NY Tax Law May Have Far-Reaching Effects

“It does seem to be an unparalleled demand for information about franchisees operating in a state,” said Bruce Ackerman, partner, Faegre & Benson LLP (Minneapolis). “New York's goal might be to find out if franchisees are properly reporting sales taxes, but it's asking the franchisor to give up all this information in order to get at it.”

“Our request for a delay of implementation of the law and a 90-day reporting period next year should not be interpreted as our endorsement of the new law,” said David French, IFA vice president of government relations.

The Law

The first part of the new reporting requirement seems fairly innocuous. A franchisor must provide the following information to the Department of Taxation and Finance: the legal name of the franchisee; its phone number; any doing-business-as (“DBA”) name; the name of the individual owner of the franchisee, if it is
an entity; and federal and state identification numbers, including, in the case of
individual franchisees, the franchisee's Social Security number. Under most circumstances, that information is readily available to the franchisor.

However, a guidance document issued on July 7 by the Office of Tax Policy Analysis, Taxpayer Guidance Division, showed the law's true intent: sales and tax information. In addition to the information above, the law requires that franchisors report:

• the beginning date of each franchise;
• the location of the franchised location and the mailing address, if different;
• the gross sales in New York as reported by the franchisee to the franchisor and, if different, the gross sales as calculated by the franchisor as a result of an independent audit of the franchised location;
• if known, the amount of sales taxes (state and local) collected at each franchised location;
• the amount of the royalty payments paid by the franchisee to the franchisor and the royalty percentage of gross sales reported; and
• the amount of sales made to the franchised location by the franchisor, its affiliates, or any supplier designated by the franchisor.

Initially, franchisors were going to be required to file their first information returns electronically on or before Sept. 20, 2009. The initial returns would have reflected any franchisee that was operating between March 1, 2009 and Aug. 31, 2009. Then, on March 20, 2010, annual filings would have been required, covering the period from the previous Sept. 1 through Feb. 28.

In response, IFA wrote a letter on July 20 to Jamie Woodward, acting commissioner of the Department, that outlined some of the problems that franchisors and franchisees would face in complying with the law. On Aug. 6, Woodward responded with a memo that provided several modifications to the program. Those modifications are:

• Reporting deadlines: Automatic 90-day extensions will be granted for the initial, as well as all future, reporting deadlines. Instructions for requesting an automatic extension will be posted online. For the initial filing, the extension will shift the deadline to Dec. 20, 2009. For 2010, the extension will shift the deadline from March 20 to June 20 for franchisors who request it.
• Supplier sales: The Department dropped the requirement that franchisors report sales made by “designated” or approved suppliers to New York franchisees. However, sales of supplies from a franchisor or its affiliates directly to a New York franchisee still must be reported.
• Franchisee gross sales: If the franchisee currently reports gross sales to the franchisor, this information must be supplied in the required reports. If a different performance measure is used (such as room-nights in lodging), that calculation must be explained and, where possible, the quantitative data for the relevant reporting period must be supplied to the state.

Penalties for non-filing, filing incorrect information, or failure to provide a franchisee with the required information will leave a franchisor facing fines of up to $500 per failure (up to 10 failures), and $50 for each additional failure. Late returns are subject to fines of up to $2,000. The maximum fine for a reporting period (a year) is $10,000. The state has included guidance indicating that fines will not be imposed if violations were “entirely due to reasonable cause and not willful neglect.”

Opposition By Franchise Industry

Opposition to the new law runs deep in the franchise industry. Franchisors see it as a significant new opening for the state to increase taxation of franchisees and franchisors. “This is the start of the [Department] really finding out who the franchisees are,” said Bruce S. Schaeffer, a franchise attorney and consultant in New York City. “With that information in-hand, then they can go after taxes, which the state ' which almost every state ' desperately needs.”

The sheer cost and effort of compliance is significant. “The amended tax law will be a tremendous burden for franchisors, particularly those with a large franchisee presence in New York,” said Oppenheim. Not only do franchisors have to obtain information that, in some cases might be difficult to obtain, but they have to provide it to the government in a specific electronic format that had not been provided to franchisors as of early August, he said.

