Doctor's Associates, Inc. v. Department of Revenue & Regulation , 2006 S.D. LEXIS 24 ( 2006 )

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2006 SD 18IN THE SUPREME COURT
OF THE
STATE OF SOUTH DAKOTA
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DOCTOR’S ASSOCIATES, INC., Plaintiff and Appellant,
v.
DEPARTMENT OF REVENUE
AND REGULATION, Defendant and Appellee.
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APPEAL FROM THE CIRCUIT COURT OF
THE SIXTH JUDICIAL CIRCUIT
HUGHES COUNTY, SOUTH DAKOTA
* * * *
HONORABLE MAX A. GORS
Judge
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TODD C. MILLER Attorney for plaintiff
Sioux Falls, South Dakota and appellant.
HARVEY M. CROW, JR.
South Dakota Department of
Revenue and Regulation Attorney for defendant
Rapid City, South Dakota and appellee.
* * * *
CONSIDERED ON BRIEFS
ON JANUARY 9, 2006
OPINION FILED 03/01/06
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KONENKAMP, Justice
[¶1.] Doctor’s Associates, Inc., headquartered in Milford, Connecticut, owns
the international Subway fast-food restaurant franchise. South Dakota has fifty-
three restaurants in the Subway chain. Subway collects an 8% “royalty” fee from
each franchisee’s weekly gross sales. After an audit, the Department of Revenue
and Regulation determined that Subway’s royalty fees constitute taxable gross
receipts. Since Subway failed to report these fees on its sales tax returns, the
Department issued a certificate of assessment for sales tax and interest. Subway
contested the assessment. Following an unsuccessful administrative appeal,
Subway now seeks review before us, claiming that its royalty fees are non-taxable
intangibles and that the Department failed in its burden of proving taxability.
Because Subway’s franchise agreement provides that its royalty fees are collected in
exchange for tangible personal property and services, these fees constitute taxable
gross receipts under South Dakota law. Therefore, we uphold the assessment.
Background
[¶2.] On August 17, 2000, the senior auditor for the Department sent
Subway a notice of intent to audit. As part of the notice, the Department requested
that Subway submit certain corporate records. The Department further informed
Subway in the notice of intent to audit that “(1) the audit period was July, 1997
through October, 2000; (2) the audit would commence on December 5, 2000; and (3)
Subway had sixty days from December 5, 2000 to present to the auditor ‘all
documents evidencing reduction, deduction or exemption from tax,’ and any such
records not presented would not have to be considered by the auditor.”
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[¶3.] To operate as a franchisee, each Subway restaurant owner was
required to sign and accept, as is, Subway’s franchise agreement, pay a one-time,
non-refundable franchise fee, and thereafter, pay an 8% “royalty” fee on the
restaurant’s gross weekly sales. When Subway received the notice of intent to
audit, it provided the Department with financial information about the South
Dakota franchisees. Subway submitted “(1) a sales quarterly ledger detailing the
royalty fees paid to Subway each week; (2) a copy of the April, 1997, ‘Limited
Amnesty Program for the Franchise Industry,’ outlining the Department’s policy
regarding taxation of royalty fees beginning July 1, 1997; and, (3) a copy of the
Franchise Agreement.”
[¶4.] The audit took place in Milford and began on December 5, 2000. It
lasted approximately six months. During the audit, the Department reviewed
Subway’s records and concluded that the 8% royalty fee received by Subway from its
franchisees constituted gross receipts and should have been reported in Subway’s
sales tax returns. In reaching its conclusion, the Department relied on the
language of the franchise agreement. Paragraph three states that Subway provides
tangible personal property to franchisees.1 Paragraph four indicates that services
1. The language of paragraph three provides:
The Company hereby grants to the Franchisee:
a. access to the Company’s recipes, formulas, food preparation
procedures, business methods, business forms, business policies and
body of knowledge pertaining to the operation of a sandwich shop,
including the loan of a copy of the Company’s Operations Manual;
b. access to information pertaining to new developments and
techniques in the Company’s sandwich business; and
(continued . . .)
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are provided to franchisees. 2 Because the franchise agreement stipulates that the
royalty fees are consideration for allowing the franchisees access to Subway’s body
of knowledge, among other things, the Department deemed the royalty fees
collected by Subway to be taxable gross receipts under SDCL 10-45-2 and 10-45-4. 3
[¶5.] Subway had the opportunity to submit any evidence to show that the
royalty fees should not be subject to sales tax. Beginning on December 5, 2000,
Subway had sixty days to present materials to the Department that would reduce,
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(. . . continued)
c. a limited license to use the Company’s rights in and to its
service marks and trademarks in connection with the operation of one
sandwich shop to be located at a site approved by the Company and the
Franchisee.
