KFC Corporation Vs. Iowa Department Of Revenue , 2010 Iowa Sup. LEXIS 149 ( 2010 )

IN THE SUPREME COURT OF IOWA
No. 09–1032
Filed December 30, 2010
KFC CORPORATION,
Appellant,
vs.
IOWA DEPARTMENT OF REVENUE,
Appellee.
Appeal from the Iowa District Court for Polk County, Don C.
Nickerson, Judge.
On review of agency action, the judgment of the district court is
affirmed. AFFIRMED.
Paul H. Frankel, Craig B. Fields, and Mitchell A. Newmark of
Morrison & Foerster LLP, New York, New York, and John V. Donnelly of
Sullivan & Ward, P.C., West Des Moines, Iowa, for appellant.
Thomas J. Miller, Attorney General, Donald D. Stanley, Jr., Special
Assistant Attorney General, and Marcia E. Mason, Assistant Attorney
General, for appellee.
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APPEL, Justice.
In this case, we must determine whether the State of Iowa may
impose an income tax on revenue received by a foreign corporation that
has no tangible physical presence within the state but receives revenues
from the use of the corporation’s intangible property within the state.
After the Iowa Department of Revenue (IDOR) imposed an income tax
assessment against the out-of-state corporation, the taxpayer filed a
protest with the agency on constitutional and statutory grounds. IDOR
rejected the protest. On review of the agency’s action, the district court
affirmed. KFC appealed. For the reasons expressed below, we affirm the
judgment of the district court.
I. Factual and Procedural Background.
KFC Corporation (KFC) is a Delaware corporation with its principal
place of business in Louisville, Kentucky. Its primary business is the
ownership and licensing of the KFC trademark and related system. KFC
licenses its system to independent franchisees who own approximately
3400 restaurants throughout the United States. While KFC also licenses
its system to related entities—including KFC National Management
Company—all KFC restaurants in Iowa are owned by independent
franchisees. KFC owns no restaurant properties in Iowa and has no
employees in Iowa.
On October 19, 2001, IDOR issued to KFC an assessment in the
amount of $284,658.08 for unpaid corporate income taxes, penalties,
and interest for 1997, 1998, and 1999. KFC filed a timely protest of the
assessment. IDOR answered the protest, and the matter was assigned
by the Iowa Department of Inspections and Appeals to an administrative
law judge (ALJ). Both sides filed motions for summary judgment.
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In its motion for summary judgment, IDOR asserted that the
requirements of the Commerce Clause were satisfied. IDOR argued that
the “physical presence” requirement established in National Bellas Hess,
Inc. v. Department of Revenue of Illinois, 386 U.S. 753, 87 S. Ct. 1389, 18
L. Ed. 2d 505 (1967), as reaffirmed in Quill Corp. v. North Dakota, 504
U.S. 298, 112 S. Ct. 1904, 119 L. Ed. 2d 91 (1992), was not necessary
when a franchisor licensed intellectual property that generated income
for the franchisor within the state from operations of independent
franchisees. IDOR asserted that KFC’s royalty income based on its
franchisees’ Iowa transactions was “taxable because it is derived from
Iowa customers and is made possible by Iowa’s infrastructure and legal
protection of the Iowa marketplace.” IDOR further argued that the
imposition of the income tax was consistent with Iowa Code section
422.33(1) (1997) and its implementing administrative rules.
KFC resisted and filed a summary judgment motion of its own.
KFC argued that its receipt of royalty income was not subject to tax by
the State of Iowa. KFC observed that in Quill, the United States Supreme
Court held that a use tax could not be imposed on a foreign corporation
that had no physical contact with the taxing state. KFC noted that the
Quill Court “did not state that its holding is limited to use tax collection
obligations.” KFC argued that, because it had no physical presence in
Iowa, the state could not constitutionally impose the income tax. In the
alternative, KFC pressed a statutory claim. KFC asserted that under
Iowa Code section 422.33(1), KFC was not subject to tax because it
lacked property “located or having a situs in this state.”
KFC did not raise any issue related to penalties in its motion for
summary judgment. In its memorandum of points and authorities,
however, KFC asserted that the penalty assessed by IDOR should be
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waived under applicable statutes because it had substantial authority to
rely upon its position. See Iowa Code § 421.27(1)(h), (2)(f), (3)(d).
The ALJ issued a detailed ruling in IDOR’s favor. The ALJ found
that KFC owned, managed, protected, and licensed KFC marks and
system during the years in question. As part of its business, KFC
entered into franchise agreements with franchisees in Iowa who remitted
royalty and/or license income to KFC for the use of KFC marks and
system at a rate of four percent of gross revenues for each month, with a
minimum royalty amount adjusted for increases in the Consumer Price
Index. Throughout the period, KFC had the right to control the use of its
marks by Iowa franchises and the right to control the nature and quality
of goods sold under the marks by them.
Further, the ALJ found that Iowa franchisees were required by
their franchise agreements to adhere to KFC’s requirements regarding
menu items, advertising, marketing, and physical facilities. In order to
comply with applicable standards, Iowa franchisees were required to
purchase equipment, supplies, paper goods, and other products from
only KFC-approved manufacturers and distributors. Quality assurance
activities were performed in Iowa on behalf of KFC by employees of KFC’s
affiliates. The ALJ also found that KFC franchisees in Iowa could deduct
from their taxable income the royalty payments made to KFC.
Applying law to these facts, the ALJ held that the IDOR
assessment did not violate the Commerce Clause or Iowa law. With
respect to the Commerce Clause question, the ALJ concluded that
“physical presence” is not required when a state imposes taxation on
income. Further, the ALJ concluded IDOR demonstrated that KFC had a
sufficient nexus to Iowa to support IDOR’s assessment. According to the
ALJ, the franchise right was an intangible with a direct connection to
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Iowa. The imposition of tax on income generated by a franchisor within a
state was not an undue burden on commerce, but rather a payment to
government that provided the economic climate for the business to
prosper.
On the state law question, the ALJ found that KFC was “deriving
income from sources within this state” as required by Iowa Code section
422.33(1). According to the ALJ, KFC received such income when it
received royalty and/or license income from franchisees located within
the state. The ALJ determined that the provision of Iowa Code section
422.33(1) requiring a “situs in this state” did not require a physical situs,
but, citing Webster’s dictionary, included “the place where some thing
exists or originates; the place where something (as a right) is held to be
located in law.” The ALJ did not make a ruling of any kind or refer in
any way to the issue of penalties in the decision.
On appeal, the director of IDOR affirmed the ALJ. The director
characterized the issue on appeal as whether “KFC ha[d] sufficient nexus
with Iowa to be subject to Iowa corporation income tax?” The director
adopted and incorporated the findings of fact of the ALJ without
revisions. The director also adopted the conclusions of law made by the
ALJ with additions and modifications. With respect to the Commerce
Clause issue, the director noted that several states have held that an
economic presence satisfies the “substantial nexus” requirement for
corporate income tax purposes. The director also found that, under Iowa
law, KFC owed corporate income tax under Iowa Code section 422.33(1).
Like the ALJ, the director made no findings on the penalty issue.
KFC sought judicial review of the agency’s decision in district
court. The district court affirmed the director on the Commerce Clause
issue, finding that “physical presence” was not required under the
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Commerce Clause for the imposition of state income tax. The district
court further found that, because KFC’s marks and trademarks were “an
integral part of business activity occurring regularly in Iowa,” the income
derived from the use of that property was taxable under Iowa law. On
the issue of penalties, the district court found the issue was not
preserved because KFC did not obtain a ruling on the issue from the
agency and also because KFC did not seek a ruling on the issue in its
motion for summary judgment.
II. Standard of Review.
The Iowa Administrative Procedure Act governs judicial review of
decisions of the Iowa Department of Revenue. See Iowa Code ch. 17A;
AOL LLC v. Iowa Dep’t of Revenue, 771 N.W.2d 404, 407 (Iowa 2009).
With respect to the constitutional questions in this case, the parties
agree that our review is de novo. See State v. Taeger, 781 N.W.2d 560,
564 (Iowa 2010).
The parties contest the standard of review on the statutory issue
presented in this case. KFC contends that the district court erred in
granting deference to IDOR’s legal conclusion on state law issues under
Iowa Code section 422.33(1) and that our review of IDOR’s legal
determinations is for errors at law. IDOR contends that it has been
clearly vested with discretion to interpret the applicable provisions of law
and that, as a result, its determinations may be reversed only if
“irrational, illogical, or wholly unjustifiable.” See Renda v. Iowa Civil
Rights Comm’n, 784 N.W.2d 8, 12–14 (Iowa 2010) (noting that the
question of whether the legislature has clearly vested an agency with
discretion to determine applicable provisions of law is generally to be
based upon an analysis of individual provisions of law, not upon a
wholesale conclusion regarding chapters of the Code); Iowa Ag Constr.