IFA's July 20 letter to the Department added that some franchisors do not have access to the information that the state is requiring them to produce about each franchisee. “Much of the requested information may not be available to the franchisor in the normal course of business, and franchisors may not have any contractual right to obligate franchisees to provide some of the information,” IFA wrote. “In particular, information such as tax identification numbers, franchisee Social Security numbers, or tax certificates of authority may not be available to every franchisor. While some of this information may have been obtained during the initial background check on a franchise investor, it is often expunged or redacted after the initial franchise investment.”

Moreover, IFA's French told FBLA, some franchise agreements in New York state don't require the sharing of financial information that is at the heart of the new law. “New York is an old franchise state. It's had franchises since the inception of this industry, and those old contracts, some of which date from the 1950s, do not conform to what the system assumes franchisors can get,” he said. “There are franchisees that do not report gross sales to franchisors; one is measured in gallons of ice cream sold, and another is measured in guest-room nights.” (Seemingly, the August 6 memo addressed this concern by allowing for reporting of franchisee data besides sales.)

Tax nexus issues also are raised by the new law, as franchisors say that it represents a new way to impose taxes on out-of-state franchisors. “This law is definitely the first of its kind in the country, and that's what has our membership concerned,” said French. “It's a continuation of a trend of state departments of revenue and tax departments becoming more aggressive in seeking nexus. But, at the same time, we see this as more complicated than a tax nexus issue.”

“Most tax nexus cases don't involve franchises. They are usually about licensing of trademarks, intangible property, and a claim that there is an effort to avoid taxation,” said Ackerman, referencing the Geoffrey decision, well-known to franchisors, as an example (Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (1993)). “But this really is an effort to tax an arms-length transaction between a franchisor and franchisee, where there's no tax-avoidance scheme involved.”

Even mandating that out-of-state franchisors provide information is unusual, according Adam B. Thimmesch, attorney, Faegre & Benson. “States have asked for information about franchisees operating in their jurisdiction, but this situation is unusual because there is a monetary penalty that an out-of-state entity would face. This is not a voluntary program,” he said.

Also troubling to franchisors is that the new law does not allow for the state's “single-sale exemption.” New York allows a franchisor with one franchise in the state to avoid registration. “Under the amended tax law, a franchisor based in Texas, or for that matter, in the United Kingdom, with one franchisee in the state of New York will be required to file regular reports with the Department or risk severe monetary penalties,” Oppenheim said.

Other problems will arise if a franchisor's sales figures do not match with a franchisee's ' a situation that Schaeffer said will be commonplace. “It practically never occurs that a franchisor's and the franchisees' revenue figures are the same,” he said. “There are different ways of reporting and different treatment of intermediate goods [purchased by the franchisor for resale or usage by the franchisee]. Also, in some systems, underreporting of sales by franchisees is a chronic problem.”

If the data are in conflict, the franchisor and/or franchisee will be required to conduct an audit at their own expense. Furthermore, if an audit uncovers underreported taxes, then franchisors or franchisees could be liable for penalties and/or back taxes, Oppenheim said. “Depending on the severity of the underpayment, it could lead to failure of the franchisee,” he said.

Finally, when the numbers don't jibe, conflict will arise between franchisor and franchisee, Schaeffer predicted. “If anybody is underreporting on anything, it will create conflict between the franchisor and franchisee ' and there's already conflict in that area ' plus the income tax and sales tax liabilities,” said Schaeffer.

“It definitely has the potential to lead to discord among parties in the franchise contract,” said Ackerman.

Impact

Attorneys assessing the possible impact of the law say that it could be far-reaching. Under the law, for the first time, New York would be able to tax franchisors for intermediate goods sold to franchisees for resale or use in providing a product or service.

“A number of franchisors are concerned the new law may lead to efforts by New York, and perhaps other states, to impose use tax-collection obligations on franchisors with respect to items sold to their franchisees and income tax return filing obligations on the part of franchisors with respect to franchise fees that are received with respect to the operations of their franchisees,” said Thimmesch. “The right of New York or any other state to impose these obligations on a franchisor depends on whether the state has jurisdiction over the franchisor for sales and use or income tax purposes.”