2. Paragraph four provides:
The Company agrees to:
a. provide a training program for the operation of sandwich
shops using the Company’s recipes, formulas, food preparation
procedures, business methods, business forms and business policies.
The Franchisee shall pay all transportation, lodging and other
expenses incurred in attending the training program.
b. provide a Company Representative that the Franchisee may
call upon during normal business hours for consultation concerning the
operation of his business; and
c. provide the Franchisee with a program of assistance which
shall include periodic consultations with a Company Representative,
publish a periodical advising of new developments and techniques in
the Company’s sandwich business, and grant access during normal
business hours to specified office personnel for consultations
concerning the operation of his business.
3. Under the Recitals section of the franchise agreement, it is provided:
The Franchise Fee, Royalty and promises by the Franchisee contained herein
constitute the sole consideration to the Company for the use by the
Franchisee of its body of knowledge, systems and trademark rights.
(Emphasis added).
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deduct, or exempt the royalty fees from tax. When the sixty days ended on
February 5, 2001, Subway had not submitted any evidence. Subway then requested
an extension in order to present additional evidence. The extension was granted.
On February 23, 2001, the Department sent Subway a “listing showing the [r]oyalty
fees subject to sales tax to Subway for review.” When the extension expired on
March 5, 2001, Subway still had not presented any evidence. Then, in May 2001,
Subway requested another extension, this time “to review the South Dakota Code
and Regulations.” Because the extension was not requested for the purpose of
presenting additional evidence, the Department denied Subway’s request.
[¶6.] In the end, the auditor received no evidence from Subway to reduce,
deduct, or exempt any portion of the royalty fees from sales taxation. Consequently,
the Department issued Subway a certificate of assessment for $270,660.70 on June
21, 2001. Subway requested a hearing and argued that the royalty fees should not
be taxed because they were not received as consideration for taxable services or
property contained within the franchise agreement. At the hearing in June 2004,
Subway attempted to offer new evidence that should have been submitted before
the sixty days expired under SDCL 10-59-7 or during the thirty-day extension. The
hearing examiner excluded the evidence and affirmed the Department’s certificate
of assessment.
[¶7.] Subway appealed the decision to the circuit court. That court also
excluded Subway’s evidence for not having been timely presented within the
statutory time and affirmed the certificate of assessment. Subway now appeals to
this Court, claiming that the circuit court erred when it affirmed the hearing
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examiner’s decision that (1) the royalty fees paid by the fifty-three South Dakota
franchisees to Subway were taxable; (2) Subway failed to overcome the presumption
of correctness of the certificate of assessment; and (3) certain testimony and
documentary evidence were inadmissible.
Analysis and Decision
[¶8.] Our review of an administrative appeal is governed by SDCL 1-26-36.
Watertown Coop. Elevator Ass’n v. S.D. Dept. of Rev., 2001 SD 56, ¶10, 627 NW2d
167, 171. “We give deference to the agency on factual matters, applying the clearly
erroneous standard of review.” Id. (citing Sopko v. C & R Transfer Co., Inc., 1998
SD 8, ¶6, 575 NW2d 225, 228 (citations omitted)). However, the agency’s
conclusions of law are reviewed de novo. W. Wireless Corp. v. Dept. of Rev., 2003
SD 68, ¶5, 665 NW2d 73, 75 (citing Sopko, 1998 SD 8, ¶6, 575 NW2d at 228).
[¶9.] Subway first contends that the circuit court erred when it concluded
that the royalty fees, which Subway claims are intangibles, could be subject to sales
tax under SDCL 10-45-2 and 10-45-4. The Department, on the other hand, asserts
that the terms of the franchise agreement illustrate that Subway provided tangible
personal property and services to South Dakota franchisees in return for the royalty
fees. Thus, the Department deems the royalty fees in this case to be taxable under
SDCL 10-45-2 and 10-45-4.
[¶10.] We begin by first examining the statutes in question. Whether SDCL
10-45-2 and 10-45-4 impose a sales tax under these circumstances is a question of
law, reviewed de novo. See S.D. Dept. of Rev. v. Sanborn Tel. Coop., 455 NW2d 223,
225 (SD 1990) (citations omitted). Under SDCL 10-45-2, “the gross receipts of all
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sales of tangible personal property consisting of goods, wares, or merchandise” are
subject to sales tax, and, under SDCL 10-45-4, a tax is imposed on “the gross
receipts of any person from the engaging in or continuing in the practice of any
business in which a service is rendered.”
