Taxpayer is a multi-state company doing business in Indiana. Taxpayer owns and licenses its trade names, trademarks, service marks, logos, slogans, and brand identities ("Intellectual Property") to various individuals who operate and provide lodging accommodation ("Franchisees") in Indiana and outside of Indiana pursuant to franchise agreements. Taxpayer manages, maintains, administers, and protects its Intellectual Property and also hires employees to perform the reservation call center services under the franchise agreements.
Taxpayer owns a subsidiary ("Subsidiary"), which, in turn, owns real property and leases real estate to Taxpayer to be used as a reservation call center. Subsidiary also provides various services to Franchisees in addition to servicing Taxpayer. The services which Subsidiary provides include, but are not limited to, (1) the day-to-day corporate management functions, including managing all employees, except employees who are hired to perform reservation call center services; (2) marketing and promoting franchise sales; (3) training Franchisees how to operate or manage the lodging accommodation business, including use of the on-line "Profit Management System" and periodical on-site visits (consultation) of Franchisees' business locations; (4) updating and maintaining the "Profit Management System."
Upon entering into the franchise agreements, the Indiana Franchisees are charged various fees, including a one-time "Initial Franchise Fee" (or an "Affiliation Fee") and various monthly fees. Those monthly fees are based on a percentage of the preceding month's gross room revenues.
The Indiana Department of Revenue ("Department") conducted a corporate income tax audit of Taxpayer's business records for tax years 2007, 2008, 2009, and 2010. Pursuant to the audit, the Department determined that Taxpayer erred in reporting their income derived and attributable to Indiana. As a result, the Department assessed Taxpayer additional corporate income tax and interest. The Department's audit determined that there is reasonable cause to waive the negligence penalty for the tax years 2007–2010. For the 2009 tax year, however, Taxpayer was assessed a penalty for failure to remit adequate estimated income tax as statutorily required (also known as an underpayment penalty or a 2220 penalty).
Additionally, for the 2011 tax year, Taxpayer failed to remit sufficient estimated corporate income tax before the statutory due date. Taxpayer requested an extension to file its corporate income tax return, but it did not pay the full amount of tax owed and interest. As a result, Taxpayer was assessed interest and a late penalty, in addition to an underpayment penalty.
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The Department's audit assessed Taxpayer additional corporate income tax on the ground that its income from the franchise agreements for licenses of intangible property and sales of services to Indiana Franchisees was attributable to Indiana.
Taxpayer, to the contrary, claims that it has no real property or employees in Indiana; that all of its costs in performing services or licenses of intangible property pursuant to its franchise agreements were outside Indiana; and that it is not responsible for the Indiana corporate income tax under the "cost of performance" rules because the rules mandate Taxpayer to source its income at issue to states other than Indiana.
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In this instance, Taxpayer states that the Department's audit erred by not applying the "cost of performance" sourcing. Taxpayer objects that the audit relied on IC § 6-3-2-2(a)(5) and IC § 6-3-2-2.2(e) to impose additional Indiana income tax. Taxpayer explains that IC § 6-3-2-2.2(e) "is to direct the sourcing of only certain types of receipts from intangible property – intangible receipts from loans, credits, financing, or other the listed fiduciary activities in 2.2." Taxpayer maintains that, in this case, pursuant to the franchise agreements, it licenses the Intellectual Property, which is intangible property, and provides non-lending or non-fiduciary services to Indiana Franchisees. Thus, Taxpayer claims that the "cost of performance" rules under IC § 6-2-2-2(f)(2) should apply. Taxpayer further asserts that all of its employees work outside Indiana and "[a]lmost all costs of performance and income producing activities performed by" Taxpayer under the franchise agreements are outside Indiana. Thus, Taxpayer, referencing Chief Industries Inc. v. Indiana Dep't of Revenue, 792 N.E.2d 972 (Ind. Tax Ct. 2000), contend that it is not responsible for the additional income tax and that the Department's assessments are not correct on the ground that the Department's audit applied an incorrect method. Taxpayer submits a summary explaining its interpretation of the statutes, regulations and case law to support its protest.
