Does an out-of-state franchisor owe New Mexico gross receipts tax on the royalty and advertising fees it collects from its New Mexico franchisees?

View original ruling (PDF)

Plain-English summary

Long John Silver's, Inc. is a Delaware/Kentucky quick-service seafood franchisor. It had no offices, employees, or company-owned stores in New Mexico — only 21 franchisee-owned restaurants operating under its trademarks and "System." From those franchisees it collected a 4% royalty fee, a 5% advertising fee (paid to its affiliate, Abbott Advertising), plus initial franchise and grand-opening fees. After a desk audit, the Department assessed $367,108.07 in gross receipts tax, plus penalty and interest, on those fees for January 1988 through June 1994 (Assessment No. 1880539). Long John Silver's protested, arguing it wasn't doing business in New Mexico, lacked nexus, and that the fees mostly paid for services performed out of state.

The Hearing Officer denied the protest in full:

• Franchise fees are rent for leasing intangible property in New Mexico. New Mexico defines "property" to include franchises (§ 7-9-3(I)) and defines "leasing" by where property is employed, not where it sits (§ 7-9-3(J)). Under a 1979 trilogy of New Mexico Court of Appeals cases — AAMCO Transmissions, American Dairy Queen, and Baskin-Robbins — franchise fees paid by in-state franchisees to out-of-state franchisors are taxable lease receipts. Long John Silver's franchise (its trademarks and whole operating "System") is employed in New Mexico, so the fees are taxable.
• The 1991 "license" amendment didn't change that. Long John Silver's argued a 1991 change — that granting "a license to use property is the sale of a license and not a lease" — meant no taxable lease. But § 7-9-3(I) still lists franchises separately from licenses; a franchise is more than a bare trademark license, it's an entire bundle of rights and obligations. So it remains leasable property.
• Substantial nexus existed. Under Quill, the Commerce Clause needs some physical presence. Long John Silver's had it: its regional director visited New Mexico franchises about 30 days a year, quality-assurance staff inspected every ~18 months, and it owned tangible property (operating manuals, videotapes) and had its trademarks/System employed in the state.
• You can't slice the fee into out-of-state services. The franchise is a non-negotiable package — franchisees can't opt out of training, design, or advertising for a discount. The fee is tied entirely to the New Mexico franchisees' in-state sales, not measured by out-of-state services (the Hearing Officer compared it to buying a Sony TV — you're buying the set, not the R&D and shipping done elsewhere). The taxpayer's appraisals purporting to attribute 60% of the royalty to "services" were found unreliable and arbitrary.
• Even the advertising fee was taxable — the hard question. Advertising is a service, done out of state, and the Department had earlier ruled some franchisors' advertising fees non-taxable. But because Long John Silver's controlled the advertising program (franchisees didn't administer or approve it, unlike in the earlier rulings), the advertising fee was integral to the franchise system being leased, not a service the franchisees separately bought. Routing it through affiliate Abbott Advertising didn't matter — Long John Silver's still received the money or "other consideration."
• No double-tax defense, and the penalty stood. The franchisees paying gross receipts tax on their food sales doesn't cover the franchisor: two taxpayers, two separate transactions. And because the law had been settled since 1979 and the company offered no explanation for not reporting, the negligence penalty was upheld (cooperating during the audit is not a defense).

What this means for you

Out-of-state franchisors with New Mexico franchisees

If franchisees operate under your trademarks and system in New Mexico, New Mexico treats your royalty and advertising fees as rent for leasing intangible property in the state — and taxes them, even though you're based elsewhere and do most of your work out of state. Being a "license" won't save you if what you grant is a full franchise. And a controlled, mandatory advertising fee is generally taxed as part of the franchise, not excused as an out-of-state service. Budget for New Mexico gross receipts tax on these fee streams and register accordingly.

Franchisees in New Mexico

This decision taxes the franchisor, not you again — but understand that the franchisor's fees are a separate taxable transaction from the gross receipts tax you already pay on your restaurant sales. The two don't offset. If your franchisor hasn't been collecting or paying, a New Mexico assessment against it doesn't reduce your own gross receipts tax obligations.

Businesses relying on out-of-state structure or old rulings

Physical presence can be modest and still be "substantial nexus" — periodic representative visits plus trademarks and manuals in the state were enough here. And a Department ruling issued to another taxpayer doesn't bind the Department as to you (§ 7-1-60 estoppel protects only the addressee); the Department can revisit an issue with better facts or analysis. Don't rely on someone else's favorable ruling.

Accountants and tax professionals

This is the leading modern application of the 1979 AAMCO / Dairy Queen / Baskin-Robbins franchise trilogy, and it extends the analysis to a controlled advertising fee and to the 1991 "license" amendment to § 7-9-3(J). Key takeaways: franchises are statutorily distinct from licenses (§ 7-9-3(I)); "leasing" turns on where property is employed (§ 7-9-3(J)); the § 7-9-3(K) predominant-ingredient/service test doesn't apply once fees are characterized as lease receipts; component-valuation appraisals are weak evidence where no market exists for the segregated pieces; and the § 7-1-17(C) presumption of correctness reaches the penalty, which the taxpayer must affirmatively rebut.

Common questions

Q: We're an out-of-state franchisor with no New Mexico office — how do we owe New Mexico tax?
A: New Mexico taxes the franchise fees as receipts from leasing your franchise (an intangible property) that your franchisees employ in New Mexico. Where you're located doesn't control; where the property is used does. Periodic visits by your representatives plus your trademarks and manuals in the state also gave you substantial nexus under the Commerce Clause.

Q: Most of what the fee pays for — training, R&D, advertising — happens out of state. Doesn't that make it untaxable?
A: No. The franchise is a single non-negotiable package tied to your franchisees' in-state sales, not a fee measured by out-of-state services. New Mexico taxes it as lease income of the franchise as a whole, and the Hearing Officer rejected appraisals trying to carve the fee into separately-located service components.

Q: Why was the advertising fee taxable when advertising is a service done elsewhere?
A: Because Long John Silver's controlled the advertising program and franchisees couldn't opt out or direct it — so it was part of the franchise system being leased, not a service the franchisees separately purchased. In earlier rulings where a franchisee advisory group ran the ad fund, the result was different; control was the deciding factor here.

Q: Our franchisees already pay New Mexico gross receipts tax on their sales — isn't that double taxation?
A: No. There are two separate taxpayers and two separate transactions: the franchisees are taxed on selling food, and the franchisor is taxed on leasing intangible property. One doesn't relieve the other.

Q: Does this decision apply to my situation?
A: Not directly. A Decision and Order resolves one taxpayer's protest on its specific facts and the law in effect at the time. It illustrates how New Mexico taxes franchise fees and analyzes nexus, but your facts may differ.

Citations and references

Statutes and regulations:

• § 7-9-3(F) NMSA 1978 — "gross receipts" is the total money or value of other consideration from selling or leasing property in, or performing services in, New Mexico
• § 7-9-3(I) NMSA 1978 — "property" includes real and tangible personal property, licenses, franchises, patents, trademarks, and copyrights (franchises listed separately from licenses)
• § 7-9-3(J) NMSA 1978 — "leasing" is any arrangement whereby, for consideration, property is employed for or by someone other than the owner (with the 1991 exception that granting a license to use property is a sale of a license, not a lease)
• § 7-9-3(K) NMSA 1978 — "service" means activities that predominantly perform a service as distinguished from selling or leasing property
• § 7-1-17(C) NMSA 1978 — a tax assessment, including penalty, is presumed correct
• § 7-1-69(A) NMSA 1978 — 2% per month penalty (max 10%) for failure to pay due to negligence
• § 7-1-60 NMSA 1978 — the Department is estopped only as to the taxpayer to whom a regulation/ruling relief was personally addressed; § 7-1-5(B)(2) — a "ruling" is of limited application to one or a few taxpayers; § 7-1-24 — protest procedure; § 7-1-4 — taxpayers must make records available
• Regulation 3 NMAC 2.1.7.5 — defines a franchise; Regulation 3 NMAC 1.11.10 — defines negligence

Case law cited:

• AAMCO Transmissions, Inc. v. Taxation and Revenue Department, 93 N.M. 389, 600 P.2d 841 (Ct. App. 1979); American Dairy Queen Corp. v. Taxation and Revenue Department, 93 N.M. 743, 605 P.2d 252 (Ct. App. 1979); Baskin-Robbins Ice Cream Co. v. Revenue Division, 93 N.M. 301, 599 P.2d 1098 (Ct. App. 1979) — franchise fees paid by New Mexico franchisees to out-of-state franchisors are gross receipts from leasing property employed in New Mexico
• Quill Corp. v. North Dakota, 504 U.S. 298 (1992) — distinguishes Due Process "minimum contacts" from Commerce Clause "substantial nexus" (physical presence)
• Scripto, Inc. v. Carson, 362 U.S. 207 (1960); Tyler Pipe Industries v. Washington State Dept. of Revenue, 483 U.S. 232 (1987); Wheeling Steel Corp. v. Fox, 298 U.S. 193 (1936); Curry v. McCanless, 307 U.S. 357 (1939) — presence establishing a market, and taxation of intangibles used in a state other than the domicile
• Tiffany Construction Co. v. Bureau of Revenue, 90 N.M. 16, 558 P.2d 1155 (Ct. App. 1976) — the presumption of correctness applies to penalty; duty to ascertain tax consequences
• Markham Advertising Co. v. Bureau of Revenue, 88 N.M. 176, 538 P.2d 1198 (Ct. App. 1975); Mountain States Advertising, Inc. v. Bureau of Revenue, 89 N.M. 331, 552 P.2d 233 (Ct. App. 1976) — advertising is treated as a service under New Mexico law

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Long John Silver's, Inc.
• Decision PDF: D&O 98-16

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
LONG JOHN SILVER’S, INC. NO. 98-16
ID. NO. 01-824513-00 7, PROTEST TO
ASSESSMENT NO. 1880539

DECISION AND ORDER

This matter came on for formal hearing before Gerald B. Richardson, Hearing

Officer, on May 20-22, 1997. Long John Silver’s, Inc., hereinafter, “Long John Silvers”

or “Taxpayer”, was represented by Curtis W. Schwartz, Esq. and Timothy C. Holm, Esq.

of Modrall, Sperling, Roehl, Harris & Sisk, P.A. The Taxation and Revenue Department,

hereinafter, “Department”, was represented by Bridget A Jacober, Esq. At the close of

the hearing, the parties were requested to file briefs and proposed findings of fact and

conclusions of law. The last pleading was filed on February 2, 1998 and the matter was

submitted for decision at that time. The parties have granted the Hearing Officer an

additional thirty days beyond the thirty days specified by Section 7-1-24(H) NMSA 1978.