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Co. v. Iowa State Bd. of Tax Review, 723 N.W.2d 167, 173 (Iowa 2006)
(holding broad rule-making authority may give rise to deference to
administrative interpretations).
In this case, however, we need not reach the issue of whether
IDOR is entitled to deference in its interpretation of Iowa Code section
422.33(1) because, even if deference were not afforded, we conclude, for
the reasons expressed in this opinion, that IDOR correctly interpreted
the applicable statutes.
III. The Dormant Commerce Clause Claim.
A. Introduction to Dormant Commerce Clause Issues
Presented in This Case. In Bellas Hess and later in Quill, the United
States Supreme Court held under the dormant Commerce Clause that, in
order for a state to require an out-of-state entity to collect sales and use
taxes on transactions with in-state residents, the entity must have some
“physical presence” within the taxing jurisdiction. Bellas Hess, 386 U.S.
at 756–59, 87 S. Ct. at 1391–93, 18 L. Ed. 2d at 508–10; Quill, 504 U.S.
at 317–18, 112 S. Ct. at 1916, 119 L. Ed. 2d at 110. In this case, two
questions arise in light of Bellas Hess and Quill. The first question is
whether the State of Iowa satisfied the “physical presence” test of Bellas
Hess and Quill in this case. The second question is whether the
“physical presence” test in Bellas Hess and Quill applies at all to cases
involving state income taxation.
We begin our discussion with a survey of the dormant Commerce
Clause cases of the United States Supreme Court. In our survey, we
focus on the nature of dormant Commerce Clause analysis and the
struggle between formalistic approaches and approaches that emphasize
economic substance in the context of both sales and use taxes and state
income taxes. We then examine state court cases after Quill grappling
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with the issues presented in this case. Using these authorities to
illuminate our discussion, we analyze the dormant Commerce Clause
issues presented in this case.
B. Approach of the United States Supreme Court to the
Dormant Commerce Clause.
1. Evolution of Supreme Court “dormant” Commerce Clause doctrine
prior to Bellas Hess and Quill. The United States Constitution expressly
authorizes Congress to “regulate Commerce . . . among the several
States.” U.S. Const. art. I, § 8, cl. 3. Since the nineteenth century, the
United States Supreme Court has interpreted the Commerce Clause as
more than merely an affirmative grant of power, finding a negative sweep
to the Clause as well. See Brown v. Maryland, 25 U.S. (12 Wheat.) 419,
448–49, 6 L. Ed. 678, 688–89 (1827); Gibbons v. Ogden, 22 U.S. (9
Wheat.) 1, 72–78, 6 L. Ed. 23, 70–78 (1824). As a result, the Supreme
Court has applied the “negative” or “dormant” Commerce Clause to limit
state taxation powers notwithstanding the absence of congressional
legislation.
Over time, the Supreme Court’s approach to state taxation under
the dormant Commerce Clause has evolved from a relatively strong
prohibition toward a more practical assessment that recognizes the
needs of the states to raise revenue. The early view of the Supreme
Court was that “no state ha[d] the right to lay a tax on interstate
commerce in any form.” Leloup v. Port of Mobile, 127 U.S. 640, 648, 8
S. Ct. 1380, 1384, 32 L. Ed. 311, 314 (1888). The Supreme Court later
chiseled this broad prohibition into one that only precluded the states
from levying taxes that imposed “direct” burdens on interstate commerce.
See, e.g., Adams Express Co. v. Ohio State Auditor, 165 U.S. 194, 220, 17
S. Ct. 305, 309, 41 L. Ed. 683, 695 (1897); see also Freeman v. Hewit,
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329 U.S. 249, 257–58, 67 S. Ct. 274, 279, 91 L. Ed. 265, 274–75 (1946);
Felt & Tarrant Mfg. Co. v. Gallagher, 306 U.S. 62, 66–68, 59 S. Ct. 376,
378, 83 L. Ed. 488, 491–92 (1939).
The “direct” vs. “indirect” distinction, however, was subject to
strong attack by Justice Stone. In a classic dissent, Justice Stone
attacked the distinction as unrealistic and opined that, “[i]n . . . making
use of the expressions, ‘direct’ and ‘indirect interference’ with commerce,
we are doing little more than using labels to describe a result rather than
any trustworthy formula by which it is reached.” Di Santo v.
Pennsylvania, 273 U.S. 34, 44, 47 S. Ct. 267, 271, 71 L. Ed. 524, 530
(1927) (Stone, J., dissenting), overruled by California v. Thompson, 313
U.S. 109, 116, 61 S. Ct. 930, 934, 85 L. Ed. 1219, 1223 (1941).
Eventually, the Supreme Court, apparently heeding Justice Stone’s call
for a more realistic and less formalistic approach, began to analyze the
validity of state taxes by applying a “nexus” doctrine under the Due
Process and dormant Commerce Clauses.
Applying the “nexus” doctrine, the Supreme Court upheld sales
and use taxes when the taxpayer had some minimal physical presence
within the jurisdiction, even though the transactions leading up to the
imposition of the tax were not linked to the physical presence. See
Scripto, Inc. v. Carson, 362 U.S. 207, 209–11, 80 S. Ct. 619, 620–22, 4
L. Ed. 2d 660, 663–64 (1960) (upholding use tax based on the physical
presence of ten advertising brokers conducting continuous solicitation in
the taxing state); Nelson v. Sears, Roebuck & Co., 312 U.S. 359, 364, 61
S. Ct. 586, 588–89, 85 L. Ed. 888, 892 (1941) (upholding use tax on
mail-order sales when the taxpayer had retail outlets in the state, even
though the retail outlets were not connected with mail-order sales).
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While none of these cases held that physical presence was required in
order for a state to require an out-of-state entity to collect sales and use
taxes from customers, the fact of physical presence in these sales and
use tax cases played a significant role in the analysis.
While “physical presence” may have been a significant feature, if
not a requirement, in the Supreme Court’s dormant Commerce Clause
analysis in early sales and use tax cases, “physical presence” in the
narrow sense does not appear as an important factor in cases involving
state income taxation. See Nw. States Portland Cement Co. v. Minnesota,
358 U.S. 450, 464, 79 S. Ct. 357, 365–66, 3 L. Ed. 2d 421, 431 (1959)
(observing that income tax could be supported if the “activities form a
sufficient ‘nexus between such a tax and transactions within a state for
which the tax is an exaction’ ” (quoting Wisconsin v. J.C. Penney Co., 311
U.S. 435, 445, 61 S. Ct. 246, 250, 85 L. Ed. 267, 271 (1940)); Int’l
Harvester Co. v. Wis. Dep’t of Taxation, 322 U.S. 435, 441, 64 S. Ct.
1060, 1064, 88 L. Ed. 1373, 1379 (1944) (stating that “[p]ersonal
presence within the state of the stockholder-taxpayers is not essential to
the constitutional levy of a tax taken out of so much of the corporation’s
Wisconsin earnings as is distributed to them”); J.C. Penney Co., 311 U.S.
at 444, 61 S. Ct. at 250, 85 L. Ed. at 270 (holding that the income-tax
test under the dormant Commerce Clause is whether the state has
“exerted its power in relation to opportunities which it has given, to
protection which it has afforded, to benefits which it has conferred by the
fact of being an orderly, civilized society”); New York ex rel. Whitney v.
Graves, 299 U.S. 366, 372, 57 S. Ct. 237, 238, 81 L. Ed. 285, 288 (1937)
(holding that, with respect to intangible property such as a seat on the
New York Stock Exchange, the business situs of the intangible property
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may “grow out of the actual transactions of a localized business”). In
these cases involving challenges to state income taxes, the Supreme
Court has not adopted a mechanical or formalistic approach to the
dormant Commerce Clause nexus requirement but, instead, has
emphasized a flexible approach based on economic reality and the nature
of the activity giving rise to the income that the state seeks to tax.
2. Emergence of the Bellas Hess physical presence test for sales
and use taxes arising from mail-order sales. In Bellas Hess, the Supreme
Court considered a challenge to an Illinois statutory requirement that an
out-of-state entity collect and remit the use tax owed by consumers who
purchased goods for use within Illinois. Bellas Hess, 386 U.S. at 755, 87
S. Ct. at 1390, 18 L. Ed. 2d at 507–08. The out-of-state entity was a
mail-order merchant that had no in-state retail outlets, sales
representatives, or property. Id. at 753–54, 87 S. Ct. at 1389–90, 18
L. Ed. 2d at 507. In Bellas Hess, the Supreme Court by a six-to-three
vote concluded that the use tax could not be constitutionally applied
under the dormant Commerce Clause if the taxpayer did not have
physical presence in the taxing jurisdiction. Id. at 759–60, 87 S. Ct. at
1392–93, 18 L. Ed. 2d at 510–11.
