KFC Corp. v. Iowa Dept. of Revenue

• Decision Date: 30 December 2010
• Docket Number: No. 09-1032.,09-1032.
• Parties: KFC CORPORATION, Appellant, v. IOWA DEPARTMENT OF REVENUE, Appellee.
• Court: Iowa Supreme Court

792 N.W.2d 308

KFC CORPORATION, Appellant,

v.IOWA DEPARTMENT OF REVENUE, Appellee.

No. 09-1032.

Supreme Court of Iowa.

Dec. 30, 2010.

Paul H. Frankel, Craig B. Fields, and Mitchell A. Newmark of Morrison & Foerster LLP, New York, New York, and John V. Donnelly of Sullivan & Ward, P.C., West Des Moines, Iowa, for appellant.

Thomas J. Miller, Attorney General, Donald D. Stanley, Jr., Special Assistant

Attorney General, and Marcia E. Mason, Assistant Attorney General, for appellee.

APPEL, Justice.

In this case, we must determine whether the State of Iowa may impose an income tax on revenue received by a foreign corporation that has no tangible physical presence within the state but receives revenues from the use of the corporation's intangible property within the state. After the Iowa Department of Revenue (IDOR) imposed an income tax assessment against the out-of-state corporation, the taxpayer filed a protest with the agency on constitutional and statutory grounds. IDOR rejected the protest. On review of the agency's action, the district court affirmed. KFC appealed. For the reasons expressed below, we affirm the judgment of the district court.

I. Factual and Procedural Background.

KFC Corporation (KFC) is a Delaware corporation with its principal place of business in Louisville, Kentucky. Its primary business is the ownership and licensing of the KFC trademark and related system. KFC licenses its system to independent franchisees who own approximately 3400 restaurants throughout the United States. While KFC also licenses its system to related entities—including KFC National Management Company—all KFC restaurants in Iowa are owned by independent franchisees. KFC owns no restaurant properties in Iowa and has no employees in Iowa.

On October 19, 2001, IDOR issued to KFC an assessment in the amount of $284,658.08 for unpaid corporate income taxes, penalties, and interest for 1997, 1998, and 1999. KFC filed a timely protest of the assessment. IDOR answered the protest, and the matter was assigned by the Iowa Department of Inspections and Appeals to an administrative law judge (ALJ). Both sides filed motions for summary judgment.

In its motion for summary judgment, IDOR asserted that the requirements of the Commerce Clause were satisfied. IDOR argued that the "physical presence" requirement established in National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753, 87 S.Ct. 1389, 18 L.Ed.2d 505 (1967), as reaffirmed in Quill Corp. v. North Dakota, 504 U.S. 298, 112 S.Ct. 1904, 119 L.Ed.2d 91 (1992), was not necessary when a franchisor licensed intellectual property that generated income for the franchisor within the state from operations of independent franchisees. IDOR asserted that KFC's royalty income based on its franchisees' Iowa transactions was "taxable because it is derived from Iowa customers and is made possible by Iowa's infrastructure and legal protection of the Iowa marketplace." IDOR further argued that the imposition of the income tax was consistent with Iowa Code section 422.33(1) (1997) and its implementing administrative rules.

KFC resisted and filed a summary judgment motion of its own. KFC argued that its receipt of royalty income was not subject to tax by the State of Iowa. KFC observed that in Quill, the United States Supreme Court held that a use tax could not be imposed on a foreign corporation that had no physical contact with the taxing state. KFC noted that the Quill Court "did not state that its holding is limited to use tax collection obligations." KFC argued that, because it had no physical presence in Iowa, the state could not constitutionally impose the income tax. In the alternative, KFC pressed a statutory claim. KFC asserted that under Iowa Code section 422.33(1), KFC was not subjectto tax because it lacked property "located or having a situs in this state."

KFC did not raise any issue related to penalties in its motion for summary judgment. In its memorandum of points and authorities, however, KFC asserted that the penalty assessed by IDOR should be waived under applicable statutes because it had substantial authority to rely upon its position. See Iowa Code § 421.27(1)( h ), (2)( f ), (3)( d ).

The ALJ issued a detailed ruling in IDOR's favor. The ALJ found that KFC owned, managed, protected, and licensed KFC marks and system during the years in question. As part of its business, KFC entered into franchise agreements with franchisees in Iowa who remitted royalty and/or license income to KFC for the use of KFC marks and system at a rate of four percent of gross revenues for each month, with a minimum royalty amount adjusted for increases in the Consumer Price Index. Throughout the period, KFC had the right to control the use of its marks by Iowa franchises and the right to control the nature and quality of goods sold under the marks by them.