Based upon the evidence and the arguments presented, IT IS DECIDED AND

ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. Long John Silver’s Restaurants, Inc., hereinafter, “Restaurants, Inc.” is a

privately owned Kentucky corporation and holding company which holds or owns 100%
of the stock of six subsidiary corporations, including that of the Taxpayer, Long John

Silvers.

2. Prior to being taken private in late 1989 through a highly leveraged buyout,

the entity that became Restaurants, Inc. was known as Jerrico, Inc.

3. QSC, Inc. is a Delaware corporation, which is a wholly-owned subsidiary of

Restaurants, Inc., which holds the Long John Silver’s trademarks and tradename and

licenses them to Long John Silver’s.

4. Long John Silver’s, is a Delaware corporation which is a wholly owned

subsidiary of QSC, Inc.

5. Abbott Advertising Agency, Inc., hereinafter, “Abbott Advertising” is a

Kentucky corporation which is a wholly owned subsidiary of Restaurants, Inc.

6. Kentucky is the principal place of business and commercial domicile of

Restaurants, Inc., Long John Silver’s, and Abbott Advertising.

7. Lexington, Kentucky is the principal place from which the businesses of both

Long John Silver’s and Abbott Advertising are operated.

8. In 1969, Jerrico, Inc. formed Long John Silver’s as a wholly-owned

subsidiary, to own and operate its new quick service seafood concept. Long John Silver’s

does so by owning and operating its own Long John Silver’s Seafood Shoppes and by

franchising that concept to franchisees.

9. After the leveraged buyout of Jerrico, Inc. and because of the large amount of

debt now being carried by Restaurants, Inc., there was not capital available to open or

acquire more company owned stores. Thus, the only available way to expand the Long

John Silver’s restaurant chain was to expand through franchising, which uses other

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people’s capital, and this became the business strategy of Restaurants, Inc. and Long John

Silver’s.

10. During the audit period, January 1, 1988 through June 30, 1994, there were

approximately 1500 Long John Silver’s restaurants, of which approximately 1000 were

company owned and operated stores and approximately 500 were owned and operated by

franchisees.

11. The concept of franchising has evolved over time. Initially, most franchising

was of a type called product and trade name franchising. This type of franchise

agreement involved licensing of trade names and trademarks, granting exclusive rights to

use those trade names and trademarks in a designated area and granting rights to sell the

products associated with those trade names and trademarks. Examples of this type of

franchising were gasoline service stations and soft drink bottlers.

12. After the second world war, a new type of franchising concept evolved, with

McDonald’s hamburger franchises representing a prime example of this type of franchise

agreement. The new concept is called business format franchising, which involves a

complete package of resources, including trademarks and trade names, company products

and systems, as well as services that a franchisee would need to succeed in business.

13. The business format type of franchising agreement is premised upon the

mutual interests of both the franchisor and the franchisees in the overall success of the

particular business being franchised. This concept is called “business partnering”. In the

context of Long John Silver’s franchising business, it means that the success of Long

John Silver’s franchisees enhances the success of Long John Silver’s and the success of

Long John Silver’s enhances the success of Long John Silver’s franchisees.

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14. Long John Silver’s is a business format franchisor in the quick service seafood

restaurant segment of the fast food franchise industry, and, in fact, is the leader of that

segment of the industry.

15. Long John Silver’s Franchise Agreement with its franchisees provides that it

“is the developer of and sole and exclusive owner of a distinctive food service system

(hereinafter, “the System” under which food is sold to the public from restaurants

operated under the name “Long John Silver’s Seafood Shoppes” (hereinafter, “LJS

Restaurants”).” The agreement lists the elements of “the System” to include:

a) methods and procedures for the preparation and serving of food and

beverage products;

b) special ingredients, confidential recipes, a secret batter mix and

distinctive service accessories such as uniforms, menus, packages,

containers and paper and plastic items;

c) methods of achieving quality control, quantity control and procedures

designed to be advantageous to LJS Restaurant operators and consumers;

d) plans and specifications for distinctive standardized premises,

addressing both interior and exterior design and decor, equipment layout

and signage;

e) a uniform method of operating as described in the Long John Silver’s

confidential operating manual;

f) distinctive and characteristic trademarks and service marks, signs,

designs and emblems (called “Proprietary Marks”);

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g) a public image that each restaurant is a unit in an established franchise

system and that all restaurants are operated with uniform standards of

service and product quality and portions; and

h) exclusive copyrights and trade secrets as are owned or may be

developed by Long John Silver’s.

16. Long John Silver’s franchisees entering into the Franchise Agreement

acknowledge that they wish to obtain a franchise to operate a Long John Silver’s

restaurant pursuant to “the System” described above and to be afforded the training and

other assistance provided by Long John Silver’s in connection with operating such a

restaurant. The franchisee further acknowledges and accepts the terms and conditions as

set forth in the Franchise Agreement as being reasonably necessary to maintain Long

John Silver’s high and uniform standards of quality, service and portions designed to

protect the good will and enhance the public image of the “Proprietary Marks” and “the

System”, and the franchisee agrees to open and operate the franchised restaurant in

faithful compliance with the uniform standards and specifications of Long John Silver’s

and to diligently promote the interests of “the System” during the term of the agreement.

17. The Franchise Agreement describes the franchise granted the franchisee as the

right to build and operate a Long John Silver’s restaurant and to use “the System” for a

specified period and at a specified location, to use Long John Silver’s “Proprietary

Marks”, and to represent to the public that the franchisee’s restaurant is part of the Long

John Silver’s “System”.

18. The specific requirements the Franchise Agreement require that the

franchisee:

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a) sell and serve only food and beverage products listed as standard menu

items in the confidential manual and which meet Long John Silver’s

uniform standards of quality and portions and which are prepared in

accordance with the recipes and food handling and preparation methods

found in the confidential manual;

b) purchase secret recipe items only from Long John Silver’s or an

approved source;

c) purchase food products, paper, plastic goods and service items which

conform to the specifications and standards of Long John Silver’s and are

included in approved lists of brands, unless prior written approval from

Long John Silver’s has been obtained;

d) purchase for its employees’ use uniforms and costumes which conform

to Long John Silver’s specifications;

e) operate the restaurant in strict accordance with the confidential manual;

f) pay the designated royalty fee and advertising fee called for in the

agreement in a timely manner;

g) follow Long John Silver’s cost control procedures, use its format for

charts of accounts and for reporting receipts.

h) construct its restaurant in strict compliance with plans either prepared

or approved by Long John Silver’s;

i) maintain the franchised restaurant premises and all equipment in

conformity with the high standards and public image of Long John Silver’s

and the System, including keeping the restaurant in the highest degree of

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sanitation, and to make no additions or alterations to the restaurant without

prior written consent from Long John Silver’s;

j) operate the restaurant for at least the minimum hours and days

prescribed in the confidential manual; and

k) comply with the training specified by Long John Silver’s for the

franchisees’ managers and employees.

19. The Franchise Agreement also specifies a number of services, benefits and

materials which the franchisor agrees to provide the franchisee, including:

a) written guidelines for site selection and lease evaluation;

b) standard plans, drawings and specifications for the franchised

restaurant;

c) standard layouts and specifications for fixtures, furnishings, interior

design and decor, signs and equipment pursuant to the System;

d) such pre-opening assistance as Long John Silver’s deems necessary for

the franchisee to meet system standards;

e) pre-opening management training and other training for such periods as

may be designated by Long John Silver’s;

f) on-site opening assistance;

g) one copy of the confidential manual, with periodic updates

h) a sample of Long John Silver’s standardized chart of accounts,

statement of earnings and balance sheet;

i) regular and continuing supervisory services and periodic inspections

and evaluations of the franchisee’s operation;

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j) Long John Silver’s marketing and advertising programs; and

k) reasonable efforts by Long John Silver’s to disseminate to suppliers

designated by the franchisee, the System standards and specifications for

non-secret food products and equipment.

20. In addition to the services outlined in the Franchise Agreement, in the course

of dealing between Long John Silver’s and its franchisees, other services are provided as

well. Many of these same services are also provided to Long John Silver’s company

owned restaurants. Those services include:

a) strategic planning to ensure that Long John Silver’s restaurants keep up

with changing consumer demands and tastes, changing consumer

demographics, new food technologies, new information technologies, etc.

to better market and sell Long John Silver’s product;

b) consultation and advice, primarily given by regional directors of

franchise operations, can also come from Long John Silver’s legal

department, public relations department, etc.;

c) quality assurance, through inspections of all Long John Silver’s

restaurants, inspection of Long John Silver’s seafood, etc., to assure the

quality and consistency of the Long John Silver’s meal experience;

d) post opening design services to update restaurant decor, layout, and

incorporate new concept changes, such as adding drive-up windows, etc.;

e) governmental relation services, such as lobbying congress on issues

affecting Long John Silver’s operations and providing restaurants with

legislative updates;

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f) training;

g) organizational buying power and procurement services for the food,

paper products and restaurant equipment.

21. Long John Silver’s maintained a training center in Lexington, Kentucky,

known as the Jerrico Center, until October, 1992. The Jerrico center was used to train

company and franchisee employees including executive, managerial and supervisory

employees. After the closing of the Jerrico Center, managerial training has been

performed at Long John Silver’s company owned restaurants. Because there are no Long

John Silver’s company owned restaurants located in New Mexico, the managerial training

for Long John Silver’s New Mexico franchisees took place out of state.

22. Franchisees’ opening managers and all successor managers and assistant

managers must successfully complete a training program prior to assuming the position of

manager or assistant manager of a franchised restaurant.