The Bellas Hess majority first noted that the nexus requirements
under the Due Process and dormant Commerce Clauses were “closely
related” and “similar.” Id. at 756, 87 S. Ct. at 1391, 18 L. Ed. 2d at 508.
The Bellas Hess Court observed that the “same principles have been held
applicable in determining the power of a State to impose the burdens of
collecting use taxes upon interstate sales.” Id. Thus, at the time of
Bellas Hess, there was no material distinction between the nexus
required by due process and the nexus required by the dormant
Commerce Clause. See id.
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Turning to whether Illinois met its burden of showing an adequate
nexus, the Bellas Hess majority noted that the Court had “never held
that a State may impose the duty of use tax collection and payment upon
a seller whose only connection with customers in the State is by common
carrier or the United States mail.” Id. at 758, 87 S. Ct. at 1392, 18
L. Ed. 2d at 509. The Bellas Hess majority emphasized that over 2300
jurisdictions could impose sales and use taxes and that, with many local
variations in rates of use tax and allowable exemptions, the
administrative burdens could impede interstate business. Id. at 759–
760 & n.12, 87 S. Ct. at 1392–93 & n.12, 18 L. Ed. 2d at 510 & n.12. In
addition, the Illinois statute imposed the burden of requiring the vendor
to provide each purchaser with a receipt showing payment of the tax, as
well as keep “such records, receipts, invoices and other pertinent books,
documents, memoranda and papers as the [State] shall require in such
form as the [State] shall require.” Id. at 755, 87 S. Ct. at 1390, 18 L. Ed.
2d at 508. Before the state could impose the administrative burdens of
determining, collecting, and documenting the myriad different taxes from
the thousands of jurisdictions that could be imposed, the Bellas Hess
majority held that some sort of physical nexus with the taxing state was
required. Id. at 758, 87 S. Ct. at 1392, 18 L. Ed. 2d at 509–10.
Justice Fortas, joined by Justices Black and Douglas, dissented.
Id. at 760, 87 S. Ct. at 1393, 18 L. Ed. 2d at 511 (Fortas, J., dissenting).
Justice Fortas stated that “large-scale, systematic, continuous
solicitation and exploitation of the Illinois consumer market” was a
sufficient basis for supporting the tax. Id. at 761–62, 87 S. Ct. at 1394,
18 L. Ed. 2d at 511. On the question of benefits from the state, Justice
Fortas asserted that, if Bellas Hess had a retail store in Illinois, or
maintained resident sales personnel in the state, the benefit it received
13
from the State of Illinois would not be affected. Id. at 762–64, 87 S. Ct.
at 1394–95, 18 L. Ed. 2d at 512–13. Conversely, the burden on Bellas
Hess is no different than on a local retailer with comparable sales. Id. at
766, 87 S. Ct. at 1396, 18 L. Ed. 2d at 514. Justice Fortas presciently
warned that the approach of the majority would open a sizable “haven of
immunity” that would increase dramatically in the future. Id. at 764, 87
S. Ct. at 1395, 18 L. Ed. 2d at 513.
Nothing in Bellas Hess, however, altered the relationship between
the Due Process and dormant Commerce Clause nexus requirements or
explicitly overruled the principles expressed in the state income tax
nexus cases. Instead, Bellas Hess seems to represent the development of
a strand of authority under the dormant Commerce Clause with at least
some formalism in its categorical approach to the dormant Commerce
Clause nexus requirement in the field of sales and use taxes.
After Bellas Hess, the Supreme Court considered the nexus issue
in a number of cases. In general, the cases stand for the proposition that
constitutionally required “physical presence” (1) is not “the slightest
physical presence,” but nonetheless need not be very substantial to
satisfy the requirements of both due process and the dormant Commerce
Clause, and (2) need not be related to the transaction giving rise to tax
liability. See, e.g., Trinova Corp. v. Mich. Dep’t of Treasury, 498 U.S. 358,
373–74, 384–87, 111 S. Ct. 818, 829, 835–37, 112 L. Ed. 2d 884, 904–
05, 911–13 (1991) (upholding a value added tax imposed on entities
having “business activity” within the state and noting that the nexus
requirement under the dormant Commerce Clause “encompasses” the
due process requirement); Nat’l Geographic Soc’y v. Cal. Bd. of
Equalization, 430 U.S. 551, 556, 97 S. Ct. 1386, 1390, 51 L. Ed. 2d 631,
637 (1977) (rejecting “slightest presence test,” but holding California
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could impose use tax on mail-order sales of an out-of-state vendor who
maintained two offices within the state, even though the offices had
nothing to do with mail-order operations); Standard Pressed Steel Co. v.
Wash. Dep’t of Revenue, 419 U.S. 560, 563–64, 95 S. Ct. 706, 709, 42 L.
Ed. 2d 719, 723–24 (1975) (holding in-state presence of one full-time
employee sufficient to support imposition of gross receipts tax on sales to
out-of-state entity).
3. Complete Auto: The demise of formalism in favor of a multifactor
test. After Bellas Hess, the United States Supreme Court revisited the
requirements of the dormant Commerce Clause in Complete Auto Transit,
Inc. v. Brady, 430 U.S. 274, 97 S. Ct. 1076, 51 L. Ed. 2d 326 (1977). In
Complete Auto, the Supreme Court, in an opinion by Justice Blackmun,
repeated the observation by Justice Holmes that “interstate commerce
may be made to pay its way” through the imposition of state taxes.
Complete Auto, 430 U.S. at 281, 284, 97 S. Ct. at 1080, 1082, 51 L. Ed.
2d at 332, 334. In order for such taxes to pass Commerce Clause
muster, however, Justice Blackmun concluded that the tax must be (1)
applied to an activity having a “substantial nexus” with the taxing state,
(2) be “fairly apportioned,” (3) not “discriminate against interstate
commerce,” and (4) be “fairly related to the services provided by the
State.” Id. at 279, 97 S. Ct. at 1079, 51 L. Ed. 2d at 331.
Justice Blackmun’s opinion in Complete Auto has emerged as a
landmark in dormant Commerce Clause jurisprudence. What precisely
was meant by the term “substantial nexus” was unclear and left for
further case law development. The Complete Auto opinion, however,
emphasizes the practical effects of state taxing statutes on interstate
commerce and avoids formal distinctions and abstractions. Id. The
dormant Commerce Clause worm seemed to have turned once again in
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Complete Auto in favor of utilization of a realistic assessment of economic
impacts rather than formal doctrinal categories.
Additional dormant Commerce Clause cases after Complete Auto
confronted the nexus issue. For instance, in Tyler Pipe Industries, Inc. v.
Washington State Department of Revenue, 483 U.S. 232, 107 S. Ct. 2810,
97 L. Ed. 2d 199 (1987), the Supreme Court, in a challenge to a state’s
business and occupation tax, rejected the notion that the actions of sales
representatives within a state could not be attributed to the out-of-state
taxpayer for purposes of determining substantial nexus because they
were independent contractors. Tyler Pipe Indus., Inc., 483 U.S. at 250,
107 S. Ct. at 2821, 97 L. Ed. 2d at 215. The Supreme Court further
cited with approval the observation made by the Washington Supreme
Court that “the crucial factor governing nexus is whether the activities
performed in this state on behalf of the taxpayer are significantly
associated with the taxpayer’s ability to establish and maintain a market
in this state for the sales.” Id.
4. Post-Bellas Hess developments in due process. In Complete
Auto, the Court imported into the Commerce Clause analysis the same
kind of thinking reflected in the evolving due process cases. Originally,
under Pennoyer v. Neff, 95 U.S. (5 Otto) 714, 723–24, 24 L. Ed. 565, 569
(1877), physical presence was central in determining whether a party
had sufficient minimum contacts with a forum to submit to its
jurisdiction. The physical presence test was famously abandoned by
Justice Stone in International Shoe Co. v. Washington, 326 U.S. 310, 66
S. Ct. 154, 90 L. Ed. 95 (1945). In International Shoe, the Supreme
Court rejected any requirement of physical presence in favor of minimum
contacts that allowed the assertion of state judicial power consistent with
“ ‘traditional notions of fair play and substantial justice.’ ” Int’l Shoe, 326
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U.S. at 316, 66 S. Ct. at 158, 90 L. Ed. at 102 (quoting Milliken v. Meyer,
311 U.S. 457, 463, 61 S. Ct. 339, 343, 85 L. Ed. 278, 283 (1940)).
In rejecting the physical presence test, Justice Stone noted in
International Shoe that the “corporate personality” was a fiction of the law
because a corporation is not physically present anywhere. Id. Yet, citing
Learned Hand, Justice Stone observed that “the terms ‘present’ or
‘presence’ are used merely to symbolize those activities of the
corporation’s agent within the state which courts will deem to be
sufficient to satisfy the demands of due process.” Id. at 316–17, 66 S.
