FRANCHISOR 101: FRANCHISORS SUBJECT TO TAXES LEVIED BY MULTIPLE JURISDICTIONS

As we reported in our January 2011 Newsletter, in December 2010, in KFC Corporation vs. Iowa Department of Revenue, the Iowa Supreme Court held that the intangibles that KFC licensed to its Iowa franchisees had "a sufficient connection to Iowa to amount to the functional equivalent of 'physical presence'" in Iowa, making KFC's royalty income from its Iowa franchisees subject to Iowa income taxes under an "economic nexus" theory.

On October 3, 2011, the United States Supreme Court refused to review the Iowa Supreme Court's decision. As a consequence, more states are expected to assess income taxes on the revenue generated for out-of-state franchisors by their franchisees located within their state. If so, franchisors may have to file income tax returns in all states where their franchisees are located and may become subject to retroactive and prospective tax assessments and the potential taxation of their revenue by multiple jurisdictions. As we reported in our August 2009, October 2009 and June 2010 Newsletters, California and New York already require franchisors operating within their borders to submit annual reports with the names, addresses and gross sales of their in-state franchisees and the total amount of any sales by the franchisors to their franchisees.

Franchisors should consider revising their Franchise Agreements to deflect these additional tax assessments. One approach will be to "gross-up" royalty payments by requiring in-state franchisees to pay all taxes levied upon the franchisors based upon their franchisees' use of their intellectual property and other intangibles during term of their Franchise Agreement. Other solutions may be forthcoming.

FRANCHISEE 101: FRANCHISEE ASSOCIATION CAN SUE FRANCHISOR 

Franchisees who are parties to franchise agreements with mandatory arbitration provisions can avoid arbitration by forming a franchisee association to be the plaintiff in the action, according to a federal District Court in Connecticut in EA Independent Franchisee Association, LLC v. Edible Arrangements International, Inc.

The franchisee association, comprised of 170 members, sought a declaratory judgment that the franchisor had violated state and federal laws and had breached its members' franchise agreements. In its motion to dismiss the case, the franchisor argued that the franchisees were bound by the arbitration provisions in their franchise agreements and the franchisee association did not have standing to bring the action.

The Court rejected that argument and held that "[t]he arbitration provision of the individual members' franchise agreements does not require the Court to conclude that [the franchisee association] lacks standing. [Franchisor's] attempt to link [the franchisee association's] allegations to [franchisor's] argument in favor of individual participation and against associational standing. ... The existence of three different versions of the relevant writings does not establish the need for individual participation. ...The Court can consider each of the versions and their corresponding fees without receiving individual guidance from [the franchisee association's] members." To see the full case, click here .