23. Franchisees are responsible for all expenses of travel, employee salaries and

room and board for their employees receiving training. Additionally, franchisees are

charged a fee to cover the operational costs of the training program in accordance with

the Franchise Development Guide provided to franchisees. Because of this, the cost of

this service is paid for by the franchisees independently of the royalty fee they pay to

Long John Silver’s.

24. Organizational buying power and procurement services involve the processes

and people at Long John Silver’s who develop supplier relationships and sources for the

food products and supplies needed in the Long John Silver’s restaurants and which

ensures a stable and predictable supply of these products, and the uniformity and quality

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of the products. The maintenance of a distribution network and relationships with

suppliers also affords the benefits of low prices to those who purchase through the

network because of volume discounts which are negotiated by Long John Silver’s. The

availability of a stable and predictable supply is especially important with regard to the

fish products sold by Long John Silver’s and its franchisees because of global shortages,

seafood diseases, and other factors which affect the source and supply of this product.

Long John Silver’s purchases these products, and sells them to an independent distributor,

Martin-Brower, or ProSource, which then distributes and sells these products to both

Long John Silver’s company owned stores and to franchisees.

25. Participation in the Long John Silver’s purchasing system is voluntary. Long

John Silver’s company owned restaurants purchase more than 95% of their food products,

restaurant supplies and related goods from Martin-Brower. Franchisee owned restaurants

purchase in the aggregate 80% of their food products, restaurant supplies and related

goods from Martin-Brower.

26. Long John Silver’s applies a mark up to the price it sells products to Martin-

Brower or ProSource to cover its costs of managing and running its procurement system.

Thus, the cost of this service is paid for by the franchisees independently of the royalty

fee they pay to Long John Silver’s.

27. The vast majority of the services provided by Long John Silver’s to its

franchisees are performed at Long John Silver’s Lexington, Kentucky headquarters or

other out-of state locations. Essentially, the only services performed in New Mexico are

those services, such as on site opening assistance and on site consultation, inspection and

the limited training provided by the regional Director of Franchise Operations and Long

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John Silver’s quality assurance personnel, which are performed in New Mexico with

respect to Long John Silver’s New Mexico franchisees.

28. During the early 1990’s Long John Silver’s developed a state of the art point

of sale software information system. It is a restaurant operating system which can be

used, among other things, for forecasting, for controlling both food and labor costs and

for quality control. Long John Silver’s licenses the point of sale software to franchisees

for $1. Franchisees are under no obligation to use the point of sale software.

29. Long John Silver’s receives thousands of inquiries annually from persons

interested in becoming Long John Silver’s franchisees. In selecting franchisees, Long

John Silver’s requires potential franchisees to have both business acumen and financial

resources. The financial resources required are a minimum net worth of $350,000 and

liquid assets of $150,000. Long John Silver’s looks more to whether a potential

franchisee has demonstrated good business expertise over time, rather than whether the

person has prior restaurant experience because Long John Silver’s business format

franchise concept provides detailed guidance on all of the basics of running a Long John

Silver’s restaurant.

30. All Long John Silver’s franchise agreements relating to franchises in New

Mexico were executed by Long John Silver’s in Kentucky.

31. All Long John Silver’s franchise agreements provide for an initial franchise

fee, a grand opening fee, an advertising fee and a royalty fee.

32. In 1988, the beginning of the audit period, the initial franchise fee for a

standard restaurant was $12,500. By the end of the audit period, 1994, the fee had been

raised to $20,000.

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33. All new franchisees are obligated to pay a grand opening fee of $2,000. The

grand opening fee is used for advertising and promotional materials benefiting the new

restaurant which is opening. The franchisee agreement requires that this payment be made

to Long John Silver’s or its designee. The franchisee pays this fee directly to Abbott

Advertising, as the designee of Long John Silver’s.

34. The Franchise Agreement requires that franchisees pay Long John Silvers a

royalty fee equal to 4% of the franchisees’ gross receipts from the operation of the

franchised restaurant, payable monthly. The Franchise Agreement does not specify,

designate, break down or tie in the royalty fee to any particular services, benefits or

trademarks and trade names provided under “the System” which is being franchised.

35. Occasionally, Long John Silver’s has had a program under which between 1%

and 2% of the 4% royalty fee (one-quarter to one-half of the royalty fee) is diverted into

the Abbott Advertising client account for the individual Long John Silver’s owned or

franchisee-owned store for the first twelve months of the new store’s operation to

promote that new restaurant in its local area.

36. The Franchise Agreement requires franchisees to pay an advertising fee equal

to 5% of gross receipts from the operation of a franchised restaurant, payable monthly.

The fee is for advertising and marketing programs. The Franchise Agreement requires

franchisees to pay the advertising fee to Long John Silver’s or its designee. Franchisees

pay this fee directly to Abbott Advertising, as designee of Long John Silver’s.

37. The Franchise Agreement requires that Long John Silver’s make an equal

contribution for advertising for each of its company owned stores as the franchisees are

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required to make under the Franchise Agreement, and Long John Silver’s made those

contributions during the audit period.

38. Under the terms of the Franchise Agreement, the franchisee recognizes the

value of advertising and the importance of advertising to further the goodwill and public

image of the long John Silver’s System. The franchisee further agrees that Long John

Silver’s or its designee conducts, determines, maintains and administers all national,

regional, local and other advertising and marketing and has sole discretion over the

concepts, materials, media, nature, type, scope, frequency, place, form, copy layout and

context of such advertising and marketing. The franchisee also acknowledges that

advertising expenditures are intended to maximize general public recognition and

acceptance of all Long John Silver’s restaurants which are part of the Long John Silver’s

system and that Long John Silver’s does not warrant or represent that any particular

restaurant, including the franchisee’s restaurant will benefit directly or pro-rata from the

advertising.

39. The purpose of the advertising fee is to promote the products sold by Long

John Silver’s and its franchisees, to increase the sales of both Long John Silver’s and the

franchisees, to enhance Long John Silver’s reputation and to maximize general public

recognition of Long John Silver’s restaurants, its trademarks, trade names and products,

wherever they are displayed and sold.

40. Each franchisee and Long John Silver’s can contract with Abbott Advertising

for its services separate and apart from the 5% advertising fee paid by both franchisees

and Long John Silver’s on behalf of its company owned stores. This additional

advertising spending is called “investment spending”.

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41. Investment spending is totally optional. Many franchisees investment spend

and many don’t. Long John Silver’s generally investment spends on advertising in a

majority of its markets.

42. Although franchisees have no right under the franchise agreement to direct or

control the advertising done with the 5% advertising fee, Long John Silver’s from time to

time consults with its Franchisee Advisory Board concerning its advertising and

marketing strategies. Individual franchisees are also sometimes consulted and listened to

by Long John Silver’s with respect to its advertising and marketing campaigns and

strategies.

43. Abbott Advertising maintains separate client account records for franchisees

and Long John Silver’s, to account for the monthly 5% advertising fees and investment

spending .

44. Long John Silver’s and its franchisees are Abbott Advertising’s only clients.

45. Abbott Advertising does not itself develop advertising campaigns. It contracts

with outside advertising agencies and develops advertising campaigns and places media

advertising through those outside advertising agencies. During the audit period Abbott

Advertising contracted with Timerlin McClain of Dallas, Texas and Mark Advertising of

Pittsburgh, Pennsylvania.

46. The 5% advertising fees received by Abbott Advertising from franchisees and

Long John Silver’s company owned stores are expended by Abbott Advertising as

follows: 12% is allocated to the “Agency Fund”, 13% is allocated to the “Production

Fund” and 75% is allocated to the “Media Fund”.

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47. The Agency Fund is used to pay for creative consultants, consumer research,

field marketing, media commissions, salaries of Abbott Advertising employees and

general and administrative expenses of Abbott Advertising.

48. The Production Fund is used to pay for the production of radio and television

commercials, the design of print media advertisements and related expenditures.

49. The Media Fund is used for the purchase of local and national advertising.

Forty-four percent (44%) of the Media Fund, which represents 33% of the 5% advertising

fee, is used to purchase national cable network television advertising. The remaining

56% of the Media Fund is used to purchase local television, radio and print advertising.

50. Abbott Advertising did not directly place advertisements in the media. The

purchasing of media advertising was handled through the advertising agencies with which

Abbott Advertising contracted.

51. During the audit period the advertising done with the 5% advertising fee

emphasized Long John Silver’s products and prices, as opposed to strictly promoting

Long John Silver’s trademarks and trade names. Of course, all advertising was identified

with Long John Silver’s by including its trademarks and trade names.

52. The work and services performed by Abbott Advertising with respect to the

5% advertising fee were performed outside of New Mexico during the audit period.

53. The Franchise Agreement is a complete and non-negotiable package. A

person wishing to become a Long John Silver’s franchisee may not pick and choose the

terms of the agreement they wish to be bound to, but must agree to all of the terms of the

Franchise Agreement in order to become a franchisee.

15

54. Franchisees pay the full amount of royalty fee and advertising fee called for in

the Franchise Agreement regardless of whether they use or utilize all of the services

embedded in the Franchise Agreement.

55. Long John Silver’s employs several individuals who hold the title of Director

of Franchise Operations. There is one Director for every 40 to 60 Long John Silver’s

restaurants. They operate as a key communication link between Long John Silver’s and

its franchisees. They deliver training in the restaurants, they consult with franchisees to

identify problems, communicate changes in the Long John Silver’s system, observe and

ensure compliance with the Long John Silver’s operational manual and procedures, etc.

56. The Long John Silver’s Director of Franchise Operations assigned to its New

Mexico franchises during the audit period was Mr. Carlos Barrera. Mr. Barrera is based

in Dallas, Texas. During the audit period, he was in New Mexico visiting New Mexico

franchise operations approximately 30 days each year.

57. From time to time, other Long John Silver’s employees visit Long John

Silver’s franchised restaurants. For example, Long John Silver’s has “quality assurance”

personnel who visit every franchise restaurant approximately every 18 months. These

personnel go through a checklist of procedures to assure that the restaurant is in

compliance with the procedures and requirements of the operations manual.

