Were franchise, accounting, and insurance fees sales of tangible property because franchisees also received manuals and promotional materials?

Subject

Franchise transactions provided various services and intangible property to franchisees,

Plain-English summary

An out-of-state franchiser received franchise fees, accounting fees, and insurance premiums from Virginia franchisees. The auditor treated all of that revenue as sales of tangible personal property because the franchiser also supplied training manuals, marketing catalogs, and other aids, and therefore sourced the Virginia-franchisee revenue to Virginia.

The Tax Commissioner reversed that characterization. The franchisees principally received franchise rights, intellectual property, accounting services, marketing and advertising benefits, and insurance. The manuals and promotional materials were incidental to those services and intangibles. The fees were therefore sales other than tangible personal property and, under the cost-of-performance rule applied in 2007, were properly sourced to the taxpayer's home state.

What this means for you

• For bundled franchise transactions, document the principal rights, services, and benefits the fee purchases.
• Incidental delivery of manuals or marketing materials did not convert these fees into sales of tangible personal property.
• Income-tax sourcing rules change over time; confirm the rule for the tax year at issue before relying on this 2007 determination.

Common questions

Did every physical item supplied to a franchisee control the sales-factor result?

No. Virginia looked at the transaction's main purpose and found the physical materials inconsequential compared with the services and intangible property.

Where were the fees sourced in this audit?

They were sourced to State A because a greater proportion of the income-producing activity, measured by costs of performance, occurred there.

Citations and references

• Va. Code § 58.1-416, sourcing sales other than tangible personal property.
• 23 VAC 10-120-230, the cost-of-performance rule applied to multistate services.
• Va. Code § 58.1-415, contrasted rule for tangible personal property received in Virginia.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 07-121

Original ruling text

July 31, 2007

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek correction of the corporate income tax assessments issued to * (the "Taxpayer"), for the taxable years ended December 31, 2001 through 2003.

FACTS

The Taxpayer is a * (State A) corporation that operates as a franchiser. Franchisees are required to operate under an operator agreement with the Taxpayer. Franchisees pay the Taxpayer an initial franchise fee and remit a franchise fee that consists of a percentage of gross sales and a percentage of the net profits. The Taxpayer provides day-to-day accounting and tax reporting services to its franchisees for which it charges an accounting fee. Franchisees also pay an insurance premium.

The Taxpayer treated the franchise fees, accounting fees and insurance premiums paid by its Virginia franchisees as the sale of services for sales factor apportionment purposes. Because the greater amount of costs to generate these fees occurred in State A, this income was attributed to State A.

The auditor determined that certain tangible personal property transferred from the Taxpayer to the franchisees ( e.g. , training manuals, marketing catalogs and other training aids) constituted the transfer of tangible personal property that was part of the franchise fees. Therefore, the auditor treated the fee revenue as sales of tangible personal property and sourced revenues generated from the Virginia franchisees to

Virginia.

The Taxpayer contests the auditor's adjustment, asserting that the transfer of the tangible material is an inconsequential part of the transfer of services provided by the Taxpayer. Accordingly, the Taxpayer believes the sales should be treated as sales of other than tangible property for apportionment purposes.

DETERMINATION

Virginia Code § 58.1-416 provides that sales, other than sales of tangible personal property, are in the Commonwealth if:

1. The income-producing activity is performed in the Commonwealth; or

2. The income-producing activity is performed both in and outside the Commonwealth and a greater proportion of the income-producing activity is performed in the Commonwealth than in any other state, based on costs of performance.

Pursuant to Title 23 of the Virginia Administrative Code (VAC) 10-120-230, sales of services from multistate activities are only included in the numerator of the Virginia sales factor if the greater proportion of the income-producing activity is performed in Virginia than in any other state, based on costs of performance. Under Va. Code § 58.1-415, tangible personal property received in Virginia as a result of a sales transaction is considered a Virginia sale.

In exchange for the fees at issue, the franchisee received the right to operate a franchise and to use the Taxpayer's intellectual property and accounting services, and to receive the benefits of the Taxpayer's marketing and advertising campaigns and insurance. In connection with the rendering of these services, the Taxpayer provided various training and marketing manuals and other promotional material. The auditor found that the provision of such tangible property was sufficient to classify the fees as sales of tangible personal property.

After reviewing the audit report and the information provided by the Taxpayer, it is my determination that the main purpose of the Taxpayer's franchise transactions was to provide various services and intangible property to franchisees, not to provide manuals and other materials. As such, the fees at issue are considered sales of other than tangible personal property for purposes of apportionment, and the Taxpayer correctly sourced the sales to State A using the cost of performance.

The assessments for the taxable years at issue have been adjusted in accordance with the attached revised audit report and schedule. A bill, with interest accrued to date, will be sent to the Taxpayer. No additional interest will accrue provided the outstanding balance in paid within 30 days from the date of the revised bill. The Taxpayer should remit its payment to: Virginia Department of Taxation, Office of Policy and Administration, P.O. Box 27203, Richmond, Virginia 23261-7203, Attention: *.

The Code of Virginia sections, regulations and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, please contact * at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-788217401B