TAKE ACTION NOW TO AVOID UNEXPECTED STATE TAX LIABILITIES
by Paul R. Fransway, Ann Arbor Office
Traditionally, nexus for state
income tax liability has required some type of physical presence or
continuous contacts by the franchisor/distributor with a particular
state. With the advent of taxing authorities asserting that all that is
needed is "economic nexus," franchisors are now increasingly exposed to
income tax liability based upon royalty revenue they receive regardless
of its bricks and mortar in the state.1 Furthermore, budget
deficits in many states cause many states to become increasingly
aggressive in the assessment and collection of taxes from nonresident
franchisors. After all, it is more politically expedient to raise
revenue from nonresident businesses than to impose new taxes on resident
businesses. Considering this, franchisors should assume that they owe
taxes not only in their home state but also in any state where they have
franchisees, regardless of whether they have a physical presence in the
state. Only through a proactive approach can tax liabilities be
quantified and minimized. These include:
1. Conduct an overall review of current operations and relationships.
A careful analysis should be conducted to determine the exposures that
exist, returns that have been filed, states in which you have not only
paid taxes, but also those with franchisees where you have not. This
review should consider not only locations, but also the applicable law
and franchisor activities that are conducted in a state.
2.Take action to limit risk. Examine where you have
franchisees and have not filed a return even if you’ve received advice
in the past that it was not necessary. As more states continue to adopt
an economic nexus approach, it may only be a matter of time before these
states begin to assert liabilities that were thought unlikely before
the advent of the assertion of economic nexus theories. This review
should also be conducted by foreign franchisors and distributors that do
business in the U.S. For example, a Canadian franchisor may not be
required to file a U.S. federal income tax return if they do not have
enough physical presence in the U.S., but such franchisors may still be
required to file returns and pay taxes to the states where they have
franchisees if their franchisees are located in states where economic
nexus is the law.
Consider also whether the states where franchisees are located have
unfavorable law or are aggressive in asserting liability on out of state
franchisors. The danger is obviously greater with a state where the
applicable law is favorable to the state and where the state has
indicated a willingness to use it. If so, the problem is not going to go
away by ignoring it. It will only get worse. It is important to
remember that if there is no return filed, the statute of limitations
will typically never run. If the state involved does assert liability
for income taxes at a later date, the assessment will also usually
require the payment of interest and penalties for not filing the
required returns. These assessments can quickly become significant
enough that the cost of even a valid challenge to the existence of
sufficient nexus and the application of the tax will force a franchisor
to consider an unfavorable settlement.
3. Determine if there are any voluntary compliance programs and examine total tax exposure in all states.
A number of states have programs to encourage voluntary compliance with
tax laws. While these programs vary from state to state, they will
often include provisions that limit how far back the state will assert
liability and that reduce or minimize penalties and interest. This may
limit exposure. Conversely, the examination should also determine if
there are any opportunities that could come from such a filing. For
example, while the ability to apportion income and to claim credit for
taxes paid to other states will vary depending upon the states involved,
a franchisor in a high tax state may be able may be able to file
amended returns reducing their taxation in their home state by
apportioning income to the remote state. This may reduce or even
eliminate the impact of the taxes paid to the franchisee’s state.
4. Consider revisions to franchise agreements.
An obvious partial solution is to include a provision that has the
effect of passing the state income tax back to the franchisees in that
state on a pro-rata basis, either through a tax indemnity or a "gross
up" provision. This solution is not, however, without its problems.
First, franchise agreements are long term agreements and it will often
take 10 years or longer to have all contracts revised.2 In
addition, the gross up of the payments made to the franchisor increases
the revenue received by the franchisor thereby further increasing the
taxes due. Such a provision would also require disclosure of the
franchisor’s tax return that would not normally be available to the
franchisee. Finally, but hardly less important, there is the potential
for not only impaired goodwill with the franchise community but also
adverse impacts upon their profitability as well. While the latter
effect is not completely unfair considering that not all states have
these tax regimes, that may be of little solace to the franchisee who is
likely to think that this is nothing more than shifting the
franchisor’s tax to them.
The evolution of the law and the need
for states to increase revenue is likely to increase the risk associated
with not proactively addressing these potential liabilities. The
exposure, if not proactively addressed, will probably increase. To
assure that all contingent liabilities that could impair the
franchisor’s balance sheet are addressed (and potentially it’s
marketability if a sale is ever considered), the sooner the issue is
addressed the more manageable it is. Only a thorough examination of the
facts and law of the states involved will limit risks that could affect
the profitability of the company.