Further, the ALJ found that Iowa franchisees were required by their franchise agreements to adhere to KFC's requirements regarding menu items, advertising, marketing, and physical facilities. In order to comply with applicable standards, Iowa franchisees were required to purchase equipment, supplies, paper goods, and other products from only KFC-approved manufacturers and distributors. Quality assurance activities were performed in Iowa on behalf of KFC by employees of KFC's affiliates. The ALJ also found that KFC franchisees in Iowa could deduct from their taxable income the royalty payments made to KFC.

Applying law to these facts, the ALJ held that the IDOR assessment did not violate the Commerce Clause or Iowa law. With respect to the Commerce Clause question, the ALJ concluded that "physical presence" is not required when a state imposes taxation on income. Further, the ALJ concluded IDOR demonstrated that KFC had a sufficient nexus to Iowa to support IDOR's assessment. According to the ALJ, the franchise right was an intangible with a direct connection to Iowa. The imposition of tax on income generated by a franchisor within a state was not an undue burden on commerce, but rather a payment to government that provided the economic climate for the business to prosper.

On the state law question, the ALJ found that KFC was "deriving income from sources within this state" as required by Iowa Code section 422.33(1). According to the ALJ, KFC received such income when it received royalty and/or license income from franchisees located within the state. The ALJ determined that the provision of Iowa Code section 422.33(1) requiring a "situs in this state" did not require a physical situs, but, citing Webster's dictionary, included "the place where some thing exists or originates; the place where something (as a right) is held to be located in law." The ALJ did not make a ruling of any kind or refer in any way to the issue of penalties in the decision.

On appeal, the director of IDOR affirmed the ALJ. The director characterized the issue on appeal as whether "KFC ha[d] sufficient nexus with Iowa to be subject to Iowa corporation income tax?" The director adopted and incorporated the findings of fact of the ALJ without revisions. The director also adopted the conclusions of law made by the ALJ with additions and modifications. With respect to the Commerce Clause issue, the director noted that several states have held that an economic presence satisfies the"substantial nexus" requirement for corporate income tax purposes. The director also found that, under Iowa law, KFC owed corporate income tax under Iowa Code section 422.33(1). Like the ALJ, the director made no findings on the penalty issue.

KFC sought judicial review of the agency's decision in district court. The district court affirmed the director on the Commerce Clause issue, finding that "physical presence" was not required under the Commerce Clause for the imposition of state income tax. The district court further found that, because KFC's marks and trademarks were "an integral part of business activity occurring regularly in Iowa," the income derived from the use of that property was taxable under Iowa law. On the issue of penalties, the district court found the issue was not preserved because KFC did not obtain a ruling on the issue from the agency and also because KFC did not seek a ruling on the issue in its motion for summary judgment.

II. Standard of Review.

The Iowa Administrative Procedure Act governs judicial review of decisions of the Iowa Department of Revenue. See Iowa Code ch. 17A; AOL LLC v. Iowa Dep't of Revenue, 771 N.W.2d 404, 407 (Iowa 2009). With respect to the constitutional questions in this case, the parties agree that our review is de novo. See State v. Taeger, 781 N.W.2d 560, 564 (Iowa 2010).

The parties contest the standard of review on the statutory issue presented in this case. KFC contends that the district court erred in granting deference to IDOR's legal conclusion on state law issues under Iowa Code section 422.33(1) and that our review of IDOR's legal determinations is for errors at law. IDOR contends that it has been clearly vested with discretion to interpret the applicable provisions of law and that, as a result, its determinations may be reversed only if "irrational, illogical, or wholly unjustifiable." See Renda v. Iowa Civil Rights Comm'n, 784 N.W.2d 8, 12-14 (Iowa 2010) (noting that the question of whether the legislature has clearly vested an agency with discretion to determine applicable provisions of law is generally to be based upon an analysis of individual provisions of law, not upon a wholesale conclusion regarding chapters of the Code); Iowa AG Constr. Co. v. Iowa State Bd. of Tax Review, 723 N.W.2d 167, 173 (Iowa 2006) (holding broad rule-making authority may give rise to deference to administrative interpretations).

In this case, however, we need not reach the issue of whether IDOR is entitled to deference in its interpretation of Iowa Code section 422.33(1) because, even if deference were not afforded, we conclude, for...