58. Long John Silver’s maintains no offices in New Mexico and has no employees

based in or residing in New Mexico.

59. Long John Silver’s does not have any company operated stores in New

Mexico.

16

60. During the audit period Long John Silver’s had 21 franchisee owned and

operated restaurants in New Mexico. Those restaurants display and utilize the Long John

Silver’s trademarks and trade names in their operations in New Mexico.

61. Long John Silver’s does not own or lease equipment in New Mexico nor does

it directly sell goods or products to its franchisees in New Mexico.

62. Long John Silver’s has tangible personal property in New Mexico in the form

of its operating manuals, which are owned by Long John Silver’s and are located in each

of its franchisee owned and operated restaurants in New Mexico, and in the form of

manuals and videotapes related to Long John Silver’s point of sale system, which is used

by most of Long John Silver’s franchisee operated stores in New Mexico.

63. Long John Silver’s secret recipes are kept in Lexington, Kentucky.

64. Long John Silver’s franchise system is employed in New Mexico. During the

audit period, there were 21 Long John Silver’s restaurants in New Mexico, each of which

was franchisee owned and operated.

65. Twenty of the twenty-one Long John Silver’s restaurants in New Mexico are

owned and operated by American Seafood Partners, which is a general partnership

organized in the state of Kansas which is controlled by Mr. Hal McCoy. American

Seafood Partners has a separate franchise agreement with Long John Silver’s for every

franchised location it owns in New Mexico.

66. Long John Silver’s franchisees in New Mexico pay gross receipts tax on their

gross receipts from operating restaurants in New Mexico.

67. In 1988 Long John Silvers obtained an evaluation of the components of its

royalty stream for the sole purpose of determining a fair market royalty rate of its

17
trademarks and trade names. As noted earlier, QSC, Inc. owns the Long John Silver’s

trademarks and trade names and licenses them to Long John Silver’s. Thus, the

evaluation was to determine the percentage of the 4% royalty fee which could be

attributed to the use of Long John Silver’s trademarks and trade names, as opposed to the

portion relating to the use of other intangibles, such as trade secrets and recipes and

know how, and as opposed to the portion of the royalty fee representing services provided

as part of the franchise system.

68. The 1988 appraisal report concluded that 30% of the 4% royalty stream (the

equivalent of 1.2% of gross sales) represented a fair market royalty rate for the use of

Long John Silver’s trademarks and trade names. The other intangibles, namely trade

secrets, recipes and know how represented 20% of the royalty stream. The remaining

50% of the royalty stream was attributed to the costs or value of services covered by the

4% royalty fee. The appraisal attributed percentages to the various services as 20% for

franchise services, consisting of policing of franchises and inspection visits conducted to

ensure that standards are being maintained throughout the system; 10% for the purchasing

network and services to assist franchisees develop new restaurants; 15% for training and

5% for general and administrative services. The report goes on to state with reference to

the purchasing, development and training services, however, that since the costs

associated with those services are charged back to the franchisees, it would not be

appropriate to charge a royalty fee for the benefit of those services.

69. In 1997, Long John Silver’s had the same appraisal firm perform a similar

appraisal for use in connection with this litigation. Although the purposes stated in the

appraisal was the same as for the 1988 appraisal, namely to determine an arms length

18
royalty rate associated with the trademarks and trade names held by QSC, Inc., in fact, the

purpose was broader, and it was to provide an opinion of the component fair market

royalty rates underlying all of the intangible assets and services that form the overall 4%

royalty rate charged franchisees. The 1997 appraisal covered the 1989-1994 time period.

70. The 1997 appraisal concluded that the value of the Long John Silver’s

trademark had declined from 30% of the royalty fee to 20% due to such factors as the

increasingly competitive environment for quick service restaurants during this period of

time, the fact that fried foods became less popular for health reasons and the depressing

effect that the 1989 buyout had on corporate earnings since Long John Silver’s carried so

much additional debt load and costs associated with that debt load. The appraisal

retained the same values as the 1988 appraisal for the other intangibles, such as trade

names, trade secrets and recipes and know how, representing 20% of the royalty fee.

Thus, the 1997 appraisal concluded that the value of intangible assets represented by the

royalty fee had declined from 50% of the royalty fee to 40% of the royalty fee.

71. The 1997 appraisal determined that the value of franchise services (policing

and inspection services) remained at 20% of the royalty fee and general and

administrative services remained at 5% of the royalty fee. The value of procurement and

development services were increased by 15% to 25% of the royalty fee based upon what

the appraiser learned about the importance of Long John Silver’s purchasing program in

ensuring a reliable supply of fish. The value of training services was decreased by 5%

based upon the closing of the training center and on the appraiser’s new understanding

that most Long John Silver’s franchisees are already experienced operators. As a result

19
of these changes, the value of services was increased by 10% from representing 50% of

the royalty fee to 60%.

72. Because there is no market for Long John Silver’s trademarks and trade names

separate and apart from the services embedded in the Long John Silver’s franchise

agreement, any appraisal which purports to arrive at an arm’s length market value for the

separate components represented by the franchise royalty fee is highly subjective and

arbitrary.

73. The 1997 appraisal concluded that the value of Long John Silver’s trademark

had declined by 10% between 1988 and 1994 even though Long John Silver’s income

from franchise royalties increased from $10,544,000 in 1988 to $11,576,000 in 1994.

74. The 1988 and 1997 appraisals are not a reliable gauge of the value of the

services embedded in the franchise agreement and relationship between Long John

Silver’s and its franchisees because it attributes a portion of the franchise royalty fee to

services, such as procurement, restaurant development and training, even though the costs

of those services are paid for separately by the franchisees in addition to the royalty fee.

75. Business format franchising is essentially a business arrangement whereby a

franchisee agrees to sell goods or services in conformity with an entire business operating

system and procedures prescribed by the franchisor and pays a fee, usually in the form of

a percentage of sales, for the use of the business operating system and the trademarks,

trade names and other proprietary marks of the franchisor. In addition to providing the

franchisee a business operating system and the use of its proprietary marks, the franchisor

markets and promotes the franchise business, the trademarks, trade names and other

20
proprietary marks and polices the entire system to ensure the quality and consistency of

businesses operating under the franchise system.

76. Long John Silver’s franchisees do not obtain services under the Franchise

Agreement, but rather, they acquire the right to use a trademark with systems and

procedures which inherently protect and promote the Long John Silver’s trademark.

77. The essence of a franchise is that the franchisor and the franchisee share a

common goal of maximizing the value of the trademark, which represents the franchise

system. The franchisor and franchisee maximize the value of the trademark by selling

more product.

78. The franchisor’s and franchisees’ common goal of selling more product is

achieved by promotion and marketing and by policing, which ensures the quality and

consistency of the product sold.

79. Each of the services performed by Long John Silver’s under the franchise

agreement is essentially an effort to either promote or police the Long John Silver’s

franchise system.

80. Commencing in late 1993, the Department conducted a desk audit of Long

John Silver’s. A desk audit is one conducted by correspondence and exchange of

information between a taxpayer and the Department, without an actual site visit to the

taxpayer to examine a taxpayer’s books and records.

81. As a result of its audit, on December 28, 1994, the Department issued

Assessment No. 1880539 to Long John Silver’s. The assessment assessed $367,108.07 in

gross receipts tax, $36,710.67 in penalty and $189,076.45 in interest for the period of

January, 1988 through June, 1994.

21

82. On February 1, 1995 the Department granted Long John Silver’s an extension

of time, until March 28, 1995, to file a protest to Assessment No. 1880539.

83. On March 27, 1995 Long John Silver’s filed a timely, written protest to

Assessment No. 1880539.

84. The gross receipts tax portion of the assessment was assessed upon the total

amount of the 4% royalty fees Long John Silver’s received from its New Mexico

franchisees during the audit period, the 5% advertising fee paid to Long John Silver’s

designee, Abbott Advertising, by Long John Silver’s New Mexico franchisees, and the

initial fees and grand opening fees paid by New Mexico franchisees. Gross receipts tax

was not assessed on any amounts paid by New Mexico franchisees for investment

spending advertising.

DISCUSSION

The issue to be determined herein is whether, and to what extent, Long John

Silver’s is subject to gross receipts tax on the revenues it receives from its New Mexico

franchisees pursuant to its franchise agreements. Conceptually, this case turns on one

basic issue. Are the revenues Long John Silver’s receives pursuant to the franchise

agreement to be treated as receipts from leasing property in New Mexico, that property

being a franchise, which consists of a bundle of intangible property rights combined with

various services which promote and protect the value of that franchise, or are the

revenues to separately analyzed with respect to the imposition of tax according to each of

the separate services and activities incorporated in the franchise agreement between Long

John Silver’s and its New Mexico franchisees?

22
LONG JOHN SILVER’S HAS GROSS RECEIPTS FROM LEASING PROPERTY
IN NEW MEXICO

Although this case presents some nuances which have not been specifically

addressed, the basic issue of how New Mexico’s gross receipts tax applies to the

franchise fees paid to out-of-state franchisors by New Mexico franchisees has been

addressed and well established in New Mexico caselaw for nearly 20 years. In 1979, the

New Mexico Court of Appeals issued three decisions which govern the determination of

most of the issues raised in the instant matter, AAMCO Transmissions, Inc. v. Taxation

and Revenue Department, 93 N.M. 389, 600 P.2d 841 (Ct. App., 1979), cert. denied, 93.

N.M. 205, 598 P.2d 1165 (1979), American Dairy Queen Corp. v. Taxation and

Revenue Department, 93 N.M. 743, 605 P.2d 252 (Ct. App. 1979) and Baskin-Robbins

Ice Cream Co. v. Revenue Division, Taxation & Revenue Department, 93 N.M. 301,

599 P.2d 1098 (Ct. App. 1979).

In each of those cases, the taxpayers argued against the imposition of gross

receipts tax upon the revenues they received from their New Mexico franchisees, alleging

that they were not engaging in business in New Mexico and there existed insufficient

nexus to impose tax under the Due Process and Commerce Clauses of the Constitution on

the grounds that they were located out of state, that the franchise agreements were

executed out of state, that they had no employees residing in New Mexico and that they

had no property in New Mexico. The taxpayers in the AAMCO Transmissions and

Baskin-Robbins case also argued that the Department was imposing gross receipts taxes

upon services performed out of state in violation of the Due Process and Commerce

Clauses.

