The Iowa Supreme Court recently handed down a decision in the case of Kentucky Fried Chicken v. The Iowa Department of Revenue and Finance, affirming the imposition of Iowa’s corporate income tax on KFC, despite lacking a physical presence in the state. The price tag for KFC was nearly a quarter billion dollars.  KFC, which operates in the state solely as a licensor of independently owned franchises, was held liable for income taxes owed on income generated from licensing KFC’s marks and systems.

There are a few heated multistate tax issues addressed in this decision which will surely remain at the forefront for years to come. The first issue is whether the bright-line physical presence test for establishing substantial nexus set forth in Quill is limited to sales and use/excise taxes. And, second, if a physical presence is not required for non-sales/use taxes, what level of economic presence is necessary to establish substantial nexus?

Ultimately, the Court concluded KFC’s economic presence, i.e. receiving royalties from the licensing of intangibles in Iowa, “satisfies the ‘substantial nexus’ requirement for corporate income tax purposes.” Interestingly, the Court found that the use of KFC’s intangibles by franchisees “firmly anchored within the state” was “the functional equivalent of ‘physical presence’ under Quill.”  Alternatively, the Court held (and more reasonably in our opinion) that the Quill physical presence standard did not apply to income-based taxes. With the advances in technology and, specifically, the removal of many burdens of participating in interstate commerce, we anticipate more states will adopt an economic presence standard for non-sales/use taxes, such as Iowa did in the KFC decision and Ohio currently has for its Commercial Activity Tax.

In addition, the KFC opinion includes an extensive review of constitutional nexus jurisprudence.  If you have questions concerning the state taxes with which your business has substantial nexus, contact us today.