore uncertain. As noted above, franchisors realistically only have the commerce clause of the U.S. Constitution standing between them and state taxation of royalty income. The parameters of what constitutes physical presence in a state sufficient to establish nexus under the commerce clause, in the context of franchise relationships, have not been established. The tax court’s commerce clause analysis also addressed the Complete Auto Transit requirement that a state tax bear a fair relationship to the benefits provided by the state to the taxpayer. As did the South Carolina Supreme Court in Geoffrey, the New Jersey. Tax Court held that because the taxpayer’s intangible property was used in the state in the licensee’s retail business, the licensor clearly enjoyed the same state benefits that were provided to the licensee.

Finally, the tax court noted that New Jersey is not without recourse to reach royalties paid for the use of intangibles. In the context of a trademark holding company member of a group of companies under common control, the court noted that some states (so-called "unitary tax" states) effectively tax such royalty income by requiring the taxpayer over which they have jurisdiction to report income for the entire group (eliminating intercompany payments) and to apportion that income to the taxing state. The court also noted that though New Jersey is not a unitary tax state, it has recently amended its corporation business tax to disallow deductions for royalty payments by a New Jersey company to a related entity for the use of intangible property. Though a unitary tax would probably not impact the receipt of royalties by an out-of-state franchisor, the disallowance of deductions for such payments, without regard to whether they are made to a related company or to an out-of-state franchisor (which early versions of the new amendment to the New Jersey corporation business tax would have provided) could impact franchising by shifting a tax burden to franchisees. It is probably more likely that more states will continue to assert the right to tax franchisor royalty income and that, for the reasons outlined above, few franchisors will find it cost effective to contest such taxes under the commerce clause, notwithstanding the New Jersey Tax Court’s decision in Lanco.

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