Ct. at 158, 90 L. Ed. at 102 (citing Hutchinson v. Chase & Gilbert, 45
F.2d 139, 141 (2d Cir. 1930)). In International Shoe, the activities carried
on within Washington “in behalf” of the corporate respondent were
“systematic and continuous” and therefore sufficient to satisfy due
process. Id. at 320, 66 S. Ct. at 160, 90 L. Ed. at 104.
Cases decided after International Shoe further reinforced the
pragmatic nature of the due process question and lessened the role of
“physical presence.” See Burger King Corp. v. Rudzewicz, 471 U.S. 462,
476, 105 S. Ct. 2174, 2184, 85 L. Ed. 2d 528, 543 (1985) (holding that
jurisdiction under due process may not be avoided merely because the
defendant “did not physically enter the forum State”); World-Wide
Volkswagen Corp. v. Woodson, 444 U.S. 286, 297–98, 100 S. Ct. 559,
567, 62 L. Ed. 2d 490, 502 (1980) (finding that due process was satisfied
when an out-of-state corporation “delivers its products into the stream of
commerce with the expectation that they will be purchased by
consumers in the forum State”); McGee v. Int’l Life Ins. Co., 355 U.S. 220,
223, 78 S. Ct. 199, 201, 2 L. Ed. 2d 223, 226 (1957) (finding sufficient
minimum contacts for purposes of due process when the suit was based
on a contract that had substantial connection with the forum state even
17
though there was no evidence of physical presence in the forum state).
Citing prior case law, the Burger King Court declared that the Court had
long ago abandoned “mechanical tests” based on “ ‘conceptualistic . . .
theories of the place of contracting or of performance.’ ” Burger King, 471
U.S. at 478–79, 105 S. Ct. at 2185, 85 L. Ed. 2d at 544–45 (quoting
Hoopeston Canning Co. v. Cullen, 318 U.S. 313, 316, 63 S. Ct. 602, 605,
87 L. Ed. 777, 782 (1943)).
5. Squaring Bellas Hess with Complete Auto and evolving due
process precedent: Quill. After Complete Auto and Burger King, a
substantial question that emerged was whether the life blood had been
drained from Bellas Hess by subsequent developments. The mail-order
industry had grown rapidly and, much as Justice Fortas had feared in
his Bellas Hess dissent, a large tax haven had been created. See Bellas
Hess, 386 U.S. at 762–64, 87 S. Ct. at 1394–95, 18 L. Ed. 2d at 512–13
(Fortas, J., dissenting). Indeed, mail-order sales amounted to only $2.4
billion four years prior to Bellas Hess, but had grown to $150 billion by
1983. See Martin L. McCann, Note, Use Tax, Mail Order Sales, and the
Constitution: Recent Developments in Connecticut, 12 U. Bridgeport L.
Rev. 137, 149 (1991). The question arose whether the Court in Bellas
Hess had inadvertently opened a tax avoidance scheme that needed to be
closed. Further, technological developments made the physical presence
requirement look rather quaint. Out-of-state mail order marketers now
availed themselves of sophisticated technology to sell their products. Id.
at 151–52. In addition, the Supreme Court in its personal jurisdiction
cases, such as International Shoe, McGee, World-Wide Volkswagen, and
Burger King, had eviscerated the physical presence requirement for due
process, which for all practical purposes was thought to be coextensive
with any restraints under the dormant Commerce Clause. Id. at 153.
 18
Finally, although there had been a number of twists and turns, it seemed
that the era of formalism or mechanical tests under the dormant
Commerce Clause was over after Complete Auto. In light of these
factors, many observers thus heard, or at least hoped they heard, a
death rattle for the “physical presence” holding of Bellas Hess. See
Paul J. Hartman, Collection of the Use Tax on Out-of-State Mail-Order
Sales, 39 Vand. L. Rev. 993, 1006–14 (1986); Sandra B. McCray,
Overturning Bellas Hess: Due Process Considerations, 1985 BYU L. Rev.
265, 295–96 (1985); Donald P. Simet, The Concept of “Nexus” and State
Use and Unapportioned Gross Receipts Taxes, 73 Nw. U. L. Rev. 112,
112–14 (1978).
Certainly the North Dakota Supreme Court was prepared to give
Bellas Hess a decent burial. In State ex rel. Heitkamp v. Quill Corp., 470
N.W.2d 203 (N.D. 1991), the North Dakota Supreme Court considered
the validity of the imposition of a use tax on an out-of-state seller who
lacked physical presence in the state. Heitkamp, 470 N.W.2d at 204–05,
overruled by Quill, 504 U.S. at 301–02, 112 S. Ct. at 1907, 119 L. Ed. 2d
at 99–100. The North Dakota Supreme Court declared that the
“economic, social, and commercial landscape upon which Bellas Hess
was premised no longer exist[ed],” which made it inappropriate to follow
Bellas Hess. Id. at 208–09. The North Dakota Supreme Court cited the
staggering growth in the mail-order business and the advance in
computer technology, which made compliance more practical. Id.
Further, the North Dakota Supreme Court noted that the legal
environment had changed in light of Complete Auto and its progeny,
which indicated that the United States Supreme Court was moving in a
direction away from the “physical presence” test in favor of a more
flexible approach. Id. at 209–13. Applying the test of Complete Auto, the
19
North Dakota Supreme Court found the test was satisfied in light of the
fact that North Dakota provided an “economic climate that fostere[d]
demand” for Quill products and maintained a legal system that
supported business within the state. Id. at 218.
The United States Supreme Court granted certiorari and reversed
the North Dakota Supreme Court. Justice Stevens wrote for the majority
that “[w]hile we agree with much of the state court’s reasoning,” the
Supreme Court nonetheless was required to reverse. Quill, 504 U.S. at
302, 112 S. Ct. at 1907, 119 L. Ed. 2d at 99.
Justice Stevens began the substantive discussion by canvassing
the existing case law regarding due process and concluding that
“physical presence” was not required to support taxation if a corporation
“purposefully avails itself of the benefits of an economic market in the
forum State.” Id. at 307, 112 S. Ct. at 1910, 119 L. Ed. 2d at 103. Thus,
to the extent Bellas Hess required “physical presence” to satisfy due
process, it was overruled. See id.
Justice Stevens then turned to the dormant Commerce Clause
issue. After reviewing the evolution of the dormant Commerce Clause
doctrine, Justice Stevens observed that, “[w]hile contemporary Commerce
Clause jurisprudence might not dictate the same result were the issue to
arise for the first time today,” the Bellas Hess approach to Commerce
Clause nexus was not inconsistent with Complete Auto. Id. at 311, 112
S. Ct. at 1912, 119 L. Ed. 2d at 105. In order to reach that result,
Justice Stevens concluded the “minimum contacts” test under due
process and the “substantial nexus” test under the Commerce Clause,
“[d]espite the similarity in phrasing,” were “not identical.” Id. at 312, 112
S. Ct. at 1913, 119 L. Ed. 2d at 106. Unlike the Due Process Clause, the
nexus requirement under the Commerce Clause does not serve as “a
20
proxy for notice, but rather a means for limiting state burdens on
interstate commerce.” Id. at 313, 112 S. Ct. at 1913, 119 L. Ed. 2d at
107. In a footnote, Justice Stevens noted, absent the physical presence
rule of Bellas Hess, a vendor might be required to comply with tax
obligations in 6000-plus taxing jurisdictions with many variations in rate
of tax, allowable exemptions, and in administrative duties. See id. at 313
n.6, 112 S. Ct. at 1914 n.6, 119 L. Ed. 2d at 107 n.6.
Turning to the decision of the North Dakota Supreme Court on the
Commerce Clause issue, Justice Stevens recognized the state supreme
court’s emphasis on the Supreme Court’s “ ‘retreat from the formalistic
constrictions of a stringent physical presence test in favor of a more
flexible substantive approach.’ ” Id. at 314, 112 S. Ct. at 1914, 119
L. Ed. 2d at 107 (quoting Heitkamp, 470 N.W.2d at 214). Yet, Justice
Stevens concluded that, “[a]lthough we agree with the state court’s
assessment of the evolution of our cases, we do not share its conclusion
that this evolution indicates that the Commerce Clause ruling of Bellas
Hess is no longer good law.” Id. at 314, 112 S. Ct. at 1914, 119 L. Ed.