23
The Court of Appeals determined that each of the taxpayers were subject to gross

receipts tax for engaging in business in New Mexico. In arriving at this conclusion, the

court relied upon the definitions of “gross receipts”, “property” and “leasing” as found in

§§ 7-9-3(F)(I)and(J) respectively of the Gross Receipts and Compensating Tax Act.

Specifically, it relied upon the broad definition of “leasing”, which is defined as, “any

arrangement, whereby, for a consideration, property is employed for or by any person

other than the owner of the property”. § 7-9-3(J). It found that franchises were

specifically defined to be property, § 7-9-3(I), and it found that gross receipts included

money or consideration received from leasing property in New Mexico. The court also

found that the franchisors had property located in New Mexico in the form of intangible

property such as a significant financial interest in the goodwill and economic health of its

franchisees. Finally, the court was not persuaded that the Department was imposing a tax

on services performed out of state. Rather, what was being taxed were lease payments

completely tied to receipts earned from business conducted in New Mexico done under

the aegis of the franchisor’s trademarks.

Long John Silver’s argues that the AAMCO Transmissions, American Dairy

Queen, and Baskin-Robbins decisions no longer apply because in 1991, subsequent to

the Court of Appeals decisions, the legislature amended the definition of “leasing”, which

the Court of Appeals had relied upon in those decisions. Specifically, the definition of

leasing was amended to define leasing to mean, “any arrangement whereby, for a

consideration, property is employed for or by any person other than the owner of the

property, except that the granting of a license to use property is the sale of a license and

not a lease.” (emphasis supplied to language added by amendment). Further, Long John

24
Silver’s relies upon Department regulation 3 NMAC 2.1.7.5 (formerly GR 3(I):2) which,

in describing a franchise, states that, “The franchise usually conveys to the franchisee a

license to use the franchisor’s trademark or trade name in the operation of the

franchisee’s business.” Long John Silver’s then goes on to argue, based upon the

amended statute and regulation, that its franchise agreement amounted to a sale of a

license to use its intangibles, and since the agreement was executed outside of New

Mexico, that there was no taxable sale of property in New Mexico.

This argument overlooks the fact that the definition of “property”, as contained in

§ 7-9-3(I) remains unchanged from how it was written when the three franchising cases

were decided by the Court of Appeals. Section 7-9-3(I) defines property to mean, “real

property, tangible personal property, licenses, franchises, patents, trademarks and

copyrights. Tangible personal property includes electricity and manufactured homes;....”

(emphasis added). Franchises are specifically defined to be property and are listed

separately from licenses in the definition of property. Since the legislature is presumed

not to use surplus or unnecessary language in writing statutes, franchises are

presumptively different than mere licenses. That fact is born out if the full language of

regulation 3 NMAC 2.1.7.5 defining franchises is consulted. Long John Silver’s failed to

take note of the first sentence of the regulation which provides:

A ‘franchise’ is an agreement in which the franchisee
agrees to undertake certain business activities or to sell a
particular type of product or service in accordance with
methods and procedures prescribed by the franchisor, and
the franchisor agrees to assist the franchisee through
advertising, promotion and other advisory services.

25
The regulation then mentions that franchises usually convey a license to use the

franchisor’s trademarks and trade names. Thus, franchises may involve the licensing of

trademarks and trade names, making licensing an aspect of franchising, but there are

many licenses which have no relationship to franchising. As the full context of the

regulation makes clear, franchises are more than a mere license to use the franchisor’s

trademarks and trade names. Franchises involve a whole bundle of rights and obligations

which the parties to a franchise agreement agree to. That is apparent from a reading of

Long John Silver’s franchise agreement. The franchisee agrees to comply with an

extensive list of requirements which essentially ensure the quality and consistency of the

product being sold and Long John Silver’s agrees to assist the franchisee by providing

various business systems, its confidential operations manual, menu management,

procurement services, training, monitoring of quality, and promotion of the Long John

Silver’s system and products. A franchisee also knows that other franchisees are also

required to conform to the same system and standards of the Long John Silver’s franchise

system. All of this is in addition to and in association with the use of Long John Silver’s

proprietary marks, which are licensed to the franchisee as a part of the entire franchise

agreement for use in New Mexico. The Long John Silver’s franchise is property. It is

“leased” in New Mexico because Long John Silver’s allows its franchise to be employed

by its New Mexico franchisees in New Mexico in consideration for the payment of the

specified franchise fees. Thus, the franchise fees are gross receipts from the leasing of

property in New Mexico, and are subject to gross receipts tax.

THE DEPARTMENT IS NOT ESTOPPED BY REGULATION 3 NMAC 2.1.7.5

26
Long John Silver’s objects to this characterization, pointing out that regulation 3

NMAC 2.1.7.5 refers to a franchise as an “agreement”, and argues that agreements cannot

be leased. Further, in reliance on Section 7-1-60, which estops the Department from

withholding relief requested by a taxpayer if the taxpayer can show that their position is

in accordance with a Department regulation, Long John Silver’s argues that the

Department is estopped from taking the position that a franchise is property when the

regulation defines it as an agreement. This argument ignores the full context of the

regulation. Although it does refer to a franchise as an agreement, the full wording of the

regulation references the activities and obligations undertaken as part of the relationship

created between the parties to a franchise agreement. The wording of the regulation is

really just a reflection of the conceptual difficulty inherent in the concept of intangible

property. As noted in 63C Am Jur.2d Property §9, “Intangibles consist of rights not

related to physical things, but are merely relationships between persons, natural or

corporate, which the law recognizes by attaching to them certain sanctions enforceable in

the courts.” (emphasis added). Thus, the franchise agreement is the physical

embodiment of the legal relationship between the parties, but the rights created by that

relationship remain and can still be properly characterized as intangible property.

Because § 7-9-3(I) specifically defines a franchise to be property and the regulation is

merely interpreting that statutory section, and reading the regulation in its full context and

in light of the nature of intangible property itself, the Department’s position is not in

conflict with the regulation and the Department is not estopped from characterizing Long

John Silver’s franchise fee receipts as receipts from leasing intangible property in New

Mexico.

27
THE LEGAL SITUS OF LONG JOHN SILVER’S INTANGIBLES IS
IRRELEVANT TO THE INQUIRY

In another argument related to this one, Long John Silver’s argues that because the

legal situs of its intangible property is the situs of the owner of that property, and since

Long John Silver’s situs is its corporate domicile, which is located out of state, that Long

John Silver’s does not have intangible property in New Mexico which may be leased.

The legal situs of Long John Silver’s intangibles is irrelevant to the inquiry herein. Under

the definition of leasing, the issue is not where the property is legally situated, but rather,

where the property is “employed”. See, Section 7-9-3(J) NMSA 1978. There can be no

doubt that Long John Silver’s intangible property is “employed” in New Mexico when its

trademarks, trade names, know-how and, in fact, its entire restaurant operating system is

used by its franchisees to sell food at its 21 franchise restaurant locations in New Mexico.

SUFFICIENT NEXUS TO TAX EXISTS UNDER BOTH THE COMMERCE
CLAUSE AND THE DUE PROCESS CLAUSES OF THE U.S. CONSTITUTION

Related to its arguments that Long John Silver’s is not leasing property in New

Mexico is its argument that it lacks sufficient nexus with New Mexico for the Department

to subject it to gross receipts tax based upon its franchising activity in New Mexico. The

issue of whether sufficient nexus exists for a state to impose a tax on activities implicates

both the Due Process Clause and the Commerce Clause of the United States Constitution.

The recent Supreme Court case, Quill Corp. v. North Dakota, 504 U.S. 298 (1992) drew

a distinction between the “minimum contacts” requirement of the Due Process Clause and

the “substantial nexus” requirement of the Commerce Clause, finding that a taxpayer may

have the “minimum contacts” with a taxing state as required by the Due Process Clause,

28
yet lack the “substantial nexus” with that state as required by the Commerce Clause. 504

U.S. at 313. Under the “minimum contacts” requirement of the Due Process Clause, the

Court ruled that a state can tax an out of state corporation, even if the corporation has no

physical presence in the state, as long as the corporation has purposefully availed itself of

the benefits of an economic market in the forum state by directing its activities at

residents of the taxing state. Id. at 307. There can be no doubt that Long John Silver’s

meets the “minimum contacts” requirement of the Due Process Clause for New Mexico

tax purposes. Long John Silver’s has purposefully availed itself of New Mexico’s

economic markets by franchising the operation of 21 Long John Silver’s restaurants in

New Mexico which provide a stream of revenue to Long John Silver’s in the form of

franchise fees.

The “substantial nexus” requirement of the Commerce Clause requires at least

some physical presence in the taxing state. In Quill, supra, the Court prohibited North

Dakota from requiring an out of state retailer with no physical presence in the state from

imposing a requirement to collect the state’s use tax on sales to in state customers.

Long John Silver’s argues that although it has some physical presence in New

Mexico through the visits to franchisees by Long John Silver’s representatives to provide

training and ensure that Long John Silver’s system standards are being maintained, that

these visits are too inconsequential to meet the requirements of “substantial nexus.” Long

John Silver’s has substantial nexus with New Mexico. Long John Silver’s regional

Director of Franchise Operations visits Long John Silver’s franchised restaurants in New

Mexico approximately 30 days each year. In addition, Long John Silver’s quality

assurance personnel visit its New Mexico franchisee owned shops approximately every

29
18 months. This regular and continuing presence of Long John Silver’s employees,

alone, is sufficient to amount to “substantial nexus.” This is because their presence is

associated with Long John Silver’s ability to establish and maintain a market in New

Mexico for the products sold under its trademark and trade names. Scripto, Inc. v.