1See KFC Corporation v. Iowa Department of Revenue, 792 NW2d 308 (Iowa 2010) cert. den. 132 S. Ct. 97, 181 L. Ed. 2d 26 (U.S. 2011).
2
A discussion of whether such a change is a material change to the
agreement and whether the franchisor has the ability to make such a
unilateral change, even on renewal, is beyond the scope of this article.
Nutrition information coming to both U.S. and Canadian Menus soon
by Wendy G. Hulton, Toronto Office
The U.S. Food and Drug
Administration (FDA) recently finalized two rules requiring calorie
information on menus and menu boards in restaurants and retail food
establishments that are part of a chain of 20 or more locations, doing
business under the same name, and offering substantially the same menu
items. The FDA rules will also require establishments to provide, upon
consumer request, written nutrition information about total calories,
total fat, calories from fat, saturated fat, trans fat, cholesterol,
sodium, total carbohydrates, fiber, sugars and protein. Restaurants and
similar retail food establishments will have one year from the date of
publication of the menu labeling final rule to comply with the
requirements.
In Canada, the province of
Ontario is moving forward with similar requirements. On February 24,
2014, the Liberal government introduced Bill 162 Making Healthier
Choices Act, 2014. Like the FDA’s rules, Ontario’s proposed legislation
will require restaurant chains and other food service providers with 20
or more locations operating under the same or substantially the same
name in Ontario to display the number of calories of all standard food
or drink items on their menus, menu boards, displays and on one or more
signs. It is worth noting that the legislation specifically includes a
franchisor of a restaurant chain or other food service provider in the
definition of a "person who owns or operates a food service premise"
that is caught by the legislation. While the manner in which the
definition is drafted creates some uncertainty on this point, the
inclusion of franchisor in the definition of "person who owns or
operates a food service premise" may mean that both the franchisor and
its franchisee could be found liable for failure to display the number
of calories of all standard food or drink items on their menus, menu
boards, displays and on one or more signs. Bill 162, is now at second
reading stage.
FDA: Food Labeling; Nutrition Labeling of Standard Menu Items in Restaurants and Similar Retail Food Establishments
Ontario: Bill 162 and its status:
AODA in Brief
by Christopher G. Graham, Toronto Office
The Accessibility for Ontarians with Disabilities Act, 2005 ("AODA") which serves as the framework for the Accessibility Standards for Customer Service (the "Customer Service Standard")
and the Integrated Accessibility Standards (such standards, together,
the "Standards"), exists to promote accessibility for Ontarians with
disabilities with respect to goods, services, facilities, accommodation,
employment, buildings, structures and premises. Each of the Standards
apply to every organization with at least one employee in Ontario that
provides goods or services to members of the public or other third
parties. As such, both franchisors and franchisees are caught by the
AODA and the Standards. The Customer Service Standard requires that
certain policies and practices are prepared and implemented in the
provision of goods and services to persons with disabilities, and
requires training for employees.
The Integrated Accessibility
Standards covers information and communications, employment,
transportation and the design of public spaces. This Standard requires, among other things,
certain policies to be implemented, training for employees and
implements technical standards for websites. Most provisions under this
Standard will apply to organizations with at least fifty employees by
December 31st, 2014. Compliance with the provisions by organizations
with fewer than fifty employees and other elements of the Standard in
respect of employers with at least fifty employees will be phased in
over the next several years. Amendments to the Ontario Building Code
also take effect January 1st, 2015.
Organizations with at least
twenty employees were required to file an accessibility compliance
report on December 31st, 2012. A second accessibility compliance report
is due from employers with at least 20 employees by December 31st, 2014.
Thereafter, reports are due every three years.
For more information contact Ned Levitt or Andrae Marrocco.
Food Safety in Canada – More work for Franchisors who import food products
by Wendy G. Hulton, Toronto Office
The Safe Foods for Canadian Act
(the Act) received Royal Assent in November 2012 and is anticipated to
start taking effect at the beginning of 2015. Health Canada and the
Canadian Food Inspection Agency (CFIA) have been busy consulting with
stakeholders to develop new Regulations to support the Act.
The key goal of the Safe Food
for Canadians Action Plan is to achieve the highest possible level of
food safety for Canadians. As part of this effort, CFIA is in the
process of developing a risk-based approach to its inspection activities
on food commodities and establishments that pose the greatest risk for
consumers. CFIA will also require all food manufacturers, including
processed food manufacturers, to be licensed and have preventive control
systems such as Hazard Analysis Critical Control Points. The Act
includes provisions to register or licence importers, holding them
accountable for the safety of the food commodities they bring into the
country. Under the proposed regulatory framework, franchisors who import
food products will need to implement the regulated food safety
requirements and develop, maintain and retain Preventative Control Plans
(PCPs). They will also have to develop systems to meet the new "one
step forward one step backward" traceability requirements and will need
to ensure compliance with new record-keeping requirements.