2d at 107–08.
Justice Stevens recognized that “we have not, in our review of
other types of taxes, articulated the same physical-presence
requirement.” Id. But, Justice Stevens reasoned that the “silence does
not imply repudiation of the Bellas Hess rule.” Id. at 314, 112 S. Ct. at
1914, 119 L. Ed. 2d at 108.
Justice Stevens then considered justifications for the continued
application of the Bellas Hess approach. He noted that Bellas Hess
created a “discrete realm of commercial activity that is free from
interstate taxation” and a “safe harbor” for vendors from state-imposed
duties to collect sales and use taxes. Id. at 315, 112 S. Ct. at 1914, 119
21
L. Ed. 2d at 108. While he recognized that the physical-presence rule,
like all bright-line rules, “appears artificial at its edges,” the artificiality
was offset by the benefits of a “clear rule.” Id. at 315, 112 S. Ct. at
1914–15, 119 L. Ed. 2d at 108.
Justice Stevens further emphasized that one of the benefits in
affirming Bellas Hess was that reaffirmance of the established rule
“encourages settled expectations.” Id. at 316, 112 S. Ct. at 1915, 119
L. Ed. 2d at 109. According to Justice Stevens, it is not unlikely that the
dramatic growth of the mail-order industry “is due in part to the bright-
line exemption from state taxation created from Bellas Hess.” Id. As a
result, Justice Stevens concluded that the Bellas Hess rule “has
engendered substantial reliance and has become part of the basic
framework of a sizeable industry.” Id. at 317, 112 S. Ct. at 1916, 119
L. Ed. 2d at 110. According to Justice Stevens, the value of a bright-line
test and the doctrine and principles of stare decisis indicate that Bellas
Hess remains good law. See id.
Justice Stevens closed his opinion by noting that the decision,
apparently a difficult one, was “made easier” by the fact Congress, which
“may be better qualified to resolve” the issue, could have the last word.
Id. at 318, 112 S. Ct. at 1916, 119 L. Ed. 2d at 110. In light of the
reversal of the due process holding of Bellas Hess, Congress is “now free
to decide whether, when, and to what extent the States may burden
interstate mail-order concerns with a duty to collect use taxes.” Id.
Justice Scalia, joined by Justices Kennedy and Thomas, concurred
in part and concurred in the judgment. Id. at 319, 112 S. Ct. at 1923,
119 L. Ed. 2d at 111 (Scalia, J., concurring). Justice Scalia concurred in
the majority opinion regarding due process. Id. On the Commerce
Clause question, Justice Scalia noted that Congress had the power to
22
change the result of Bellas Hess through legislation. Id. at 320, 112
S. Ct. at 1923, 119 L. Ed. 2d at 111–12. As a result, Justice Scalia
further noted that stare decisis applies with special force where Congress
retains the power to override a court decision. Id. Justice Scalia would
not have engaged in any revisiting of the merits of the holding. Id.
Justice White concurred in part and dissented in part. Id. at 321,
112 S. Ct. at 1916, 119 L. Ed. 2d at 112 (White, J., concurring in part
and dissenting in part). He agreed that physical presence was not
required for due process, but also asserted that it was not required
under the Commerce Clause. Id. at 321–22, 112 S. Ct. at 1916–17, 119
L. Ed. 2d at 113. In particular, Justice White noted that, in National
Geographic Society, the Court decoupled any notion of transactional
nexus from the inquiry and focused solely on whether there were
sufficient contacts with the jurisdiction imposing the tax. Id. at 323–24,
112 S. Ct. at 1918, 119 L. Ed. 2d at 114. Further, Justice White
concluded that cases subsequent to Bellas Hess undermine its continued
vitality and that the rule should be abandoned in its entirety. Id. at 326–
27, 112 S. Ct. at 1919–20, 119 L. Ed. 2d at 115–16. Justice White would
jettison the formalism in the physical presence test for the functionality
of Justice Rutledge’s concurring opinion in Freeman. Id. at 325–27, 112
S. Ct. at 1918–20, 119 L. Ed. 2d at 115–16 (citing Freeman, 329 U.S. at
259, 67 S. Ct. at 280, 91 L. Ed. at 275 (Rutledge, J., concurring)). He
noted the illogic of imposing a tax on a small, out-of-state vendor with
one employee residing in the taxing state, while allowing a large vendor
with no employees to escape the tax. Id. at 328–29, 112 S. Ct. at 1920,
119 L. Ed. 2d at 117.
6. Post-Quill developments. After Quill, the Supreme Court has
generally avoided Commerce Clause cases involving the authority of
23
states to impose taxes other than sales and use taxes on out-of-state
entities with or without “physical presence.” While there have been a
number of cases in which the question has been squarely posed, the
Supreme Court has repeatedly denied certiorari on them. See, e.g., A & F
Trademark, Inc. v. Tolson, 605 S.E.2d 187, 194–95 (N.C. Ct. App. 2004),
cert. denied, 546 U.S. 821 (2005); Geoffrey, Inc. v. S.C. Tax Comm’n, 437
S.E.2d 13, 18–19 (S.C.), cert. denied, 510 U.S. 992 (1993); J.C. Penney
Nat’l Bank v. Johnson, 19 S.W.3d 831, 836–42 (Tenn. Ct. App. 1999),
cert. denied, 531 U.S. 927 (2000).
C. Approach of State Appellate Courts to Nexus Requirement
Under Dormant Commerce Clause for State Taxation of Income.
Geoffrey is the first state case considering the question of whether
“physical presence” was required for the imposition of state taxes other
than sales or use taxes. Geoffrey, 437 S.E.2d at 18 & n.4. In Geoffrey,
the South Carolina Supreme Court considered whether state income
taxes could be imposed on out-of-state franchisors who earned income
based on franchise activities within the state. Id. at 15. In concluding
that a state had such power, the Geoffrey court relied upon the notion
that intangible property acquired a “business situs” in a state where it is
used by a local business. Id. at 18–19; see also Wheeling Steel Corp. v.
Fox, 298 U.S. 193, 210, 56 S. Ct. 773, 777, 80 L. Ed. 1143, 1148 (1936).
Further, the Geoffrey court cited International Harvester for the
proposition that a state may impose a tax on
such part of the income of a non-resident as is fairly
attributable either to property located in the state or to
events or transactions which, occurring there, are within the
protection of the state and entitled to the numerous other
benefits which it[] confers.
24
Geoffrey, 437 S.E.2d at 18 (citing Int’l Harvester, 322 U.S. at 441–42, 64
S. Ct. at 1063–64, 88 L. Ed. at 1379).
As an alternative ground, the Geoffrey court, in summary fashion,
concluded that the physical presence requirement of Bellas Hess and
Quill was not required. Id. According to Geoffrey, “any corporation that
regularly exploits the markets of a state should be subject to its
jurisdiction to impose an income tax even though not physically present.”
Id.; see I Jerome R. Hellerstein & Walter Hellerstein, State Taxation
¶ 6.11, at 6-54 to -83 (3d ed. 2006). Further, the Geoffrey court
concluded that the presence of intangible property of the taxpayer within
the state was a sufficient nexus to support the imposition of state income
taxes under the Commerce Clause. Geoffrey, 437 S.E.2d at 18.
While the reasoning of Geoffrey has been criticized as cursory and
conclusory, see Richard H. Kirk, Note, Supreme Court Refuses to Re-
Examine Whether Physical Presence is a Prerequisite to State Income Tax
Jurisdiction: Geoffrey, Inc. v. South Carolina Tax Commission, 48 Tax
Law. 271, 276 (1994), the result has been embraced by other state courts
considering whether the licensing of intangible property, such as
trademarks and business methods, for use within a state provides a
sufficient nexus for income taxation. For example, in A & F Trademark,
the court emphasized that the language of Quill is cramped and limiting,
that Quill was driven largely by considerations of stare decisis that were
inapplicable outside the sales and use tax context, and that the burdens
of sales and use taxes are more substantial than other taxes, such as
state income taxes. A & F Trademark, 605 S.E.2d at 194–95; see also
Comptroller of the Treasury v. SYL, Inc., 825 A.2d 399, 416–17 (Md. 2003)
(citing Geoffrey with approval); Lanco, Inc. v. Dir., Div. of Taxation, 908
A.2d 176, 177 (N.J. 2006), cert. denied, 551 U.S. 1131 (2007)
25
(interpreting Quill narrowly and noting that the Quill Court “carefully
limited its language to a discussion of sales and use taxes”).