[¶11.] In examining SDCL 10-45-2 and 10-45-4 together, we see that the
royalty fees will be subject to sales tax if they constitute gross receipts for the sale of
tangible personal property or service. “Gross receipts” is defined in SDCL 10-45-1(6)
as the “consideration, including cash, credit, property, and services, for which
tangible personal property or services are sold, leased, or rented, valued in money,
whether received in money or otherwise. . . .” And “tangible personal property” is
defined as “personal property that can be seen, weighed, measured, felt, or touched,
or that is in any other manner perceptible to the senses.” SDCL 10-45-1(14).
Finally, the definition of “service” is contained in SDCL 10-45-4.1, which includes
“all activities engaged in for other persons for a fee, retainer, commission, or other
monetary charge, which activities involve predominantly the performance of a
service as distinguished from selling property.”
[¶12.] By applying these statutory definitions to the facts of this case, the
royalty fees received by Subway were properly considered gross receipts from the
sale of tangible personal property and services. This determination is based on the
records Subway provided the Department for the audit, specifically the franchise
agreement. First, in the section entitled Agreement, paragraph three states that
Subway “grants” the franchisee access to, among other things, “the Company’s
recipes, formulas, food preparation procedures, business methods, business forms,
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business policies and body of knowledge. . . .” From this language it is clear that
Subway is providing its franchisees with “tangible personal property” as defined in
SDCL 10-45-1(14). Then in paragraph four, Subway agrees to “provide” franchisees
a “Company Representative that the Franchisee may call upon during normal
business hours for consultation concerning the operation of his business[.]” Based
on the language of paragraph four, Subway is providing its franchisees with
“services” as defined in SDCL 10-45-4.1. Finally, in the Recitals section of the
agreement, we see that Subway receives consideration, i.e. “royalty,” constituting
“gross receipts” under SDCL 10-45-1(6), for the tangible personal property it grants
under paragraph three and the services it provides under paragraph four.
[¶13.] Accordingly, Subway provides tangible personal property and services
in return for the royalty fee, and SDCL 10-45-2 and 10-45-4 apply to impose sales
tax on these receipts. This finding, however, does not automatically obligate
Subway to pay sales tax on the entire royalty fee collected from the fifty-three
Subway franchisees across South Dakota. Subway was afforded an opportunity to
present evidence to reduce, deduct, or exempt the royalty fees, or a portion thereof,
from taxation, within sixty days of the commencement of the audit. See SDCL 10-
59-3; SDCL 10-59-7; AT&T Corp. v. S.D. Dept. of Rev., 2002 SD 25, ¶18, 640 NW2d
752, 757 (citing In re Pam Oil, Inc., 459 NW2d 251, 257 (SD 1990)). This Subway
failed to do until more than two years later. Thus, the circuit court did not err when
it concluded that the entire royalty fee was subject to sales tax under SDCL 10-45-2
and 10-45-4. See AT&T Corp., 2002 SD 25, ¶18, 640 NW2d at 757; Pam Oil, Inc.,
459 NW2d at 257.
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[¶14.] Subway’s next contention is similar to its first claim, that royalty fees,
as a whole, are not taxable. Subway asserts that the certificate of assessment is per
se incorrect because the Department “did not seek a reasonable value of services
and tangible personal property that the Department deemed taxable.” For that
reason, Subway insists that the circuit court erred when it held that Subway failed
to overcome the presumption of correctness of the certificate of assessment. It is
well settled that certificates of assessment are presumed correct and thus the
burden was on Subway to overcome that presumption. See SDCL 10-59-8. Subway
must present evidence that there was a mistake of fact or error of law in the
conduct of the audit which resulted in the assessment. See SDCL 10-59-9.
[¶15.] Subway does not suggest that the certificate contains a mistake, or
that the Department’s calculations or figures in the certificate of assessment were
inaccurate. Rather, Subway argues that SDCL 10-46-18.2 imposes a burden on the
Department to determine the “reasonable value” of the services and tangible
personal property Subway sold in return for the royalty fees. Specifically, Subway
alleges that SDCL 10-46-18.2 requires the Department to categorize the items listed
in paragraphs three and four as either tangible personal property or services.
Subway further claims that the Department was required to “verify whether
Subway actually performed any services for the [fifty-three] franchisees in the State
of South Dakota” in order to determine what, if any, tax should be assessed.
[¶16.] The problem with this argument is that SDCL 10-46-18.2 is a use tax
statute. Here Subway was assessed a sales tax under SDCL 10-45-2 and 10-45-4.
The Department reviewed Subway’s financial records and franchise agreement and
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determined the amount of tax applicable to the 8% royalty fees Subway received.
Subway has not contested these calculations under the sales tax statutes. Nor has
Subway presented competent evidence that the certificate of assessment contained
a mistake of fact or error of law. As such, the circuit court did not err when it held
that Subway failed to overcome the presumption of correctness for the certificate of
assessment.
