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U.S. Supreme Court won’t hear KFC tax dispute

Despite pressure from national tax executives, the U.S. Supreme Court has refused to hear an Iowa-based case involving fried chicken giant KFC, which means the company will be liable for a quarter of million in back corporate income taxes on franchised restaurants in the state.

The case, KFC Corporation v. Iowa Department of Revenue, questioned if the company, which owns no restaurants or employs no person directly in the state, could be held liable for property taxes on its licensed franchises. Attorneys for KFC launched the suit, arguing that an earlier U.S. Supreme Court case that found a mail order vender with no physical address in North Dakota to be exempt from paying sales and use taxes under Commerce Clause law also applied to company that had no physical assets in Iowa.

In an Amicus brief by Washington, D.C.-based Tax Executives Institute, Inc. attorneys for the organization held that the key issue of the case was if a state could impose a corporate income tax on a business with no connection to the state other than having customers.

Since the Court’s 1992 decision in Quill Corp. v. North Dakota, which sustained a taxpayer challenge under the Commerce Clause, states and taxpayers have been left unassisted in their efforts to interpret and apply these limits. The resulting clutter of vague and inconsistent standards has undermined the protections of the Commerce Clause.

In December 2010, as part as one of the last opinions generated by three earlier ousted Iowa Supreme Court justices, the court explained that the U.S. Supreme Court would likely look at income benefits above physical presence in deciding if the state could hold a company accountable, and essentially created a state standard of “economic presence” to usurp the SCOTUS assertion of “physical presence” established in Quill.

Finally, we think taxation of the income here is most consistent with the now prevailing substance-over-form approach embraced in most of the modern cases decided by the Supreme Court under the dormant Commerce Clause. When a company earns hundreds of thousands of dollars from sales to Iowa customers arising from the licensing of intangibles associated with the fast-food business, we concluded that the Supreme Court would engage in a realistic substance-over-form assessment that would allow a state legislature to require the payment of the company’s fair share of taxes without violating the dormant Commerce Clause. …

In fact, “physical presence” in today’s world is not “a meaningful surrogate for the economic presence sufficient to make a seller the subject of state taxation.” … “Physical presence” often reflects more the manner in which a company does business rather than the degree to which the company benefits from the provision of government services in the taxing state. Does it really make sense to require Barnes and Noble to collect and remit use taxes, but not impose the same obligation on Amazon.com, based on the difference in their business methods? …

Further, extension of the “physical presence” approach in [the earlier SCOTUS ruling] would be an incentive for entity isolation in which potentially liable taxpayers create wholly owned affiliates without physical presence in order to defeat potential tax liability. … We doubt that the Supreme Court would want to extend such form-over-substance activity into the income tax arena where substance over form has been the traditional battle cry.

In essence, the Iowa Supreme Court offered that a lack of subsequent rulings along the same lines as the earlier SCOTUS decision held as proof that the nation’s High Court saw the need for greater interpretation by states, given the current technologically-driven economic climate. And, given SCOTUS’s refusal to weigh in on the issue, it appears the Iowa Supremes were on target with their belief.

The end result for the Kentucky-based KFC Corp. is that it will now need to cough up the nearly $250,000 it owes in back income taxes from 1997 and 1999.

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