Carson, 302 U.S. 207 (1960), Tyler Pipe Industries v. Washington State Dept. of

Revenue, 483 U.S. 232 (1987). Additionally, however, Long John Silver’s has both

tangible and intangible property in New Mexico. The tangible property consists of its

confidential operating manuals, which it provides to each of its franchise locations. Long

John Silver’s also owns videotapes which it makes available to its New Mexico

franchisees. More significantly, however, Long John Silver’s has substantial intangible

property in New Mexico consisting of its franchise system and its trademarks and trade

names which it permits its franchisees to use to promote the sale of Long John Silver’s

products. Although the legal situs of these intangibles is Long John Silver’s corporate

domicile, the nature of intangibles allows them to be used in more than one place at the

same time. Thus, it has long been recognized that although a taxpayer may be domiciled

in one state, if he carries on business in another, he is subject to tax in the other state

which can be measured by the value of the intangibles used in the other state. Wheeling

Steel Corp. v. Fox, 298 U.S. 193 (1936), Curry v. McCanless, 307 U.S. 357 (1939). In

this case, Long John Silver’s continuously avails itself of New Mexico’s markets by

extending franchises and licensing its trademarks and trade names to its New Mexico

franchisees. There can be no doubt that there exists substantial nexus for New Mexico to

impose a tax on Long John Silver’s franchising activities in New Mexico as measured by

its franchise fees which are directly tied to sales conducted under Long John Silver’s

30
trademark in New Mexico. The Court of Appeals arrived at the same result when it

rejected the claim of insufficient nexus raised in AAMCO Transmissions, supra. The

court recognized that although the situs of AAMCO’’s trademarks was in Pennsylvania, it

also had substantial other intangible property in New Mexico in the form of AAMCO’s

substantial monetary interest in the good will and economic health of its New Mexico

franchisees’ businesses, which it noted were protected and benefited by the laws of New

Mexico. Id. 93 N.M. at 392. Additionally, it quoted with approval the following excerpt

from Curry v. McCanless, supra, at 307 U.S. 367-368:

when the taxpayer extends his activities with respect to his
intangibles, so as to avail himself of the protection and
benefit of the laws of another state, in such a way as to
bring his person or property within the reach of the tax
gatherer there, the reason for a single place of taxation no
longer obtains....[I]ncome may be taxed both by the state
where it is earned and by the state of the recipient’s
domicile. Protection, benefit and power over the subject
matter are not confined to either state. The taxpayer who is
domiciled in one state but carries on business in another is
subject to a tax there measured by the value of the
intangibles used in his business.

AAMCO Transmissions, 93 N.M. at 393. Because of Long John Silver’s substantial and

continuous presence in New Mexico through its franchisees’ use of Long John Silver’s

proprietary marks and its entire franchise system for selling fish and other food products,

substantial nexus exists for purposes of the Commerce Clause.

LONG JOHN SILVER’S FRANCHISE FEES ARE NOT GROSS RECEIPTS
FROM PERFORMING SERVICES OUT OF STATE

Long John Silver’s has argued that the franchise fees it receives from its New

Mexico franchisees must be examined and broken down into fees for the various services

31
and activities embedded in the franchise agreement with its franchisees and that since the

vast majority of those services are performed out of state, that the Department may not

impose gross receipts tax upon those fees. An additional part of its argument relies upon

the allegation that the preponderance of the fees relate to services. Thus, the entire

franchise agreement must be characterized as a contract to perform services, and since

those services are performed out of state, none of the franchise fees may be taxed. With

the exception of the argument concerning the portion of the franchise fees relating to

advertising, which will be discussed separately, these issues have already been

determined adversely to Long John Silver’s by the Court of Appeals in its AAMCO

Transmissions and Baskin-Robbins decisions.

In both the AAMCO Transmissions and Baskin-Robbins cases, the taxpayers

argued that New Mexico was imposing its gross receipts tax upon services performed out

of state in violation of the Commerce Clause. The Baskin-Robbins decision contains the

most extensive discussion of this issue. Baskin-Robbins Ice Cream Company (“Baskin-

Robbins”) was a Delaware corporation headquartered in California which had no

employees or offices in New Mexico, nor did it directly manufacture or sell any products

in New Mexico. It owned distinctive trademarks, trade names, emblems, merchandizing

designs and services, recipes and formulas. It entered into a franchise agreement with

Creamland Dairies, Inc. (“Creamland”), where Creamland used Baskin-Robbins recipes

and other products in the manufacture and sale of Baskin-Robbins ice cream through

stores established by Creamland through a “Baskin-Robbins Retailers Franchise

Agreement.” The court noted that Baskin-Robbins’ most valuable assets were its trade

name, trademark and related intangibles, which properties, secret formulas and techniques

32
were utilized in New Mexico. Creamland paid Baskin-Robbins a royalty based upon the

Baskin-Robbins ice cream products sold by Creamland to its New Mexico retail stores

and New Mexico assessed gross receipts tax on those royalties. The court couched its

inquiry as follows:

What are Taxpayer’s ‘activities’ or ‘services’ that place it in
the stream of [interststate] commerce? (1) New flavors are
developed in California; (2) forms for leases and
agreements supplied by Taxpayer are developed in
California; (3) trademarks are the symbol of the good will
of Taxpayer’s business and its continued value depends
upon the continuing use of the trademarks in its business
with its continuing effort to regulate the use of the
trademarks. When we bundle up these ‘activities’ or
‘services,’ we find no relationship to the concept of
interstate commerce. The only contact Taxpayer has with
New Mexico is its Area Franchise Agreement.
When Taxpayer’s recipes, recipe book and
trademarks come to rest in New Mexico, their use becomes
localized and have left the stream of interstate commerce.

Baskin-Robbins, 93 N.M. at 304. The court went on to conclude:

Taxpayer is not engaged in interstate commerce. The tax
here imposed is conditioned on Creamland’s local business
of manufacturing and selling ice cream products in New
Mexico. It is not a tax imposed on the importation of
property or the rendering of services outside the state;
neither is it a tax measured by income derived from
manufacturing and selling ice cream products in any other
state; nor is the tax different from that assessed and paid by
local taxpayers in manufacturing and selling ice cream
products for others. (emphasis added).

Id., 93 N.M. at 306. The court in its AAMCO Transmissions decision took a similar

approach to the issue, although the Department assessed tax only upon the 9% “franchise

fee” which did not include “license fees”, “service fees” or “advertising assessments” and

receipts from inventory and specialty sales paid to AAMCO by its franchisees. It is

33
impossible to tell from the court decision how these license fees, service fees or

advertising assessments operated and upon what activities they were imposed.

Nonetheless, the court applied the same reasoning which it applied in Baskin-Robbins,

where it found that New Mexico’s tax was conditioned upon activities occurring in New

Mexico, concluding:

None of the fees upon which the tax is assessed relate to
any of the alleged interstate services available from
AAMCO to the franchisee but, rather, are tied directly and
completely to the monthly lease payments computed on
receipts earned from the day-to-day operation of the
businesses under AAMCO’s trademark and trade name in
New Mexico. (emphasis added.)

AAMCO Transmissions, 93 N.M. at 392.

The same can be said about the Department’s assessment of gross receipts taxes in

this case. The assessment is tied directly and completely to the 9% lease payments called

for by Long John Silver’s franchise agreement, computed on receipts earned from the day

to day operation of Long John Silver’s New Mexico franchisees doing business under

Long John Silver’s trademark and trade name in New Mexico.

Conceptually, this issue turns upon the nature or character of the activity upon

which the tax is imposed. Is the tax imposed upon Long John Silver’s receipts from

leasing intangible property consisting of its trademarks, trade names and, ultimately its

entire franchise system, which admittedly includes promotional services as well as other

activities which ensure the consistency and quality of the Long John Silver’s experience?

Or, as Long John Silver’s argues, do we analyze separately the components of the

franchise system and determine how much of the franchise fee is attributable to each

component and where that component is being leased to determine taxability?

34
In concluding that the former approach is the correct approach, I am guided by the

language of the Long John Silver’s franchise agreement, which describes the franchise as

an entire system, together with the fact that franchisees cannot pick and choose which

elements of the system they want or are willing to pay franchise fees for. This concept of

what is being leased in New Mexico is also consistent with the concept of business

format franchising, as it was explained by the Department’s expert witness.

Exhibits S-4, S-5 and S-6 are representative franchise agreements during the audit

period for three different New Mexico restaurant locations. The recitals at the beginning

of the agreement set out the parties’ general understanding of the franchise business

arrangement the parties are entering into, providing, “The Company is the developer of

and sole and exclusive owner of a distinctive food service system, (hereinafter, the

“System”) under which food is sold to the public from restaurants operated under the

name “Long John Silver’s Seafood Shoppes” (hereinafter, “LJS Restaurants)” (emphasis

added). The recitals then go on to list the elements of the system, such as the secret

ingredients and food preparation and serving methodologies, quality and quantity control

methods, restaurant design and decor, uniform restaurant operating methodologies,

distinctive trademarks, service marks, designs and emblems, and a public image that each

restaurant is a unit of an established franchise system operated with uniform standards of

service and product quality. In the recitals, the franchisee expresses a desire to operate a

Long John Silver’s restaurant pursuant to “the System”, to receive the training and

assistance provided by Long John Silver’s in connection with operating a restaurant, and

the franchisee affirms an understanding and acceptance of the terms of the agreement as

being necessary to maintain the high uniform standards of quality, service and portions

35
designed to protect the good will and enhance the public image of the proprietary marks

and the system. The franchisee agrees with the necessity of operating its Long John

Silver’s restaurant in faithful compliance with the terms of the agreement and with Long

John Silver’s standards and specifications. Paragraph 1.01 then describes what Long

John Silver’s is granting the franchisee, stating, “the Company grants to Franchisee, for

and during the term hereof, the right to build and operate an LJS Restaurant (the

“Franchised Restaurant”) and to use the System at the location described..., to use such

Proprietary Marks of the Company as are now or may hereafter be specifically designated

by the Company in writing for use with the System..., and to indicate to the public that the

Franchised Restaurant is operated as a part of, or unit in, the System....” (emphasis

added.)

