Colorado Issues Guidance on Application of Factor Presence Nexus Rules

A taxpayer may have nexus in Colorado if more than $500,000 of its sales are sourced to the state, even if the taxpayer does not have a physical presence there.

By Jess Johannesen, SALT manager

Several states, including Colorado, have enacted laws in which out-of-state companies can establish income tax nexus without any physical presence in the state, known as “factor presence nexus.” [1] These “factor presence nexus” rules state that a taxpayer has income tax nexus if the taxpayer’s property, payroll or sales/gross receipts exceed a certain level. Therefore, an important consideration in applying these rules is how a state sources its sales (e.g., when is a sale considered a Colorado sale vs. an out-of-state sale). Colorado, one of these factor presence nexus states, recently released a General Information Letter (“GIL”) that discusses how a franchisor would source certain types of sales arising from its franchisor-franchisee model when considering the state’s factor presence nexus laws. [2]

The franchisor is located outside of Colorado and sells franchises which sell products that clean cooking oils in restaurants and other commercial cooking facilities. While a franchisee may be located in Colorado, the franchisor executes the franchise agreement, provides training and receives the franchise fee for the machinery and territory rights all outside of Colorado. Additionally, the franchisee brings a franchisee-owned van to the franchisor’s location outside of Colorado to have the equipment installed and advertising placed on the van. Once the franchisee begins operations, it may purchase additional services and supplies from the franchisor, and it pays monthly royalty fees and monthly advertising fees to the franchisor. The franchisee may also purchase from the franchisor items that are resold to the franchisee’s customers, including cooking oil, cleaning chemicals, and trays and filters for restaurant refrigerators. Lastly, the franchisor and franchisee share in the profits from servicing the disposal of used cooking oil.

Colorado regulations provide that income tax nexus is established for an out-of-state company if it has more than $500,000 of sales sourced to the state or if at least 25 percent of its total sales are sourced to the state. [3] This same regulation also provides the methodology for sourcing various types of sales to the state, and the Colorado GIL discusses these sourcing methodologies as they relate to the franchisor’s revenue streams: [4]

  • When determining whether the franchisor’s Colorado-sourced sales exceed the $500,000 threshold, the franchise agreement is considered an intangible and sourced to Colorado if the franchisor knows that the primary use will be in Colorado. Therefore, payments received from Colorado franchisees pursuant to the agreement (including royalty payments and territory fees) will be sourced to Colorado because the trademark or tradename is primarily used in the state.
  • The monthly fees received from franchisees for advertising, however, are likely treated as the sale of a service and would be apportioned amongst the franchisee states to represent the proportionate usage of the franchisor’s advertising service in Colorado.
    The franchisor’s training of the franchisees is also considered a service, but this would be sourced entirely outside of Colorado since the training occurs at the franchisor’s location.
  • The franchisor’s sales of equipment and supplies shipped to a Colorado franchisee will also be sourced to Colorado while any sales of such tangible property shipped to other franchisees located outside of Colorado would not be counted towards the $500,000.
  • Lastly, the GIL did not provide guidance regarding the sourcing of the used cooking oil disposal service, but this service would likely be sourced similarly to the monthly advertising fees which are apportioned amongst the franchisee states to represent the proportion of the disposal service used specifically in Colorado.

If the franchisor’s Colorado-sourced sales described above do exceed $500,000, then the franchisor must comply with Colorado’s income tax laws and file Colorado income tax returns. Although the franchisor represented does not have property or payroll located in Colorado, the franchisor’s entire business income earned from all of its franchisees could be subject to Colorado taxation, subject to apportionment.

Although companies generally determine their state tax nexus primarily based on their physical presence among the states, this GIL illustrates that companies must consider their economic presence as well. Aprio’s SALT team has experience assisting companies in evaluating their state tax nexus profile, including these factor presence nexus rules. We regularly monitor nexus and other state tax developments and will include any significant updates in future issues of the Aprio SALT Newsletter.

Contact Jess Johannesen, SALT manager, at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

[1] Other states that have factor presence nexus rules include California, Connecticut, Michigan, New York, Ohio (for the Commercial Activity Tax) and Washington (for certain classifications of its Business & Occupation Tax).

[2] Co. Dept. of Revenue GIL-16-004, 05/03/2016. The Colorado Department of Revenue issues general information letters and private letter rulings. A general information letter provides an overview of tax issues and is not binding on the Department. A private letter ruling provides a specific determination for a specific set of facts, is binding on the Department but not on the taxpayer and requires payment of a fee.

[3] Colo. Code Regs. §39-22-301.1(2(b).

[4] Colo. Code Regs. §39-22-301.1(2)(c)(iii).

This article was featured in the October 2016 SALT Newsletter. To view the newsletter, click here.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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