“It's another attempt by a state government at what has been called 'more efficient' collection of taxes 'owed' to them,” said French. “Some people in state government view franchises as a tax-avoidance scheme, rather than as a way for an entrepreneur to go into business without having to start from scratch and to take all the risk. We have to continually educate state legislators and regulators on what franchising is all about.”

The new law “is not a new theory,” said Schaeffer. “It's 'economic nexus,' and it stays the same as it has since Geoffrey. The difference is in the collection and ready collation of the information. I know of no state that has ever asked for such information about only one economic sector. Obviously, access to readily sortable data accommodates an immediate math audit of franchisees for sales tax purposes and franchisors for income tax purposes.”

The New York law also reinforces the importance of resolving the definition of a “physical presence” that would trigger a nexus for tax purposes, French added. The most important case in that area in the last 20 years ' Quill v. North Dakota, 504 U.S. 298 (1992) ' affirmed that states cannot impose sales and use taxes on out-of-state entities unless they have a physical presence in the state. However, Quill did not define physical presence with enough clarity for the franchising industry, French said.

Regardless, Oppenheim said that, “save for a legislative amendment repealing the law, which is unlikely, franchisors should be prepared to comply.” He is recommending to his franchisor clients that they contact their franchisees and make sure they know about the law, but that they do not provide legal or accounting advice. “Instead, advise the franchisees to see counsel,” Oppenheim said. “Franchisor attorneys must advise all franchise clients with licensees in New York. While many franchisors received written notices and phone calls directly from the Department, I know of many (large and small) that did not. Therefore, it is incumbent on us as franchise counsel to educate our clients. We should not presume that our clients are aware of the new law.”

Kevin Adler is associate editor of FBLA. He can be contacted at [email protected].

Franchisors and franchisees will be heading into uncharted territory in New York state when a new law takes effect in December 2009. The new law is incorporated into the state's sale tax statutes (Subpart G of Part V-1 of Chapter 57 of the New York State Laws of 2009), and it requires that every franchisor must provide the Department of Taxation and Finance (“Department”) with contact information and extensive sales and tax data about each franchisee that is operating in the state.

Originally, the legislation was slated to come into effect on Sept. 20, 2009, but the Department delayed the first reporting deadline to Dec. 20, after receiving critiques from the International Franchise Association (“IFA”) and individual franchisors and franchise attorneys.

Still, the law is a considerable change from the status quo. “It can only be described as unprecedented and over-reaching legislation,” said David Oppenheim, partner, Kaufmann Gildin (New York).

“It does seem to be an unparalleled demand for information about franchisees operating in a state,” said Bruce Ackerman, partner, Faegre & Benson LLP (Minneapolis). “New York's goal might be to find out if franchisees are properly reporting sales taxes, but it's asking the franchisor to give up all this information in order to get at it.”

“Our request for a delay of implementation of the law and a 90-day reporting period next year should not be interpreted as our endorsement of the new law,” said David French, IFA vice president of government relations.

The Law

The first part of the new reporting requirement seems fairly innocuous. A franchisor must provide the following information to the Department of Taxation and Finance: the legal name of the franchisee; its phone number; any doing-business-as (“DBA”) name; the name of the individual owner of the franchisee, if it is
an entity; and federal and state identification numbers, including, in the case of
individual franchisees, the franchisee's Social Security number. Under most circumstances, that information is readily available to the franchisor.

However, a guidance document issued on July 7 by the Office of Tax Policy Analysis, Taxpayer Guidance Division, showed the law's true intent: sales and tax information. In addition to the information above, the law requires that franchisors report:

• the beginning date of each franchise;
• the location of the franchised location and the mailing address, if different;
• the gross sales in New York as reported by the franchisee to the franchisor and, if different, the gross sales as calculated by the franchisor as a result of an independent audit of the franchised location;
• if known, the amount of sales taxes (state and local) collected at each franchised location;
• the amount of the royalty payments paid by the franchisee to the franchisor and the royalty percentage of gross sales reported; and
• the amount of sales made to the franchised location by the franchisor, its affiliates, or any supplier designated by the franchisor.

