CA Tells Franchisees to Withhold 7% from Franchisor Royalties

The FTB's Sept. 24 memorandum tells franchisees: “If you pay California source income to nonresidents of California, the FTB wants to make you aware that unless certain exceptions apply, you must withhold and send to FTB seven percent of all payments that exceed $1,500 in a calendar year. (Revenue and Taxation Code Section 18662)”

The implementing FTB regulations require withholding “in the case of rentals or royalties for use of, or for the privilege of using in the State, patents, copyrights, secret processes and formulas, good will, trademarks, brands, franchises, and other like property of such intangible property having a business or taxable situs” in California. Cal. Code Regulations ' 18:18662-2 (emphasis added). Section 18:17952(c) of the Regulations goes on to provide that intangible personal property (such as a franchise license) has a business or taxable situs in California if: 1) the intangible property is employed as capital in California, or 2) possession and control of the intangible property is “ localized” in a business, trade, or profession in California based upon its substantial use in California.

There is no clear standard for when an intangible asset like a franchise license qualifies as being “employed as capital” in California or “localized” with a California business. Often cited as authority on this issue is Rainer Brewing v. McCogan, 94 Cal. App. 2d 118 (1949), which involved a California trademark licensor and a Washington licensee. Ranier Brewing held that the business situs of intangible property is the licensor's domicile or principal place of business and, on that basis, subjected the California licensor to state income tax on royalties paid by the Washington licensee. The recent FTB withholding directive involves the opposite facts (Nonresident Franchisor and California licensee) to those in Rainier Brewing (California licensor and Nonresident franchisee), which should mean, following Rainier Brewing's logic, that the business situs of a Nonresident Franchisor's intangible property is outside of California and, therefore, not subject to California withholding.

The FTB's published guidance, FTB Publication 1017, offers no answers; it addresses the obligation for withholding only with respect to royalties paid for the use of natural resources located in California or personal services performed in California. In light of the new withholding instructions, Nonresident Franchisors and their California franchisees have, at best, confusing guidance from the FTB on how to determine if a franchise license has acquired a business situs in California requiring a California franchisee to withhold a portion of the fees payable to the Nonresident Franchisor.

Some commentators suggest that the FTB's recent withholding directive rests implicitly on the idea that a franchisor's intangible property exists in the locations where franchisees operate. In speaking with the FTB's legal staff in preparing this article, we were told that is not the FTB's perspective. (The FTB informed us that staff member Mike Bailey of the FTB's Withholding Services, 916-845-4806 will answer questions about California's new withholding instructions. We spoke with others at the FTB in preparing this article.) The FTB informally explained that the withholding requirement is not based on the situs of the intangible franchise license being in California, but on the more general premise that the franchisee's payments are California source income since the payments come from California franchisees. Taxing California source income is not a new concept. However, using withholding to collect the Nonresident Franchisor's California tax liability is novel in the franchise context and may be unprecedented among the states.

Whether the FTB will be able to defend its authority to impose the withholding requirement in the franchise context, given the narrowly written regulations, remains an open question. Nonresident Franchisors may argue that the regulations control and that a “business situs” must exist in each taxpayer's individual case to justify withholding.

Should Franchisees Comply with Withholding Instructions?

With this uncertain background, Nonresident Franchisors might be tempted to tell their California franchisees not to comply with the FTB's directives and offer to indemnify the franchisees in any enforcement proceedings. On this point, FTB Publication 1017 states at Section 15: “If the withholding agent is certain that an intangible asset has acquired a California business situs, withholding is clear. If the status is not clear, the withholding agent is not required to withhold.”

We do not know yet what enforcement efforts may be in the offing. The potential for penalties and the cost of legal proceedings are not trivial. Therefore, we do not recommend that Nonresident Franchisors encourage their California franchisees to disregard the FTB's memorandum.

Mismatch Between Withholding and Income Tax Liability?

Even if one assumes that a franchise license granted by a Nonresident Franchisor to a California franchisee has acquired a business situs in California, the 7% withholding rate may result in “over withholding.” The business situs standard does not govern the amount of a taxpayer's income tax liability. Instead, via the Uniform Division of Income for Tax Purposes Act (“UDITPA”), California provides a formula apportionment method to determine the amount of a taxpayer's California tax liability. The net income allocated to California could be substantially less than the gross royalties received from California franchisees. Indeed, the formula could in some cases produce zero California taxable income. In these cases, submitting to California income tax filing requirements may be an attractive alternative to withholding.

Tax Implications of Qualifying As a Foreign Corporation in California

If a Nonresident Franchisor chooses to qualify to do business in California (“Qualified Franchisor”), the franchisor is subject to California's minimum tax of $800 and must file a California income tax return. Withholding by franchisees is not required when a franchisor qualifies to do business in California. California's current UDITPA formula looks at sales, property (excluding the value of the intangible franchise), and payroll, with double weight being applied to the sales factor, to compute the California income of taxpayers subject to tax in multiple states. (In 2011, the state will begin permitting taxpayers to elect to use a single-factor sales formula.)