A number of state courts have gone even further than the cases
dealing with intangible property and have held that even banking
transactions within a state satisfy the nexus demands of the Commerce
Clause for purposes of imposition of state taxes other than those on sales
and use. See Capital One Bank v. Comm’r of Revenue, 899 N.E.2d 76,
84–87 (Mass. 2009) (adopting flexible economic substance analysis
rather than physical presence test in context of financial institution
excise taxes); Tax Comm’r v. MBNA Am. Bank, N.A., 640 S.E.2d 226, 234–
36 (W. Va. 2006) (adopting an economic presence analysis in context of
franchise and income taxes). These cases represent the frontier of state
assertions of nexus to tax out-of-state entities in contexts other than
sales or use taxes.
While most state courts limit Quill to the specific context of sales
and use taxes, a few state court cases seem more sympathetic to
applying Quill outside the sales and use tax context. In Johnson, the
Tennessee Court of Appeals considered the validity of franchise and
excise taxes imposed against an out-of-state corporation engaged in
credit card activities within the taxing jurisdiction. Johnson, 19 S.W.3d
at 832. While there is language in Johnson that indicated there was no
basis for distinguishing between sales and use taxes and the franchise
and excise taxes involved in the case, the court declined to determine
“whether ‘physical presence’ is required under the Commerce Clause.”
Id. at 842. A subsequent unpublished opinion of the same court
expresses doubt on the issue. See Am. Online, Inc. v. Johnson, No.
M2001-00927-COA-R3-CV, 2002 WL 1751434, at *2 (Tenn. Ct. App. July
30, 2002). Further, it is not clear how the Johnson court would have
26
treated a case involving use of intellectual property such as trade names
and trademarks, which arguably have a stronger nexus to the host
jurisdiction than credit cards and other lending transactions.
In Rylander v. Bandag Licensing Corp., 18 S.W.3d 296 (Tex. App.
2000), the court considered the validity of a tax based solely on the
taxpayer’s possession of a license to do business in Texas. Rylander, 18
S.W.3d at 298. As in Johnson, the court noted that it saw no principled
basis for distinguishing between the sales and use taxes and other types
of state taxes. Id. at 299–300. The court, however, did not consider
whether income taxes could be imposed on an out-of-state corporation
from income related to royalty payments arising from the licensing of
intangibles. See id.
On the precise issue of whether licensing of intangibles for use in a
state that produces income within a state for an out-of-state corporation
is subject to income tax, the weight of state authority is that it does,
either on the ground that physical presence has been satisfied or that the
physical presence requirement does not apply outside the context of
sales or use taxes. In both Bellas Hess and Quill, however, the Supreme
Court reversed judgments of state supreme courts that expansively
applied the “substantial nexus test” of Complete Auto through an
economic impact analysis. Further, it might be argued that state
supreme courts are inherently more sympathetic to robust taxing powers
of states than is the United States Supreme Court.
D. Analysis of Constitutionality Under Dormant Commerce
Clause of State Income Tax Assessments in this Case.
1. Introduction. At the outset, it is important to identify our task
in this case. Our function is to determine, to the best of our ability, how
the United States Supreme Court would decide this case under its case
27
law and established dormant Commerce Clause doctrine. In performing
this task, we do not engage in independent constitutional adjudication,
and we do not seek to improve or clarify Supreme Court doctrine. We
simply do our best to predict how the Supreme Court would decide the
issues presented in this case.
Based upon our analysis of the above authorities and our
understanding of the underlying constitutional purposes of the dormant
Commerce Clause, we conclude that the district court, in light of the
available Supreme Court precedents, adopted a sound approach when it
held that the dormant Commerce Clause is not offended by the
imposition of Iowa income tax on KFC’s royalties earned from the use of
its intangibles within the State of Iowa. We reach this conclusion for the
reasons expressed below.
2. Application of Quill “physical presence” test to use of intangible
property to revenue within a state for an out-of-state entity. We first
consider whether the Quill “physical presence” test is satisfied in this
case. Unlike in Quill, where the only presence in the state, except for
“title to ‘a few floppy diskettes,’ ” resulted from the use of United States
mail and common carriers, this case involves the use of KFC’s intangible
property within the State of Iowa to produce royalty income for KFC. See
Quill, 504 U.S. at 315 n.8, 112 S. Ct. at 1914 n.8, 119 L. Ed. 2d at 108
n.8.
The United States Supreme Court has not considered this precise
question post-Quill. In Quill, the majority dismissively referred to the
vendor’s “title to ‘a few floppy diskettes’ ” but recognized that the
diskettes “might constitute some minimal nexus.” Id. Apparently, the
Court believed that the minimal physical presence presented by title to a
28
few floppy diskettes was not “substantial” enough to satisfy Complete
Auto. See id.
Here, however, the nexus presented by the use of KFC’s intangible
property within the State of Iowa strikes us as far more than title to a few
floppy diskettes. In this case, KFC has licensed its valuable intellectual
property for use within the geographic boundaries of the State of Iowa to
produce income. This case thus does not involve the arguably “slightest
presence” of intangible property within Iowa, but a far greater
involvement with the forum state.
Under the applicable pre-Quill case law, the use of intangibles
within a state to generate revenue for an out-of-state entity was generally
regarded as a sufficient nexus under the dormant Commerce Clause to
support the imposition of a state income tax. For instance, in Whitney,
noted above, the Court upheld a Commerce Clause challenge to the
taxation of profits made from the sale of a seat on the New York Stock
Exchange. Whitney, 299 U.S. at 374, 57 S. Ct. at 239, 81 L. Ed. at 289.
Although the taxpayer had no physical presence in New York, the Court
reasoned intangibles may be sufficiently localized “to bring it within the
taxing power” of the state. Id. We view the intangibles in this case to be
sufficiently “localized” under Whitney to provide a “business situs”
sufficient to support an income tax on revenue generated by the use of
the intangibles within Iowa. See id.; see also Mobil Oil Corp. v. Comm’r of
Taxes, 445 U.S. 425, 445–46, 100 S. Ct. 1223, 1235–36, 63 L. Ed. 2d
510, 526 (1980) (holding intangibles may be located in more than one
state depending upon their use); Wheeling Steel Corp., 298 U.S. at 213–
14, 56 S. Ct. at 778–79, 80 L. Ed. at 1149–50 (1936) (concluding that
accounts receivable and bank deposits have business situs in host state);
Sheldon H. Laskin, Only a Name? Trademark Royalties, Nexus, and
29
Taxing That Which Enriches, 22 Akron Tax J. 1, 16–21 (2007) [hereinafter
Laskin].
Similarly, the presence of transactions within the state that give
rise to KFC’s revenue provide a sufficient nexus under established
Supreme Court precedent. In International Harvester, the Court
considered whether Wisconsin could impose an income tax on dividends
received by out-of-state stockholders. Int’l Harvester, 322 U.S. at 438,
64 S. Ct. at 1062, 88 L. Ed. at 1377. The Court concluded that personal
presence within the state is not essential, and that:
A state may tax such part of the income of a non-resident as
is fairly attributable either to property located in the state or
to events or transactions which, occurring there, are subject
to state regulation and which are within the protection of the
state and entitled to the numerous other benefits which it
confers.
Id. at 441–42, 64 S. Ct. at 1064, 88 L. Ed. at 1379 (emphasis added); see
also Curry v. McCanless, 307 U.S. 357, 368, 59 S. Ct. 900, 906, 83 L. Ed.
1339, 1348 (1939) (reasoning that income may be taxed on the basis of
source as well as residence); Shaffer v. Carter, 252 U.S. 37, 57, 40 S. Ct.
221, 227, 64 L. Ed. 445, 458–59 (1920) (same); Jerome R. Hellerstein &
Walter Hellerstein, State and Local Taxation: Cases and Materials 368–69
(7th ed. 2001) [hereinafter Hellerstein & Hellerstein, State and Local
Taxation] (citing Curry, 307 U.S. at 368, 59 S. Ct. at 906, 83 L. Ed. at
1348).
As a result, we conclude that the Supreme Court would likely find
intangibles owned by KFC, but utilized in a fast-food business by its
franchisees that are firmly anchored within the state, would be regarded
as having a sufficient connection to Iowa to amount to the functional
equivalent of “physical presence” under Quill. Furthermore, the fact that
the transactions that produced the revenue were based upon use of the
30
intangibles in Iowa also provides a sufficient basis to support the tax
under the Commerce Clause.
3. Extension of “physical presence” nexus requirement to state
taxation of income based on use of intangibles within forum state. In the
alternative, even if the use of intangibles within the state in a franchised
business does not amount to “physical presence” under Quill, the
question arises whether the Supreme Court would extend the Quill
“physical presence” requirement to prevent a state from imposing, on
out-of-state residents, an income tax based on revenue generated from
the use of intangibles within the taxing jurisdiction. For the reasons
expressed below, we do not believe the Supreme Court would extend the
rule beyond its established moorings in Quill.