Initially, franchisors were going to be required to file their first information returns electronically on or before Sept. 20, 2009. The initial returns would have reflected any franchisee that was operating between March 1, 2009 and Aug. 31, 2009. Then, on March 20, 2010, annual filings would have been required, covering the period from the previous Sept. 1 through Feb. 28.

In response, IFA wrote a letter on July 20 to Jamie Woodward, acting commissioner of the Department, that outlined some of the problems that franchisors and franchisees would face in complying with the law. On Aug. 6, Woodward responded with a memo that provided several modifications to the program. Those modifications are:

• Reporting deadlines: Automatic 90-day extensions will be granted for the initial, as well as all future, reporting deadlines. Instructions for requesting an automatic extension will be posted online. For the initial filing, the extension will shift the deadline to Dec. 20, 2009. For 2010, the extension will shift the deadline from March 20 to June 20 for franchisors who request it.
• Supplier sales: The Department dropped the requirement that franchisors report sales made by “designated” or approved suppliers to New York franchisees. However, sales of supplies from a franchisor or its affiliates directly to a New York franchisee still must be reported.
• Franchisee gross sales: If the franchisee currently reports gross sales to the franchisor, this information must be supplied in the required reports. If a different performance measure is used (such as room-nights in lodging), that calculation must be explained and, where possible, the quantitative data for the relevant reporting period must be supplied to the state.

Penalties for non-filing, filing incorrect information, or failure to provide a franchisee with the required information will leave a franchisor facing fines of up to $500 per failure (up to 10 failures), and $50 for each additional failure. Late returns are subject to fines of up to $2,000. The maximum fine for a reporting period (a year) is $10,000. The state has included guidance indicating that fines will not be imposed if violations were “entirely due to reasonable cause and not willful neglect.”

Opposition By Franchise Industry

Opposition to the new law runs deep in the franchise industry. Franchisors see it as a significant new opening for the state to increase taxation of franchisees and franchisors. “This is the start of the [Department] really finding out who the franchisees are,” said Bruce S. Schaeffer, a franchise attorney and consultant in New York City. “With that information in-hand, then they can go after taxes, which the state ' which almost every state ' desperately needs.”

The sheer cost and effort of compliance is significant. “The amended tax law will be a tremendous burden for franchisors, particularly those with a large franchisee presence in New York,” said Oppenheim. Not only do franchisors have to obtain information that, in some cases might be difficult to obtain, but they have to provide it to the government in a specific electronic format that had not been provided to franchisors as of early August, he said.

IFA's July 20 letter to the Department added that some franchisors do not have access to the information that the state is requiring them to produce about each franchisee. “Much of the requested information may not be available to the franchisor in the normal course of business, and franchisors may not have any contractual right to obligate franchisees to provide some of the information,” IFA wrote. “In particular, information such as tax identification numbers, franchisee Social Security numbers, or tax certificates of authority may not be available to every franchisor. While some of this information may have been obtained during the initial background check on a franchise investor, it is often expunged or redacted after the initial franchise investment.”

Moreover, IFA's French told FBLA, some franchise agreements in New York state don't require the sharing of financial information that is at the heart of the new law. “New York is an old franchise state. It's had franchises since the inception of this industry, and those old contracts, some of which date from the 1950s, do not conform to what the system assumes franchisors can get,” he said. “There are franchisees that do not report gross sales to franchisors; one is measured in gallons of ice cream sold, and another is measured in guest-room nights.” (Seemingly, the August 6 memo addressed this concern by allowing for reporting of franchisee data besides sales.)

Tax nexus issues also are raised by the new law, as franchisors say that it represents a new way to impose taxes on out-of-state franchisors. “This law is definitely the first of its kind in the country, and that's what has our membership concerned,” said French. “It's a continuation of a trend of state departments of revenue and tax departments becoming more aggressive in seeking nexus. But, at the same time, we see this as more complicated than a tax nexus issue.”

“Most tax nexus cases don't involve franchises. They are usually about licensing of trademarks, intangible property, and a claim that there is an effort to avoid taxation,” said Ackerman, referencing the Geoffrey decision, well-known to franchisors, as an example ( Geoffrey, Inc. v. South Carolina Tax Commission , 437 S.E.2d 13 (1993)). “But this really is an effort to tax an arms-length transaction between a franchisor and franchisee, where there's no tax-avoidance scheme involved.”