For sales-factor purposes, California treats royalties paid by California franchisees as part of the franchisor's California sales factor only if the franchisor is “taxable” in California. Cal. Code Regulations ' 13:25137-3(b)(2)(B).

The sales factor rule raises the question of whether a Qualified Franchisor with no physical presence in California must pay California income tax. California courts and the U.S. Supreme Court have not taken a clear position on whether there is a physical presence standard for state income tax nexus purposes. See Quill v. North Dakota, 504 U.S. 298 (1992) (physical presence required for imposing sales tax collection duty on remote sellers). In fact, the FTB's current audit manual states, “the case law is still developing in this area.” The FTB may be getting ready to litigate the claim that a Nonresident Franchisor creates a “substantial nexus” with California by granting a franchise right to a California franchisee. Given California's economic problems, it should surprise no one if the FTB takes a more aggressive approach to income tax nexus.

Even if nexus is conceded and a Nonresident Franchisor's royalties paid by California franchisees are allocated to California, the net income tax at California's top corporate tax rate (8.84%) may be significantly less costly than the withholding against gross franchise royalties and rentals at 7%.

Conclusion

Nonresident Franchisors should review their own tax situations carefully before making any decision regarding the FTB's withholding directive. Most Nonresident Franchisors will find that allowing withholding will cost them more than qualifying to do business as a foreign corporation. Fighting withholding based on the FTB's lack of regulatory authority is best approached through an organized, collective effort. A middle course, registering as a foreign corporation to do business in California, buys Nonresident Franchisors time to develop a tax strategy that takes into account nexus and apportionment considerations and allows for measured responses to new developments in the FTB's enforcement position. At the moment, the middle course may be the best option available to Nonresident Franchisors.

Dirk Giseburt is a tax partner in the Seattle office of Davis Wright Tremaine LLP. Rochelle Spandorf, a member of this newsletter's Board of Editors, is a partner and Jaymee Castrillo is an associate in the firm's Los Angeles office, where they represent franchise parties in franchise regulatory and transactional matters.

On the heels of the New York State Department of Taxation and Finance's recent move to require annual information returns from franchisors to help the state catch New York franchisees who underreport sales taxes, the California Franchise Tax Board (the “FTB”) recently told California franchisees to begin withholding 7% of all lease and royalty payments to out-of-state franchisors (“Nonresident Franchisors”) that exceed $1,500 per calendar year. In a Sept. 24, 2009 memorandum, the FTB explained franchisee withholding responsibilities and directed California franchisees to begin paying withheld amounts to the state if their Nonresident Franchisor is not qualified to do business in California.

The FTB's directive is straightforward, but there is more than meets the eye. California's apparent goal is to induce all Nonresident Franchisors to qualify to do business in California and begin filing state income tax returns. Nonresident Franchisors, forced to choose between qualifying to do business in California or accepting a 7% withholding of fees by their California franchisees, are scrambling to figure out which option leaves them better off. Not surprisingly, franchise organizations, like the International Franchise Association, are openly questioning the FTB's authority to impose the unorthodox withholding requirement.

Background/Legal Basis

The FTB's Sept. 24 memorandum tells franchisees: “If you pay California source income to nonresidents of California, the FTB wants to make you aware that unless certain exceptions apply, you must withhold and send to FTB seven percent of all payments that exceed $1,500 in a calendar year. (Revenue and Taxation Code Section 18662)”

The implementing FTB regulations require withholding “in the case of rentals or royalties for use of, or for the privilege of using in the State, patents, copyrights, secret processes and formulas, good will, trademarks, brands, franchises, and other like property of such intangible property having a business or taxable situs” in California. Cal. Code Regulations ' 18:18662-2 (emphasis added). Section 18:17952(c) of the Regulations goes on to provide that intangible personal property (such as a franchise license) has a business or taxable situs in California if: 1) the intangible property is employed as capital in California, or 2) possession and control of the intangible property is “ localized” in a business, trade, or profession in California based upon its substantial use in California.

There is no clear standard for when an intangible asset like a franchise license qualifies as being “employed as capital” in California or “localized” with a California business. Often cited as authority on this issue is Rainer Brewing v. McCogan , 94 Cal. App. 2d 118 (1949), which involved a California trademark licensor and a Washington licensee. Ranier Brewing held that the business situs of intangible property is the licensor's domicile or principal place of business and, on that basis, subjected the California licensor to state income tax on royalties paid by the Washington licensee. The recent FTB withholding directive involves the opposite facts (Nonresident Franchisor and California licensee) to those in Rainier Brewing (California licensor and Nonresident franchisee), which should mean, following Rainier Brewing's logic, that the business situs of a Nonresident Franchisor's intangible property is outside of California and, therefore, not subject to California withholding.

The FTB's published guidance, FTB Publication 1017, offers no answers; it addresses the obligation for withholding only with respect to royalties paid for the use of natural resources located in California or personal services performed in California. In light of the new withholding instructions, Nonresident Franchisors and their California franchisees have, at best, confusing guidance from the FTB on how to determine if a franchise license has acquired a business situs in California requiring a California franchisee to withhold a portion of the fees payable to the Nonresident Franchisor.

