Franchise 101: State’s Changed Tax Interpretation; and Gratuitous Promises

October 2018

Franchisor 101: Franchisor Fails to Escape State’s Changed Tax Interpretation

A&W Hit by Definition of “Franchise” vs. “Trademark License”

A state appellate court (“Court”) in New Mexico upheld a decision by the state’s Taxation and Revenue Department (“Department”) that royalties paid to out-of-state franchisors are subject to the state’s gross receipts tax (“Tax”) even though trademark licenses are excluded by law from the Tax.

The franchisor, A&W, challenged the Department’s ruling that A&W owed $29,349.33 in Tax for royalties received from New Mexico franchisees under their franchise agreements. A&W based their challenge on a 2007 statute that changed the definition of “property” subject to the Tax from “licenses, and franchises” to “licenses other than the licenses of copyrights, trademarks, or patents and franchises.” A&W claimed the royalties were exempt because they were paid pursuant to trademark licenses.

The Court disagreed and ruled that a franchise agreement is different from a standalone trademark license because a trademark is central to the overall franchise agreement. The Court felt that a franchise agreement and trademark were intertwined and should be subject to the Tax. Also, the 2007 statute came the year after a state Supreme Court decision, named Sonic II, held that the Tax applied only to revenue from the sale or lease of property. That decision had the effect of letting out-of-state franchisors avoid the Tax. This fact pointed to the Legislature’s intent to include franchise gross receipts from royalty payments in the definition of property subject to the Tax. The Court held that a franchise is “bundled” property that includes a trademark license from the franchisor, in addition to other obligations owed by the franchisor to the franchisee under the agreement.

In light of the New Mexico decision and other similar decisions, franchisors should be aware of changes and new interpretations of state tax codes that make out-of-state franchisors liable for royalties received from out of state franchises. Often, taxes paid to some states may be deductible to reduce tax in a franchisor’s home state. But this trend may increase overall taxes paid, and increase compliance costs as returns and payments may need to be made in more states.

Lewitt Hackman’s Franchise & Distribution Practice Group is monitoring the tax liability for franchisors in states across the country and can assist in addressing this growing tax liability issue affecting franchisors.

A&W Restaurants v. Taxation and Revenue, N.M. App. (August 22, 2018)

Franchisee 101: No Gain from Gratuitous Promises

JTH Tax, Inc.’s Gratuitous Promise

A federal Appeals Court has held that an offer to extend a franchisee’s buyback period lacked consideration required to form an enforceable contract and, instead, was an unenforceable gratuitous promise by the franchisor.

The IRS revoked the Electronic Filing Identification Number (“EFIN”) of a franchisee who owned nine tax preparation franchises. The IRS acted due to improper business practices of the franchisee. As an alternative to terminating the franchise, the franchisor and franchisee entered into a purchase and sale agreement (“PSA”) in January, 2016. The PSA gave the franchisee until May 2016 to obtain a valid EFIN and buyback the nine franchised locations from the franchisor.

In April, the franchisor, by phone, offered to extend the May buyback deadline until December 31. The franchisee confirmed this by email. In the meantime, however, the relationship between the franchisor and franchisee deteriorated due to the franchisee’s failure to assign leases for the franchised locations to the franchisor, as required under the PSA.

A lower court held the franchisor liable for breaching the PSA. The court found that the franchisor’s promise to extend the deadline was an enforceable contract. But, on appeal, the franchisor successfully argued that the offer to extend the deadline was unenforceable because the obligations the franchisee agreed to after May were either part of the original PSA or promises that were not separately bargained for with additional consideration from the franchisee.

While valid consideration can consist of even a modest promise, the Court of Appeals held that the transfer of leases, payment of utilities and rent and the franchisee’s efforts to obtain a valid EFIN did not equate to consideration. This was because the franchisee was not asked to do any of these things in exchange for a deadline extension.

Without there being “consideration,” the franchisor’s promise was just a gratuitous promise, not an enforceable contract. While damages could be recovered for the franchisor’s breach of the PSA, the franchisee was not entitled to damages for the franchisor’s refusal to sell back the franchisee’s former franchised businesses.

Franchisees should consult legal counsel when entering into agreements with a franchisor and before accepting terms made outside of an enforceable contract to reduce the risk that the changed terms will be found to lack adequate consideration, rendering them unenforceable in court.

JTH Tax, Inc. V. Aime, 4th Cir. (August 8, 2018)

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