Even mandating that out-of-state franchisors provide information is unusual, according Adam B. Thimmesch, attorney, Faegre & Benson. “States have asked for information about franchisees operating in their jurisdiction, but this situation is unusual because there is a monetary penalty that an out-of-state entity would face. This is not a voluntary program,” he said.

Also troubling to franchisors is that the new law does not allow for the state's “single-sale exemption.” New York allows a franchisor with one franchise in the state to avoid registration. “Under the amended tax law, a franchisor based in Texas, or for that matter, in the United Kingdom, with one franchisee in the state of New York will be required to file regular reports with the Department or risk severe monetary penalties,” Oppenheim said.

Other problems will arise if a franchisor's sales figures do not match with a franchisee's ' a situation that Schaeffer said will be commonplace. “It practically never occurs that a franchisor's and the franchisees' revenue figures are the same,” he said. “There are different ways of reporting and different treatment of intermediate goods [purchased by the franchisor for resale or usage by the franchisee]. Also, in some systems, underreporting of sales by franchisees is a chronic problem.”

If the data are in conflict, the franchisor and/or franchisee will be required to conduct an audit at their own expense. Furthermore, if an audit uncovers underreported taxes, then franchisors or franchisees could be liable for penalties and/or back taxes, Oppenheim said. “Depending on the severity of the underpayment, it could lead to failure of the franchisee,” he said.

Finally, when the numbers don't jibe, conflict will arise between franchisor and franchisee, Schaeffer predicted. “If anybody is underreporting on anything, it will create conflict between the franchisor and franchisee ' and there's already conflict in that area ' plus the income tax and sales tax liabilities,” said Schaeffer.

“It definitely has the potential to lead to discord among parties in the franchise contract,” said Ackerman.

Impact

Attorneys assessing the possible impact of the law say that it could be far-reaching. Under the law, for the first time, New York would be able to tax franchisors for intermediate goods sold to franchisees for resale or use in providing a product or service.

“A number of franchisors are concerned the new law may lead to efforts by New York, and perhaps other states, to impose use tax-collection obligations on franchisors with respect to items sold to their franchisees and income tax return filing obligations on the part of franchisors with respect to franchise fees that are received with respect to the operations of their franchisees,” said Thimmesch. “The right of New York or any other state to impose these obligations on a franchisor depends on whether the state has jurisdiction over the franchisor for sales and use or income tax purposes.”

“It's another attempt by a state government at what has been called 'more efficient' collection of taxes 'owed' to them,” said French. “Some people in state government view franchises as a tax-avoidance scheme, rather than as a way for an entrepreneur to go into business without having to start from scratch and to take all the risk. We have to continually educate state legislators and regulators on what franchising is all about.”

The new law “is not a new theory,” said Schaeffer. “It's 'economic nexus,' and it stays the same as it has since Geoffrey. The difference is in the collection and ready collation of the information. I know of no state that has ever asked for such information about only one economic sector. Obviously, access to readily sortable data accommodates an immediate math audit of franchisees for sales tax purposes and franchisors for income tax purposes.”

The New York law also reinforces the importance of resolving the definition of a “physical presence” that would trigger a nexus for tax purposes, French added. The most important case in that area in the last 20 years ' Quill v. North Dakota , 504 U.S. 298 (1992) ' affirmed that states cannot impose sales and use taxes on out-of-state entities unless they have a physical presence in the state. However, Quill did not define physical presence with enough clarity for the franchising industry, French said.

Regardless, Oppenheim said that, “save for a legislative amendment repealing the law, which is unlikely, franchisors should be prepared to comply.” He is recommending to his franchisor clients that they contact their franchisees and make sure they know about the law, but that they do not provide legal or accounting advice. “Instead, advise the franchisees to see counsel,” Oppenheim said. “Franchisor attorneys must advise all franchise clients with licensees in New York. While many franchisors received written notices and phone calls directly from the Department, I know of many (large and small) that did not. Therefore, it is incumbent on us as franchise counsel to educate our clients. We should not presume that our clients are aware of the new law.”

Kevin Adler is associate editor of FBLA. He can be contacted at [email protected].