Upon review, however, the Department is not able to agree with Taxpayer's conclusion that the "cost of performance" rules apply as a result. First, Chief Industries interpreted a previous statutory language concerning IC § 6-3-2-2(a)(5), which was applied in a dispute over an income tax assessment for tax year 1986. That previous provision stated that "income from . . . franchises and other intangible personal property having a situs" in Indiana. Since then, the Indiana General Assembly revised IC § 6-3-2-2(a)(5), deleting "having a situs" and adding "if the receipt from the intangible is attributable to Indiana under section 2.2 of this chapter" (Emphasis in original 1989 amendment) after "other intangible personal property." The Indiana General Assembly in the revised IC § 6-3-2-2(a)(5) kept the specific "income from stocks, bonds, notes, bank deposits, patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises" intact and clarified the meaning of "other intangible personal property" by including an internal reference to IC § 6-3-2-2.2. IC § 6-3-2-2.2 is limited in its effect acting only to describe the manner in which interest and dividend income are attributed to the state. Specifically, IC § 6-3-2-2(a)(5) (as in effect for tax years 2007 – 2010) states that "[w]ith regard to corporations . . . 'adjusted gross income derived from sources within Indiana', for the purposes of this article, shall mean and include . . . income from . . . trademarks, trade brands, franchises, and other intangible personal property . . . ." The Indiana General Assembly clearly intended to tax income earned from trademarks, trade brands, and franchises that is attributable to Indiana. Thus, Taxpayer's reliance on Chief Industries is misplaced.
In this instance, Taxpayer entered into various franchise agreements with Indiana Franchisees. The Indiana Franchisees pay Taxpayer various fees, which include among other things the right to use Taxpayer's Intellectual Property and receive services in Indiana pursuant to the franchise agreements. The value attached to Taxpayer's Intellectual Property does not derive from – however necessary – activities surrounding the administration of the Intellectual Property outside this state but results from Taxpayer's ability to exploit the value of the property within the stream of Indiana commerce and to derive income from its ability to do so. The Intellectual Property, standing alone, does not have any value unless Taxpayer takes steps to associate that property with the conduct of a specific business operation, namely Franchisees' business operations. Taxpayer is not paid fees because it successfully administers and maintains the Intellectual Property or renders services at an out-of-state location; Taxpayer receives income because it licenses Intellectual Property to Indiana Franchisees and routinely conducts business activities to ensure the fulfillment of the franchise agreements in Indiana. Thus, Taxpayer's income at issue is business income and is attributable to Indiana under IC § 6-3-2-2(a)(2) or (a)(5).
Even if, assuming IC § 6-3-2-2(a)(2) and (a)(5), as well as IC § 6-3-2-2.2(e) do not apply, Taxpayer's income at issue, that Taxpayer classifies as fees paid for intangible property and services, is still attributable to Indiana and subject to Indiana income tax because the income producing activity is performed in Indiana.
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Accordingly, Taxpayer has business income derived from licenses of intangible property or sales of services; the income at issue is a "principal source of business income" for Taxpayer and is from "income-producing activity" that was performed in Indiana under 45 IAC 3.1-1-55 . Given the totality of circumstances, in the absence of other supporting documentation, the Department is not able to agree that Taxpayer met its burden demonstrating that the Department's assessments are not correct and that the "cost of performance" rules mandate Taxpayer to source its income at issue to states other than Indiana.
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The Department assessed Taxpayer an underpayment penalty for 2009 tax year after the audit was concluded even though the audit did not impose negligence penalty. For tax year 2011, the Department did not audit Taxpayer. Nonetheless, Taxpayer was assessed an underpayment penalty and a negligence penalty.
Taxpayer protests the imposition of the underpayment and negligence penalties.
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In this instance, the Department audited Taxpayer for tax years 2007 through 2010 and adjusted its income tax liability for those years. The Department assessed Taxpayer an underpayment penalty for 2009 tax year as a result of the audit's adjustments. Taxpayer has provided sufficient documentation demonstrating that the imposition of the underpayment for 2009 tax year is not appropriate.
As to the underpayment penalty for the 2011 tax year, Taxpayer explains that although the Department did not audit Taxpayer's 2011 return, it prepared its 2011 return following the audit methodology. Thus, Taxpayer contends that the underpayment penalty for 2011 tax year is not appropriate.
Upon reviewing the Department's records, however, the Department is not able to agree. First, the underpayment penalty at issue is not related to the Department's audit adjustments. Thus, whether Taxpayer prepared its 2011 return following the audit's methodology is not relevant. Taxpayer is required to timely remit estimated income tax before the statutory due date. Second, the Department's records show that, previously, Taxpayer has timely made its quarterly estimated payments in April, June, and September 2010 for the 2010 year; however, it made only a $1,000 estimated payment, in April 2011, for the tax year 2011. Taxpayer in this instance did not provide any documentation to demonstrate a reasonable cause for penalty waiver.
In short, Taxpayer's protest of the 2009 underpayment penalty is sustained, but its protest of the 2011 underpayment penalty is denied.
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