Navigating the Cyber Liability Storm – Part II
by Andrae J. Marrocco, Toronto Office
Franchisors are facing a
precarious three-way intersection of increased accountability and
regulation over consumer privacy, the growing volume and sophistication
of cyber-attacks on consumer data, and the expanding boundaries of
franchisor liability for matters arising at the franchise unit level.
Two recent cases (
Aaron’s, Inc.
1 and
Wyndham2)
have raised awareness of the risky climate for franchisors in the realm
of cybersecurity and privacy compliance. For a summary of these cases
see
"Navigating the Cyber Liability Storm – Part I."
Weathering the storm
In light of the Aaron’s, Inc. case (notwithstanding the Privacy Commissioner of Canada’s decision not to pursue franchisors) and the Wyndham
case (which is yet to be finally determined), it would be wisdom of the
most doubtful kind that would prevent franchisors from taking immediate
action to develop information governance programs to protect their
brands from potential data security breach liability.
Understandably (and yet in
this case ironically), franchisors typically refrain from interfering
with franchisee level operations (including as in this case providing
services and guidance on matters such as cybersecurity) for risk of
liability. This is part of the delicate balancing act that franchisors
face in protecting their brand while avoiding direct and vicarious
liability. Add to this the fact that addressing information governance
across a franchise system is complex, time consuming and costly, and no
governmental authority or court has to date offered guidance on how
franchisors should develop information governance programs.
However, those issues and concerns are outweighed by the following
factors that militate in favour of the franchisor taking action with
respect to cybersecurity and information governance: (i) first and
foremost, the reputational harm and economic impact of addressing
cyber-attacks can be formidable (one study put the average financial
expenditure in dealing with after effects at $5.5m); (ii) franchisees do
not have the necessary financial or human resources to develop and
maintain appropriate information governance programs on their own; (iii)
it is apparent from the cases above that the computer systems of
franchisees and franchisors are often interconnected, making
cybersecurity a joint responsibility; (iv) the cases articulate an
obligation imposed on franchisors to create cybersecurity policies and
programs for franchisees and to oversee and monitor their practices; and
(v) taking a proactive approach in developing robust policies and
procedures and monitoring compliance will provide increased protection
against cyber-attacks and will also provide a defence in circumstances
of data security breach liability.
Practical steps
Franchisors should take the following steps in developing their information governance program.
Invest human capital. The best intentions will not
develop or implement a robust information governance program.
Franchisors need to dedicate the requisite human resources to the
project by identifying people that are responsible for data management
and privacy compliance, complement as necessary (perhaps with management
level officers), and assemble a functional project team to address
information governance.
Audit and risk assessment. Undertake a review of
existing policies and procedures with respect to information governance
together with current practices relating to the collection and
maintenance of data and cybersecurity. Take time and care to identify
vulnerabilities, and potential risks; Canvass and consider alternative
industry practices (including current hardware and software applications
used).
Develop an information governance program. This is
an expansive project. It incorporates the entire process by which the
franchise system collects, uses, stores and ensures the security of data
(including the approach to privacy and data compliance). Part of the
program will involve determining the apportionment of financial and
practical responsibilities between the franchisor and the franchisee. In
certain circumstances, it may be justifiable for the franchisor to
impose a fee for services provided as part of the program (e.g. in
setting up systems for the franchisees).
Training and monitoring. Determine the appropriate
level of training required and whether such training will be provided
internally or outsourced. The same consideration applies to monitoring
of the information governance program. Organizing external
training/monitoring periodically provides opportunity to have ongoing
independent assessment of your information governance program. It is
critical that franchisees are provided with all possible resources to
ensure the success of the program.
Compliance. Include in the franchise agreement a
provision requiring compliance and commitment to the information
governance program (referenced as being part of the operating manual).
The details of the program should be included in a separate chapter or
segment of the operating manual to allow for more efficient and
practical updating.
Updating. Given the increasingly rapid pace at which
technology continues to advance, and the sophistication of
cyber-attacks, the information governance program should be reviewed and
updated on a regular basis. Undoubtedly, policies, procedures, systems,
hardware, software etc will require updating across the franchise
system.
1 Aaron’s, Inc., 122 FTC 3264 (2014) (Docket No. C-4442)
2 Federal Trade Commission v Wyndham Worldwide Corporation, No. 13-cv-01887, (U.S. District Court of New Jersey, April 7, 2014)