The lynchpin of the Supreme Court’s opinion in Quill was not logic,
or the developing Commerce Clause jurisprudence, but stare decisis.
See Quill, 504 U.S. at 317, 112 S. Ct. at 1915–16, 119 L. Ed. 2d at 109–
10. The prior Bellas Hess standard created an incentive for consumers
to purchase goods from an out-of-state entity, an incentive which in turn
contributed to the dramatic growth of the mail-order business. See
Michael T. Fatale, Geoffrey Sidesteps Quill: Constitutional Nexus,
Intangible Property and the State Taxation of Income, 23 Hofstra L. Rev.
407, 409–10 (1994) [hereinafter Fatale]. The Quill Court was unwilling to
upset the settled expectations of a huge mail-order industry after its
growth was spawned by a prior court decision. See Quill, 504 U.S. at
316, 112 S. Ct. at 1915, 119 L. Ed. 2d at 109. Despite this, the Supreme
Court repeatedly recognized that the tides of due process and Commerce
Clause jurisprudence tugged strongly in the opposite direction and that
the issue may have been decided differently if it was one of first
impression. Id. at 311, 112 S. Ct. at 1912, 119 L. Ed. 2d at 105.
31
Further, it appears that the Court may have been concerned about
the potential of retroactive application if Bellas Hess were reversed. See
id. at 318 n.10, 112 S. Ct. at 1916 n.10, 119 L. Ed. 2d at 110 n.10. This
prospect may have been particularly daunting in Quill, as a reversal of
Bellas Hess could have created a huge tax liability imposed upon out-of-
state vendors for their failure to collect sales and use taxes owed by
others. Here, however, there is no vicarious liability for taxes that should
have been imposed on third parties. Instead, in the income-tax context,
the tax is either owed by the taxpayer or it is not. See 2 Paul J. Hartman
& Charles A. Trost, Federal Limitations on State & Local Taxation 2d
§ 10:7, at 12–13 (Supp. 2010).
In this case, there is simply no similar reliance interest. With
respect to state taxation of income whose source is the employment of
intangibles within the taxing jurisdiction, there is simply no Bellas Hess
precedent that gives rise to reliance interests. As demonstrated by the
income-tax nexus cases discussed above, the majority in Quill correctly
noted that “we have not, in our review of other types of taxes, articulated
the same physical-presence requirement that Bellas Hess established for
sales and use taxes.” Quill, 504 U.S. at 314, 112 S. Ct. at 1914, 119
L. Ed. 2d at 108. To the extent there are any antecedents for state
income taxes, they are International Harvester and Whitney, which do not
require physical presence. Although these cases are due process cases,
they were decided at a time when the nexus requirements of the Due
Process Clause and the dormant Commerce Clause were thought to be
interchangeable.
In addition, the Supreme Court in Quill sought to defend its
Commerce Clause based physical-presence test with a burdens-type
analysis, noting that if a state could be required to collect and remit use
32
taxes, it might be required to comply with potentially differing
requirements in 6000 or more jurisdictions. Id. at 313 n.6, 112 S. Ct. at
1914 n.6, 119 L. Ed. 2d at 107 n.6. The burden of state income
taxation, however, is substantially less when far fewer jurisdictions are
involved, when the taxpayer does not become a virtual agent of the state
in collecting taxes from thousands of individual customers, and when tax
assessments are only made periodically. Indeed, in cases involving
income taxes, the Court has not seemed overly concerned with the
compliance burdens. See Barclays Bank PLC v. Franchise Tax Bd., 512
U.S. 298, 313–14, 114 S. Ct. 2268, 2277–78, 129 L. Ed. 2d 244, 259–60
(1994); Nw. States Portland Cement Co., 358 U.S. at 462–63, 79 S. Ct. at
364–65, 3 L. Ed. 2d at 429–30.
Advocates of extension of the physical presence test to income
taxes stress the potential burdens on small out-of-state sellers. A
hypothetical often cited is the author of a book whose work is sold within
a state where the author has never had a physical presence. To impose
income tax on royalties earned by such a transaction, according to some,
would be absurd.
The hypothetical fails for several reasons. First, slight presence in
a state has never been held sufficient to establish a “substantial nexus”
under the dormant Commerce Clause, and a truly de minimus economic
presence by a book author should not be subject to tax. See Nat’l
Geographic Soc’y, 430 U.S. at 556, 97 S. Ct. at 1390, 51 L. Ed. 2d at
637. Moreover, royalties earned by an author of a book are ordinarily
paid by a publisher to the author, not by a local retailer. The income
from a book deal thus arises out of the contract between the publisher
and the author. The relationship between the publisher and the local
retailer has no relevance for purposes of income taxation. See Fatale, 23
33
Hofstra L. Rev. at 450; Laskin, 22 Akron Tax J. at 25–26. Further, if
states become overly aggressive in their tax policy, Congress has the
express authority to intervene under the Commerce Clause.
We also doubt that the Supreme Court would extend the “physical
presence” rule outside the sales and use tax context of Quill. The use of
a “physical presence” test does, of course, limit the power of the state to
tax out-of-state taxpayers, but it does so in an irrational way. For
example, while in Quill the Court was concerned about the undue burden
on interstate commerce caused by enforcement of sales and use taxes,
“physical presence” within the state does not reduce that burden. See
John A. Swain, State Sales and Use Tax Jurisdiction: An Economic Nexus
Standard for the Twenty-First Century, 38 Ga. L. Rev. 343, 361–62 (2003)
[hereinafter Swain]. Further, the “physical presence” test may protect
small vendors, but it also protects large vendors who are not unduly
burdened. Id. at 363.
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? See H. Beau Baez III, The Rush to the Goblin Market: The
Blurring of Quill’s Two Nexus Tests, 29 Seattle U. L. Rev. 581, 582 n.8
(2006) [hereinafter Baez]; Bradley W. Joondeph, Rethinking the Role of
the Dormant Commerce Clause in State Tax Jurisdiction, 24 Va. Tax Rev.
109, 135 (2004).
34
It also seems that, to the extent the Court desired to achieve a
“bright line,” it may not have achieved its objective. As Justice White
predicted in his separate opinion in Quill, the “physical presence” test
has not put an end to dormant Commerce Clause litigation in the sales
and use tax area. Quill, 504 U.S. at 329–30, 112 S. Ct. at 1921, 119
L. Ed. 2d at 118. Quill clearly established that a small sales force, plant,
or office is enough to satisfy the nexus test under the dormant
Commerce Clause. See id. at 315, 112 S. Ct. at 1914–15, 119 L. Ed. 2d
at 108. Nevertheless, the question of how much “physical presence” is
required to establish a “substantial nexus” has still proven problematic.
Compare Orvis Co. v. Tax Appeals Tribunal, 654 N.E.2d 954, 961 (N.Y.)
(holding that occasional traveling personnel entering jurisdiction is
sufficient), cert. denied sub nom. Vt. Info. Processing, Inc. v. Comm’r, 516
U.S. 989 (1995), with Johnson, 19 S.W.3d at 840 & n.18 (reasoning that
physical presence of thousands of credit cards was “constitutionally
insignificant”). Many other cases grapple with the question of what
amounts to sufficient physical presence to satisfy Quill.1 See Hellerstein
& Hellerstein, State and Local Taxation at 352–54 (citing cases); see also
Baez, 29 Seattle U. L. Rev. at 595–600; Matthew T. Troyer, Note, Mail
Order Retailers and Commerce Clause Nexus: A Bright Line Rule or an
Opaque Standard?, 30 Ind. L. Rev. 881, 897 (1997) (asserting
“ ‘[s]ubstantial nexus’ is too vague to function as a bright-line rule”).
1In a pre-Quill case, we grappled with the problem of physical presence when an
Illinois retailer’s contact with Iowa was incidental general advertising and occasional
deliveries via employee-driven, company-owned trucks. Good’s Furniture House, Inc. v.
Iowa State Bd. of Tax Review, 382 N.W.2d 145, 146–47 (Iowa), cert. denied, 479 U.S.
817 (1986). We concluded that the requisite physical presence under Bellas Hess was
established. Id. at 150. Our ruling was criticized for eroding the physical presence
nexus standard. See Chris M. Amantea, Use Tax Collection Jurisdiction: Retail Stores
on a State Border Held Hostage, 63 Chi.-Kent L. Rev. 747, 759–64 (1987).