Some commentators suggest that the FTB's recent withholding directive rests implicitly on the idea that a franchisor's intangible property exists in the locations where franchisees operate. In speaking with the FTB's legal staff in preparing this article, we were told that is not the FTB's perspective. (The FTB informed us that staff member Mike Bailey of the FTB's Withholding Services, 916-845-4806 will answer questions about California's new withholding instructions. We spoke with others at the FTB in preparing this article.) The FTB informally explained that the withholding requirement is not based on the situs of the intangible franchise license being in California, but on the more general premise that the franchisee's payments are California source income since the payments come from California franchisees. Taxing California source income is not a new concept. However, using withholding to collect the Nonresident Franchisor's California tax liability is novel in the franchise context and may be unprecedented among the states.

Whether the FTB will be able to defend its authority to impose the withholding requirement in the franchise context, given the narrowly written regulations, remains an open question. Nonresident Franchisors may argue that the regulations control and that a “business situs” must exist in each taxpayer's individual case to justify withholding.

Should Franchisees Comply with Withholding Instructions?

With this uncertain background, Nonresident Franchisors might be tempted to tell their California franchisees not to comply with the FTB's directives and offer to indemnify the franchisees in any enforcement proceedings. On this point, FTB Publication 1017 states at Section 15: “If the withholding agent is certain that an intangible asset has acquired a California business situs, withholding is clear. If the status is not clear, the withholding agent is not required to withhold.”

We do not know yet what enforcement efforts may be in the offing. The potential for penalties and the cost of legal proceedings are not trivial. Therefore, we do not recommend that Nonresident Franchisors encourage their California franchisees to disregard the FTB's memorandum.

Mismatch Between Withholding and Income Tax Liability?

Even if one assumes that a franchise license granted by a Nonresident Franchisor to a California franchisee has acquired a business situs in California, the 7% withholding rate may result in “over withholding.” The business situs standard does not govern the amount of a taxpayer's income tax liability. Instead, via the Uniform Division of Income for Tax Purposes Act (“UDITPA”), California provides a formula apportionment method to determine the amount of a taxpayer's California tax liability. The net income allocated to California could be substantially less than the gross royalties received from California franchisees. Indeed, the formula could in some cases produce zero California taxable income. In these cases, submitting to California income tax filing requirements may be an attractive alternative to withholding.

Tax Implications of Qualifying As a Foreign Corporation in California

If a Nonresident Franchisor chooses to qualify to do business in California (“Qualified Franchisor”), the franchisor is subject to California's minimum tax of $800 and must file a California income tax return. Withholding by franchisees is not required when a franchisor qualifies to do business in California. California's current UDITPA formula looks at sales, property (excluding the value of the intangible franchise), and payroll, with double weight being applied to the sales factor, to compute the California income of taxpayers subject to tax in multiple states. (In 2011, the state will begin permitting taxpayers to elect to use a single-factor sales formula.)

For sales-factor purposes, California treats royalties paid by California franchisees as part of the franchisor's California sales factor only if the franchisor is “taxable” in California. Cal. Code Regulations ' 13:25137-3(b)(2)(B).

The sales factor rule raises the question of whether a Qualified Franchisor with no physical presence in California must pay California income tax. California courts and the U.S. Supreme Court have not taken a clear position on whether there is a physical presence standard for state income tax nexus purposes. See Quill v. North Dakota , 504 U.S. 298 (1992) (physical presence required for imposing sales tax collection duty on remote sellers). In fact, the FTB's current audit manual states, “the case law is still developing in this area.” The FTB may be getting ready to litigate the claim that a Nonresident Franchisor creates a “substantial nexus” with California by granting a franchise right to a California franchisee. Given California's economic problems, it should surprise no one if the FTB takes a more aggressive approach to income tax nexus.

Even if nexus is conceded and a Nonresident Franchisor's royalties paid by California franchisees are allocated to California, the net income tax at California's top corporate tax rate (8.84%) may be significantly less costly than the withholding against gross franchise royalties and rentals at 7%.

Conclusion

Nonresident Franchisors should review their own tax situations carefully before making any decision regarding the FTB's withholding directive. Most Nonresident Franchisors will find that allowing withholding will cost them more than qualifying to do business as a foreign corporation. Fighting withholding based on the FTB's lack of regulatory authority is best approached through an organized, collective effort. A middle course, registering as a foreign corporation to do business in California, buys Nonresident Franchisors time to develop a tax strategy that takes into account nexus and apportionment considerations and allows for measured responses to new developments in the FTB's enforcement position. At the moment, the middle course may be the best option available to Nonresident Franchisors.

Dirk Giseburt is a tax partner in the Seattle office of Davis Wright Tremaine LLP. Rochelle Spandorf, a member of this newsletter's Board of Editors, is a partner and Jaymee Castrillo is an associate in the firm's Los Angeles office, where they represent franchise parties in franchise regulatory and transactional matters.