Many states have enacted or are considering laws that expand the definition of “nexus,” the legal term for the presence of a business in the state that triggers an obligation to collect and remit taxes on sales sourced to the state. Out-of-state businesses can become obligated to collect sales taxes for practices such as allowing returns of Internet purchases at brick-and-mortar stores or paying an in-state business a commission for an ad on its web site that generates a sale when a user clicks through (referred to as click-through nexus).
The ruling raises more questions for multistate restaurant franchises that it can begin to answer.
A recent letter ruling by the Missouri Department of Revenue (Letter Ruling Number 7686) described a situation that could trigger a variety of sales tax obligations for the parties involved. The guidance focuses on the use of a touch-screen tablet that restaurant customers will use to order food and also to access premium content through the restaurant’s virtual private network for an additional fee. This premium content includes access to news, sports, social media, music, and interactive games. This ruling applies specifically to one company with multiple locations in Missouri, yet this is not just a Missouri issue. If you think more broadly about how a similar situation could arise for a franchisor with franchisees in multiple states, you’ll see that the ruling raises more questions for multistate restaurant franchises that it can begin to answer.
Imagine a similar plan to implement tablet menus with premium content at a restaurant franchise with the following structure:
- Franchisor: Delaware corporation, nexus in IL, MI, and OH
- Franchisor’s distribution subsidiary: Illinois corporation, nexus in IL
- Individual franchisees: Ohio, Illinois, Michigan corporations each with nexus in home state
- Tablet seller: Texas corporation, no nexus in IL, MI, or OH
- Software provider/updater: California corporation, no nexus in IL, MI, or OH
- Premium content provider: New York corporation, no nexus in IL, MI, or OH
Who buys or leases the tablets?
The first layer of complexity arises from the physical tablets. Each of the following possible scenarios could generate a different answer to the question of who owes sales or use tax and where:
- Franchisor instructs distribution company to buy tablets and resell to franchisees.
- Franchisor instructs distribution company to buy and then lease tablets to franchisees.
- Franchisor instructs franchisees to buy or lease tablets directly from Texas tablet seller.
Because each state applies its own rules to transactions, the franchisor could choose one structure for this deal and find that it has different sales tax obligations depending on the location of the franchisee. For instance, leasing the tablets to franchisees could be exempt from sales or use tax in one state but subject to tax in another. Taxation of the lease may also depend upon whether sales or use tax was paid when the tablet was purchased by the lessor. Many states like Missouri and Michigan allow the lessor to either purchase the tablets exempt from tax and then charge tax on the lease revenue stream, or to pay tax on the purchase of the tablets, relieving them from having to charge tax on the lease. Other states like Illinois do not allow for that option and require tax to be paid on the purchase by the lessor.
What about the software?
Tablet devices like these will always require software updates and upgrades. If someone pays for those upgrades, sales tax obligations may attach. But in order to figure out who owes that tax and where, there are many questions to answer, like:
- Does the franchisor pay for the updates and host software on its servers for download by franchisees?
- Do franchisees contract directly with the software provider for updates?
- Do franchisees update software via cloud connections, a digital download, or a hard disk delivered to them?
- If updates are cloud based, where is the server that hosts them?
- Are the software updates separately stated on the invoice from other possibly nontaxable maintenance services such as phone support, and does that matter?
What happens when customers use premium content or click on ads?
Restaurants that implement tablet menus with premium and/or ad content are looking for an additional stream of revenue from existing customers. The states where those restaurants reside will need to determine if sales tax rules apply by asking questions such as:
- Who gets the revenue from premium content? All or part of the revenue could go to the franchisee in-state, the Illinois distributor, the Delaware holding company, the Texas tablet seller, and/or the California software company. Who owes what where?
- If a customer clicks an ad on the tablet and makes a purchase, could the customer create nexus between the seller and the state where none previously existed?
The goal this article is not to try to answer these questions. Any answers will depend on specific facts and circumstances in each transaction. The goal here is to give you some idea of how many questions a transaction like this can raise. As technology makes consumers more mobile and states continue to enforce existing sales tax rules and expand the reach of those rules to reflect the modern economy, this issue will only get more complex. For help understanding how sales tax and nexus rules may apply to your business, please give us a call.