In the last batch of opinions for three of its judges, the Iowa Supreme Court yesterday upheld the Department of Revenue's position that 'physical presence' is not required to subject taxpayers to Iowa's corporation income tax.
KFC owns no Iowa restaurants or employees. It instead licenses franchisees in Iowa. Relying on the U.S. Supreme Court's Quill decision, KFC argued that it's lack of physical presence in Iowa exempted it from Iowa's highest-in-the-nation corporation tax. As noted here last week, the Department of Revenue disagrees.
Quill held that a mail order vendor with no physical presence in North Dakota was exempt from paying sales and use tax there under Commerce Clause case law. Iowa Judge Appel's 40-page opinion spends most of its time explaining why the same Commerce Clause allows taxation of a corporation with no Iowa physical assets. The opinion addresses the problem of a contrary U.S. Supreme Court opinion that's less than 20 years old this way:
Finally, we think taxation of the income here is most consistent with the now prevailing substance-over-form approach embraced in most of the modern cases decided by the Supreme Court under the dormant Commerce Clause. When a company earns hundreds of thousands of dollars from sales to Iowa customers arising from the licensing of intangibles associated with the fast-food business, we conclude that the Supreme Court would engage in a realistic substance-over-form assessment that would allow a state legislature to require the payment of the company’s fair share of taxes without violating the dormant Commerce Clause.
But much of the opinion is really a policy argument. For example:
In fact, “physical presence” in today’s world is not “a meaningful surrogate for the economic presence sufficient to make a seller the subject of state taxation.” Id. at 392. “Physical presence” often reflects more the manner in which a company does business rather than the degree to which the company benefits from the provision of government services in the taxing state. Does it really make sense to require Barnes and Noble to collect and remit use taxes, but not impose the same obligation on Amazon.com, based on the difference in their business methods?
Further, extension of the “physical presence” approach in Quill would be an incentive for entity isolation in which potentially liable taxpayers create wholly owned affiliates without physical presence in order to defeat potential tax liability. See Swain, 38 Ga. L. Rev. at 366–68. We doubt that the Supreme Court would want to extend such form-over-substance activity into the income tax arena where substance over form has been the traditional battle cry.
In this decision, Iowa infers from the U.S. Supreme Court's silence since Quill that it didn't really mean it, or else that it wouldn't decide the same way today, at least in an income tax case. That seems like a bold result from a state court, but the Iowa court has a history of defying the U.S. Supreme Court in tax cases. Also, Iowa's court is not alone here; it joins supreme courts in a South Carolina, North Carolina, New Mexico, Ohio and West Virginia in holding that Quill's "physical presence" rule doesn't apply to income taxes.
Unless the U.S. Supreme Court rules on the issue, or Congress exercises its authority to settle Commerce Clause tax allocation problems, states will be increasingly bold in going after out-of-state corporations. After all, nothing says "welcome to our state" like hammering taxpayers. Iowa could distinguish itself in this area by adopting the Tax Update's Quick and Dirty Iowa Tax Reform, but don't hold your breath.
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