[¶17.] Subway’s final argument on appeal is that the circuit court erred when
it disallowed testimonial and documentary evidence that would have established
the value of services and personal property subject to taxation. The evidence
Subway offered, Exhibit D, is a statistical summary prepared by Subway in 2003,
containing values for 2002, 2001, 2000, 1999, and 1998. Subway also attempted to
offer the testimony of Mike Dolishny, who was not employed by Subway during the
time of the audit, but would have testified concerning Exhibit D. The circuit court
affirmed the hearing examiner’s decision to exclude Exhibit D and Dolishny’s
testimony because Subway failed to present the evidence during the audit. See
SDCL 10-59-7.
[¶18.] Nonetheless, Subway insists that SDCL 10-59-7 is inapplicable under
the circumstances. Subway argues that Exhibit D was not required to be kept by
law and therefore should have been allowed at any time and that Dolishny should
have been permitted to testify about Exhibit D. Subway also claims that Exhibit D
and Dolishny’s testimony were not offered to prove a “reduction, deduction or
exemption” from tax. Instead, Subway offered Exhibit D to show how royalty fees
were intangibles and should not be taxed in the first place. Subway also claims that
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the Department arbitrarily denied its request for an extension of time, and as a
result, the evidence should be allowed.
[¶19.] We start with Subway’s assertion that the Department arbitrarily
denied its second request for an extension of time to submit further evidence. This
argument is not supported by the evidence. A review of the record shows that
Subway sent a letter to the Department requesting a second extension of time for
the purpose of reviewing the “South Dakota Code and Regulations.” Because the
extension was not for the purpose of submitting additional evidence, the
Department denied Subway’s request. We fail to see how this decision was
arbitrary, especially when the Department had earlier granted an extension.
[¶20.] We next address Subway’s argument that SDCL 10-59-7 does not
apply because Exhibit D, a statistical summary, was not a document required to be
kept by law and was not offered as evidence of a reduction, deduction or exemption
from tax under SDCL 10-59-7. 4 Subway was fully aware that the Department
considered the fees taxable based on the language of the franchise agreement. Yet,
Subway failed to present Exhibit D to the Department during the audit, or during
the extension granted by the Department. Although Subway indicates that Exhibit
D existed at the time of the audit, Subway did not present this material until more
4. SDCL 10-59-7 provides, in relevant part:
Any documents or record required to be kept by law to evidence reduction,
deduction, or exemption from tax not prepared for presentation to the auditor
within sixty days from the commencement date of the audit do not have to be
considered by the auditor or secretary.
(Emphasis added).
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than two years later. Nevertheless, Subway claims Exhibit D was not required to
be kept by law, and thus it should now be allowed.
[¶21.] Under SDCL 10-45-45, Subway is required to “keep records and books
of all receipts and sales, together with invoices, bills of lading, copies of bills of sale,
and other pertinent papers and documents.” (Emphasis added). Here Subway is
offering Exhibit D as evidence that the royalty fees should not be subject to tax
under SDCL 10-45-2 and 10-45-4. Exhibit D is therefore a pertinent document.
Because Exhibit D is a pertinent document it was contemplated under the statutory
time frame set out in SDCL 10-59-3 and 10-59-7. Also, because the purpose of
Exhibit D wa s an attempt to remove the royalty fees from tax under SDCL 10-45-2
and 10-45-4, it is certainly evidence purporting to reduce, deduct or exempt the
royalty fees from tax. Exhibit D should have been presented to the Department as
required under SDCL 10-59-3 and 10-59-7.
[¶22.] Because Subway failed to submit the evidence during the sixty days
required under SDCL 10-59-3 and 10-59-7, plus the thirty-day extension, Subway
had no right to later offer this material. See AT&T Corp., 2002 SD 25, ¶18, 640
NW2d at 757; Pam Oil, Inc., 459 NW2d at 257. To allow late submittal of these
materials long after the audit has ended would make the audit process interminable
and unworkable. As a result, the circuit court did not err when it affirmed the
hearing examiner’s decision to exclude Exhibit D and Dolishny’s testimony
pertaining to Exhibit D. 5
5. Some of the services Subway provides to its franchisees in exchange for the
royalty fees may not be subject to sales tax. For example, the training for
(continued . . .)
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[¶23.] Affirmed.
[¶24.] GILBERTSON, Chief Justice, and SABERS, ZINTER, and
MEIERHENRY, Justices, concur.
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(. . . continued)
franchisee employees takes place in Connecticut. However, Subway failed to
timely submit proof of valid deductions and therefore they could not be
considered in this audit.
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