As a reading of the Franchise Agreement makes clear, what the franchisee is

getting is the right to operate a Long John Silver’s Restaurant and to use the Long John

Silver’s trademark and other proprietary marks as a part of the Long John Silver’s

restaurant system. “The System”, as described in the Franchise Agreement is a complete

and integrated system designed to efficiently and cost-effectively deliver a consistent and

quality restaurant and dining experience to Long John Silver’s customers, no matter

which Long John Silver’s restaurant the consumer chooses to patronize. It is also

significant, when considering Long John Silver’s argument that each component of the

system must be analyzed separately for tax purposes, that none of the so-called

components of the system are negotiable by franchisees who wish to become a part of

Long John Silver’s franchised restaurant system. It is a package. You can take it or leave

it, but the package and the franchise fees are non-negotiable. Thus, it is the Long John

36
Silver’s franchise system itself which the parties to the Franchise Agreement have

bargained for and agreed to. Conceptually, it is analogous to buying a new television

with digital technology. Undoubtedly, the research and development services, as well as

the promotional activities that made me want to buy a Sony, all probably occurred outside

of New Mexico, and in a sense, I am buying those, as well, when I buy a Sony television.

Nonetheless, what the Sony dealer is selling me and what I am purchasing is a television

set. Not the pieces of the set, the services to assemble it, the services to develop its

technology, the services to ship it and stock it and the services involved in selling it to me

in a retail establishment.

It is also significant that the system which Long John Silver’s grants its

franchisees the right to operate under is entirely consistent with the concept of a franchise

system as described by the Department’s expert witness, Dr. Paul Rubin. As noted

above, in the recitals of the Franchise Agreement, the franchisee accepts the terms,

conditions and covenants of the Franchise Agreement, “as those reasonably necessary to

maintain the Company’s high and uniform standards of quality, service and portions

designed to protect the good will and enhance the public image of the Proprietary Marks

and the System,...” (emphasis added). Dr. Rubin testified as follows with respect to the

significance of the Long John Silver’s trademark:

I think the significance of the trademark is in a way the
most important aspect of the case, and I think it’s been
misinterpreted by many of the other witnesses. The
trademark as such is not the key, but the key thing is in
selling a product like Long John Silver’s, people have to
know what it is and where to buy it. The only way they
know where it is and where to buy it is by seeing that Long
John Silver’s name and symbol and so forth in a store, in an
ad, somewhere so they can know what they’re doing. So,

37
the value of the franchise is essentially that people know
what they’re getting when they walk into a Long John
Silver’s, and the trademark conveys that information. So
the goal--in the real sense, the goal of Long John Silver’s,
the franchisor, and of each of [the] franchisee[s] is to
maximize the value of that trademark, not because the
trademark itself is important, but because by maximizing
the value of the trademark, they’re really maximizing the
value of the business. (emphasis added).

TR 595-596. When asked how they maximize the value of the trademark, Mr. Rubin

testified that is accomplished through two activities, promotion and advertising, and

through policing. Mr. Rubin testified that the services Long John Silver’s provides as

part of its obligations under the Franchise Agreement are essentially policing. Policing

assures the consistency and quality of the Long John Silver’s experience and is very

important to the value of the trademark, because if a customer has one bad fish

experience at a Long John Silver’s, he won’t patronize any Long John Silver’s restaurant

again. Thus, a bad meal at one Long John Silver’s restaurant damages the business of all

Long John Silver’s restaurants.

It is also interesting to note that because of the mutually beneficial structure

created by the Long John Silver’s franchise, the services that Long John Silver’s provides

its franchisees not only benefit the franchisees, but also Long John Silver’s. Thus, the

procurement services which assure a steady, reliable supply of quality fish and other

products benefit the franchisees, but they also benefit Long John Silver’s. Not only

because Long John Silver’s benefits through its company owned stores, but because it

ensures the quality and consistency of the Long John Silver’s dining experience

anywhere, enhancing the value of the Long John Silver’s trademark everywhere.

In summary, Mr. Rubin testified:

38
So that the value of the trademark--and that’s in the interest
of both the franchisor, because he wants to sell more
franchises and wants to sell more fish, and the franchisee,
because they have the same goals. So the whole structure
of the arrangement is aimed at maximizing that value, both
through promotion, through advertising and equally
important through policing, to making sure that people get
high quality fish and the same quality fish wherever they
may go into a Long John Silver’s.

TR 597. Thus, the Long John Silver’s trademark represents the entire Long John Silver’s

restaurant system. That is where the value of the system resides. And that system is what

is employed in New Mexico by Long John Silver’s New Mexico franchisees. Even

though the promotion and policing services may largely be performed out of state, their

value ultimately resides in the Long John Silver’s trademark, representing the Long John

Silver’s system. Long John Silver’s New Mexico franchisees derive a benefit from being

part of the Long John Silver’s system. It is the Long John Silver’s system and trademarks

that the franchisees are paying for. It is intangible property which Long John Silver’s is

leasing in New Mexico. The Department is not taxing the rendition of services out of

state. It is taxing Long John Silver’s lease receipts from leasing intangible property in

New Mexico. These receipts are not conditioned upon or measured by services

performed out of state. They are completely tied to the revenues generated by the New

Mexico franchisees operating under the Long John Silver’s trademarks and system in

New Mexico. As such, they are subject to New Mexico gross receipts tax. AAMCO

Transmissions, Baskin-Robbins, supra.

In spite of the fact that New Mexico’s courts have examined franchises and

treated franchise fees as gross receipts from leasing property employed in New Mexico,

Long John Silver’s argues that New Mexico should follow the treatment given franchise

39
fees by the states of South Dakota and Michigan. See, Long John Silver’s Post-Hearing

Reply Brief, p.8. Apparently, because of how the South Dakota tax code is written, South

Dakota does not subject to either sales or use tax the fees (characterized as “royalty fees”)

paid by a franchisee which are strictly for the privilege of engaging in business using the

franchisor’s name. It does, however, impose tax on royalty fees to the extent that they are

for services or tangibles provided by the franchisor. Clearly, New Mexico does impose

its gross receipts tax upon royalty fees paid by franchisees for the lease of intangible

property employed in New Mexico. AAMCO Transmissions, Baskin-Robbins and

American Dairy Queen, supra. Given our own court’s examination of this issue, and the

different statutory provisions being applied, South Dakota’s treatment is not persuasive.

The Michigan case cited by Long John Silver’s is similarly inapposite and unpersuasive.

Mourad Brothers, Inc. v. Dept. of Treasury, 171 Mich. App. 792, 431 N.W. 2d 98

(1988) involved the application of Michigan’s single business tax. That tax required that

“royalties” be added to business income to arrive at the taxable base. Michigan’s single

business tax did not apply to services or advertising. The fee at issue was a 5% fee

designated as a 1% royalty fee and 4% for advertising and other services. The case

simply applied the statutes to include the 1% royalty fee in business income. Given New

Mexico’s different tax statutes and our own court’s examination of this issue, Mourad

Brothers is unpersuasive.

Long John Silver’s presented appraisals by American Appraisal Associates,

(exhibits S-47 and S-47) in support of its argument that its Franchise Agreement

represents a contract for the performance of services, almost all of which are performed

out of state. Long John Silver’s relies upon the 1997 appraisal, which concluded that

40
60% of the royalty fee represented the value of services performed for franchisees and

that only 40% of the royalty fee was attributable to the value of intangibles. Long John

Silver’s relies upon the definition of “service”, found at § 7-9-3(K) NMSA 1978, which

provides in pertinent part:

‘service’ means all activities engaged in for other persons
for a consideration which activities involve predominantly
the performance of a service as distinguished from selling
or leasing property. (emphasis added).

Long John Silver’s argues that since the appraisals establish that the majority of the value

of the 4% royalty fee relates to services provided franchisees, the entire fee must be

characterized as a receipt for performing services. Since the vast majority of those

services are performed out of state, the Department may not impose tax upon any of the

4% royalty fee Long John Silver’s received from its New Mexico franchisees. As

discussed above, I believe that Long John Silver’s argument mischaracterizes the nature

of its franchise agreement with its franchisees, which is properly characterized as a lease

of intangible property, as established not only by the terms of the franchise agreement

itself, but also the decisions of the Court of Appeals in the AAMCO Transmissions and

Baskin-Robbins decisions. I also found the appraisals not to be reliable evidence that the

services made up the predominant part of the royalty fees paid to Long John Silver’s. In

the first place, even Long John Silver’s appraiser admitted that he was not aware of any

franchise without a trademark, nor was he aware of any market for a franchise trademark

separate and apart from the franchise that it is associated with. TR 532. Simply stated,

there is no market for the items he was attempting to segregate out of the 4% royalty fee

against which his purported values can ever be referenced to verify their accuracy. The

41
nature of the appraisal performed may suffice for accounting conventions which insist on

arriving at some sort of value for various things on a company’s books of account, even

though the value is highly speculative, but it is not sufficiently reliable for purposes of

convincing this fact finder that the majority of the royalty fee represents the value of

services. The arbitrariness of the appraisals is manifest when we look more carefully at

them. The 1988 appraisal had concluded that 50% of the royalty was attributable to the

intangibles and 50% to the services. That appraisal was done independently of this

litigation and would not establish that the preponderance of the fee was for services. The

1997 appraisal, done for the purposes of this litigation, managed to shift 10% to the

service end of things based upon some questionable assumptions. The most notable

conclusion was that the value of Long John Silver’s trademark had declined during the

audit years by 10%, because of the increasingly competitive fast food environment and

the rising popularity of ethnic foods and the declining popularity of fried foods. Mr.

Travis also cited the 1989 leveraged buyout of Long John Silver’s, which, because of the

significant debt incurred, had less capital available to invest in its trademark. Mr. Travis

gave no explanation of how exactly the 10% was arrived at as opposed to 7%, 9% or even

12%. The percentages changed by increments of 5% to 10% for all categories which

changed between the two appraisals, which is of itself, a confirmation of the somewhat

arbitrary and speculative nature of such an appraisal. Most troubling, however, was that

while Mr. Travis made some rather general assumptions about the franchise food industry

and fried foods in particular, he did not take into account that Long John Silver’s own

revenues from franchise royalties actually increased over the same corresponding period.

