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

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

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

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

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