35
There is also the difficult question of when the physical presence of
third parties should be attributed to an out-of-state party for purposes of
establishing a substantial nexus under Complete Auto. The cases are
hardly uniform. Compare Syms Corp. v. Comm’r of Revenue, 765 N.E.2d
758, 766 (Mass. 2002) (precluding deduction from taxable income royalty
payments made to a passive investment company), with Sherwin-
Williams Co. v. Comm’r of Revenue, 778 N.E.2d 504, 518–19 (Mass. 2002)
(permitting deduction from taxable income royalty payments made to a
passive investment company). See generally Laskin, 22 Akron Tax J. at
7 n.24, 8–13.
Moreover, if a “bright line” test is needed in the income tax arena,
it may not be physical location but something else, particularly when
taxation is based upon the source of the income. For example, the three-
factor formula behind the Uniform Division of Income for Tax Purposes
Act has been called “something of a benchmark.” Container Corp. of Am.
v. Franchise Tax Bd., 463 U.S. 159, 170, 103 S. Ct. 2933, 2943, 77
L. Ed. 2d 545, 556 (1983).
We also note that the Quill decision impliedly suggests a desire on
the part of the Supreme Court to defer to Congress on most nexus
issues. We find significant the holding of the Quill Court that the
imposition of sales and use taxes by states on out-of-state residents who
utilize only mail and common carriers did not violate due process. By
removing the due process impediment to state taxation of mail-order
sales when physical presence was lacking, the Quill Court opened the
door to congressional action.
It seems clear that the Quill majority recognized that difficult
issues of determining the extent to which the states should be allowed to
impose tax obligations on comparatively remote entities was infused with
36
policy and legislative-type judgments that could not be resolved in the
context of judicial determination of a particular case. Certainly Justice
Scalia and Justice Thomas would not extend the line drawing under the
dormant Commerce Clause outside what is required by stare decisis.
See, e.g., Am. Trucking Ass’ns v. Scheiner, 483 U.S. 266, 304, 107 S. Ct.
2829, 2851, 97 L. Ed. 2d 226, 256 (1987) (Scalia, J., dissenting)
(asserting judicial intervention under dormant Commerce Clause should
be limited to cases involving discrimination against interstate commerce).
We recognize that a counterargument could be made that
aggressive judicial intervention is required to prevent states from shifting
tax burdens onto out-of-state parties who lack political power in the
taxing jurisdiction. We question, however, whether out-of-state entities
are as powerless in the halls of state legislatures as they once were in
light of the growth of national advocacy groups that protect the local
interests of their members and the involvement of national political
parties in state political affairs. In addition, in this case, the in-state
presence of franchisees, whose interest in tax matters are likely to be
aligned with the franchisor, are well positioned to participate in the local
political process. We further note that the mechanism to control any
improper shifting of tax burdens onto out-of-state taxpayers is
enforcement of the discrimination and apportionment prongs of Complete
Auto, not the nexus requirement.
Another factor that suggests the physical-presence test should not
be extended outside its sales and use tax confines is the potential for tax
evasion that the test engenders. Obviously, this concern did not carry
the day in Quill. But experience should be instructive; namely, the result
in Bellas Hess created a huge loophole in the tax structure that, twenty-
five years later was practically impossible to close. Further, extension of
37
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. Scripto, Inc., 362 U.S. at 211, 80 S. Ct. at 622, 4
L. Ed. 2d at 664 (noting that to permit the fine distinction between
employees and independent contractors to control the result of taxation
under the Commerce Clause would “open the gates to a stampede of tax
avoidance”).
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.
For the above reasons, we hold that a physical presence is not
required under the dormant Commerce Clause of the United States
Constitution in order for the Iowa legislature to impose an income tax on
revenue earned by an out-of-state corporation arising from the use of its
intangibles by franchisees located within the State of Iowa. We hold that,
by licensing franchises within Iowa, KFC has received the benefit of an
orderly society within the state and, as a result, is subject to the
38
payment of income taxes that otherwise meet the requirements of the
dormant Commerce Clause. As a result, the district court judgment on
the dormant Commerce Clause issues in this case is affirmed.
IV. State Law Claims.
A. State Law Claim Under Iowa Code Section 422.33. In the
alternative to its constitutional attack under the dormant Commerce
Clause, KFC argues that the imposition of tax in this case is not
authorized by the provisions of Iowa law and related administrative
regulations that authorize the imposition of income tax on corporations
because of the lack of physical presence within Iowa.
We do not agree. The applicable provision of the Code, Iowa Code
section 422.33(1) (1997), imposes an income tax on each corporation
“doing business in this state, or deriving income from sources within this
state.” Iowa Code § 422.33(1). Iowa Code section 422.33(1) further
provides that “income from sources within the state” includes “income
from real, tangible, or intangible property located or having a situs in the
state.” Id. § 422.33(1)(d). The reference to “intangible property” located
or “having a situs in the state” is a clear reference to the applicable case
law dealing with taxation of income arising from the use of intangibles in
connection with transactions within a state. See, e.g., Nw. States
Portland Cement Co., 358 U.S. at 464–65, 79 S. Ct. at 365–66, 3
L. Ed. 2d at 430–31; Int’l Harvester, 322 U.S. at 442, 64 S. Ct. at 1064,
88 L. Ed. at 1379–80; Whitney, 299 U.S. at 371–72, 57 S. Ct. at 238, 81
L. Ed. at 287–88. Therefore, the tax at issue in this case falls squarely
within the intended scope of Iowa Code section 422.33.
This interpretation is not diminished by, nor is there anything
invalid about, the administrative regulations promulgated pursuant to
the statute. IDOR has promulgated regulations implementing Iowa Code
39
section 422.33(1). Under the applicable rules, the statutory phrase
“intangible property located or having a situs in this state” is further
defined to include intangible property that “has become an integral part
of some business activity occurring regularly in Iowa.” Iowa Admin. Code
r. 701—52.1(1)(d), (4) (1997). Citing Geoffrey, the rules specifically
provide that, if a corporation owns trademarks and trade names that are
used in Iowa, a business situs for purposes of taxation may be present
even though the corporation has no physical presence or other contact
with Iowa. See Iowa Admin. Code r. 701—52.1(4) (Example 4); see also
Geoffrey, 437 S.E.2d at 18–19. The administrative regulations are
simply a logical interpretation of the statute with citation to the evolving
case law on the taxation of revenues earned or arising out of intangible
property.
B. Other State Law Claims. KFC raises two other state law
claims on appeal. First, it claims that a policy letter issued by IDOR is
contrary to the position IDOR has taken in this case and that IDOR has
not provided an adequate explanation for its departure from its
established policy. Second, KFC claims that IDOR erred by assessing
penalties against KFC for its failure to pay the asserted taxes.
Neither of these issues, however, has been preserved for our
review. KFC claims that the issues were properly raised before the
agency. Even if the issues were properly raised before the agency, KFC
was required to file a motion for rehearing under Iowa Code section
17A.16(2) (2009) to preserve the issues when the agency issued a final
order that did not address them. This KFC did not do. As a result, when
KFC filed its appeal of the administrative action with the district court,
there was no ruling on the policy letter or penalty issues for the district
court to review.
40
When an agency fails to address an issue in its ruling and a party
fails to point out the issue in a motion for rehearing, we find that error
on these issues has not been preserved. Our respect for agency
processes in administrative proceedings is comparable to that afforded to
district courts in ordinary civil proceedings. Just as we do not entertain
issues that were not ruled upon by the district court and that were not
brought to the district court’s attention through a proper posttrial
motion, Meier v. Senecaut, 641 N.W.2d 532, 540 (Iowa 2002), we decline
to entertain issues not ruled upon by an agency when the aggrieved
party failed to follow available procedures to alert the agency of the issue.
See Soo Line R.R. v. Iowa Dep’t of Transp., 521 N.W.2d 685, 688 (Iowa
1994) (stating that the scope of administrative review is limited to
questions that were actually considered by the agency); Chi. & Nw.
Transp. Co. v. Iowa Transp. Regulation Bd., 322 N.W.2d 273, 276 (Iowa
1982) (finding that an issue first raised in motion for rehearing and
considered by the agency is preserved); Charles Gabus Ford, Inc. v. Iowa
State Highway Comm’n, 224 N.W.2d 639, 647 (Iowa 1974) (discussing
requirement of exhaustion of administrative remedies when agency has
primary or exclusive jurisdiction over controversy).
V. Conclusion.
For the above reasons, we conclude that the assessment of income
tax liability made by IDOR against KFC does not violate the dormant
Commerce Clause or any provision of Iowa law. We further conclude
that the issues related to the policy letter and the assessment of
penalties have not been preserved. As a result, we affirm the judgment
of the district court upholding the action of IDOR in all respects.
AFFIRMED.
All justices concur except Wiggins, J., who concurs in result.