Those revenues are directly linked to the sales volume of Long John Silver’s franchised

42
restaurants, which indicates that the value of at least Long John Silver’s own trademark

was not declining in that same period, because as we know from Dr. Rubin’s testimony,

the value of the franchise business resides in the trademark and in its ability to generate

business for the franchisor and the franchisees.

I also found that the appraisals themselves were faulty in their analysis. The

appraisals purport to determine an arm’s length royalty rate for the rights to Long John

Silver’s trademarks and trade names. It did this by analyzing the various components of

the 4% royalty fee paid by franchisees, and valuing each of those components, breaking

them down into the fees for the intangibles (trademark and trade name) and the portion

representing the various services provided to franchisees. The testimony revealed that

Long John Silver’s puts a mark-up on the products it sells to the distributors, Martin-

Brower and ProSource, who in turn sell those products to Long John Silver’s franchisees.

The mark up is intended to cover Long John Silver’s costs of running its procurement

program. Long John Silver’s Development Guide, exhibit S-32, which is provided to

new franchisees to assist them in learning about the Long John Silver’s franchise system,

explains that in addition to being responsible for their own management trainee

employee’s expenses while attending mandatory management training, that Long John

Silver’s imposes a “nominal charge” for field training taken in company shops. This

charge covers the operational costs of the field training program. Thus, the costs of these

“services” for franchisees are paid for separate and apart from any portion of the 4%

royalty fee. This fact was actually recognized and acknowledged in each appraisal by the

following language found on page 9 of each appraisal:

43
Since the purpose of this investigation is to determine an
arm’s length royalty rate for the rights to certain intangible
assets as previously defined, we shall exclude from
consideration all benefits and services that are primarily a
function of the company and would be necessary for
operations regardless of ownership. For instance, the
inspection and accounting functions are to ensure that
standards are being maintained and that all royalty income
due is accounted for. Other services, such as development,
purchasing and training would all be required for any type
of ownership structure. Generally, costs associated with
these services are charged back to the franchisees.
Therefore, it would not be appropriate to charge a royalty
fee for the benefit of these services. (emphasis added).

In spite of this statement, purchasing and development services were valued at 25% of the

royalty fee, or 1% of the 4% fee, and training services were valued at 10% of the royalty

fee, or .4%. It thus appears that the appraisal methodology itself was fatally flawed, at

least with respect to any probative value the appraisals would have for purposes of

determining the relative portion of the 4% royalty fee attributable to services which are

provided to franchisees as part of the Long John Silver’s franchise system.

ADVERTISING SERVICES ARE AN INTEGRAL PART OF THE FRANCHISE
SYSTEM BEING LEASED IN NEW MEXICO

Although the analysis in the preceding section is applicable to the issue of whether

the portion of Long John Silver’s franchise fees represented by the 5% advertising fee is

subject to gross receipts tax, the advertising fee itself warrants further discussion. Long

John Silver’s has correctly pointed out that the Court of Appeals’ previous decisions did

not specifically address advertising fees. Neither of the American Dairy Queen or

Baskin-Robbins decisions make any mention of advertising fees, and in AAMCO

Transmissions, the court noted that the Department had not included AAMCO’s receipts

44
from “advertising assessments” in its assessment of tax. Id., 93 N.M. at 390. This is

indicative, that at least at the time that the earlier franchise cases were being litigated, the

Department chose not to include advertising fees in the franchise fees which were being

subjected to tax. Long John Silver’s also relies upon two Department rulings, exhibits S-

55 and S-56, issued in 1996, which ruled that advertising fees collected by franchisors

from New Mexico franchisees were not receipts from selling property in New Mexico,

performing services in New Mexico, leasing property in New Mexico or from the sale of

research and development services performed out of state and initially used in New

Mexico so as to be subject to gross receipts tax. Although there are some differences in

how the advertising funds are administered, the rulings are really quite close to the facts

of the instant matter. Long John Silver’s also correctly points out that advertising is

characterized as a service under numerous Department regulations as well as New

Mexico appellate decisions. See, e.g. Markham Advertising Co. v. Bureau of Revenue,

88 N.M. 176,177, 538 P.2d 1198 (Ct. App.), cert. denied, 88 N.M. 318, 540 P.2d 248

(1975); Mountain States Advertising Inc. v. Bureau of Revenue, 89 N.M. 331, 332, 552

P.2d 233, 234 (Ct. App.) cert. denied, 90 N.M. 8, 558 P.2d 620 (1976); regulations 3

NMAC 2.1.18.4; 3 NMAC 2.1.18.15; 3 NMAC 2.10.10; 3 NMAC 2.48.13.1; 3 NMAC

2.48.13.2 and 3 NMAC 2.55.7.2. Finally, Long John Silver’s argues that the advertising

fees cannot be considered to be gross receipts of Long John Silver’s because they are paid

directly by the franchisees to Abbott Advertising.

The latter issue will be addressed first, because there is no point in even

determining the applicability of the gross receipts tax to advertising revenues if Long

John Silver’s cannot be considered the proper taxpayer to raise this issue. Abbott

45
Advertising is a wholly owned subsidiary of Long John Silver’s Restaurants, Inc., which

is a holding company which owns QSC, Inc., which owns the Taxpayer in this case, Long

John Silver’s. Thus, Long John Silver’s and Abbott Advertising are closely related

corporations which are part of the same family of Long John Silver’s related corporations.

Paragraph 7.01 of the Franchise Agreement provides as follows:

Recognizing the value of advertising, and the importance of
the standardization of advertising to the furtherance of the
goodwill and public image of the System, Franchisee agrees
that the Company [Long John Silver’s] or its designee shall
conduct, determine, maintain and administer all national,
regional, local and other advertising and marketing as may
be instituted from time to time, and shall direct all such
advertising and marketing with sole discretion over the
concepts, materials, media, nature, type, scope, frequency,
place, form, copy, layout and context used therein.
(emphasis added).

Paragraph 7.02 of the Franchise Agreement specifically lists Abbott Advertising as its

designee, providing in pertinent part:

The Company shall have the right to delegate and
redelegate its responsibilities and duties hereunder to any
designee(s) of its choosing, including to its affiliate, Abbott
Advertising Agency, Inc., or any successor or other agency;
however, the right of final approval of all advertising
programs shall be retained at all times by the Company.

The advertising fee paid by franchisees is provided for in paragraph 6.02(a), which

provides in pertinent part:

Franchisee shall pay to the Company or its designee for
advertising and marketing programs, a sum equal to five
percent (5%) of Franchisee’s Gross Receipts from the
operation of the Franchised Restaurant.

These paragraphs make clear that not only is Abbott Advertising Long John Silver’s

designee under the Franchise Agreement, but that ultimately, Long John Silver’s retains

46
complete and total control over the Long John Silver’s advertising program, regardless of

who its designee is. As such, it is clear that the advertising fees are receipts of Long John

Silver’s under the terms of the Franchise Agreement. Long John Silver’s simply chooses

to direct its franchisees to make payment to its designee, rather than itself. This does not

change the fact that the ultimate recipient is Long John Silver’s, the franchisor under the

agreement. Even if one is persuaded by the form of the payment transaction, the

advertising fee still meets the applicable part of the definition of “gross receipts” being

considered for purposes of this discussion. This is because gross receipts is defined to be,

“the total amount of money or the value of other consideration received” from selling or

leasing property in New Mexico, or from performing services in New Mexico, etc. See, §

7-9-3(F) NMSA 1978. Thus, even if Long John Silver’s did not receive the money, it

received “other consideration” in the form of the activities engaged in by Abbott

Advertising in fulfillment of Long John Silver’s obligations to administer the advertising

and marketing program for Long John Silver’s and its franchisees.

Admittedly, the treatment of the 5% advertising fee is a far more difficult issue

than the 4% royalty fee. For one thing, the fee is specifically earmarked for advertising

and promotion, as opposed to the difficulty presented with determining the relative

portions of the royalty fee attributable to various activities undertaken as part of the

franchising agreement. There can also be no dispute that advertising is a service, and that

the advertising services performed by Long John Silver’s through its designee were

performed out of state. The Department’s own rulings are also indicative of the strength

47
of Long John Silver’s argument on this issue1. Nonetheless, the Department has

apparently taken a new look at this issue and, while reasonable minds may differ, I am

persuaded that the advertising fee is integral to the concept of franchising, as explained by

the Department’s expert witness, and it cannot be segregated from the entire franchise

system which Long John Silver’s New Mexico franchisees employ in New Mexico.

In arriving at this conclusion, I am persuaded by several factors. Foremost among

them is the fact that it is clear, both from the unambiguous language of the Franchise

Agreement, as excerpted above, as well as the testimony of Long John Silver’s own

witness, Mark Sievers, that Long John Silver’s, and not the franchisees, controls and

directs Long John Silver’s advertising and marketing program. This is distinct from the

situation described in Ruling 401-96-05, where a franchisee advisory group actually

administers the advertising fund and from the situation described in Ruling 401-96-6,

where the franchisee advisory group actually approves or disapproves of advertising

programs and estimated costs. Because the franchisees do not have the power to control

the advertising and marketing which is paid for as part of the franchise fees, it is far less

convincing that the advertising fee is actually a service they are purchasing directly with

their advertising fee.

1
Rulings were defined during the audit period herein at § 7-1-5(B)(2) NMSA 1978 (1993 Repl. Pamp.) as,
“written statements of the secretary, of limited application to one or a small number of taxpayers,
interpreting the statutes to which they relate, ordinarily issued in response to a request for clarification of
the tax consequences of a specified set of circumstances” (emphasis added). Although the Department is
estopped from taking action not in accordance with a ruling with respect to taxpayers to whom a written
ruling was personally addressed, § 7-1-60 NMSA 1978, there is no allegation that Long John Silver’s was
the addressee of either of the two rulings at issue herein. While rulings are persuasive evidence of the
Department’s view of the tax consequences of a given situation, they are limited to the facts stated and the
taxpayer to whom they are issued. Additionally, the fact that rulings have been issued on a subject does not
prohibit the Department from taking a new look at the issue, in light of more developed facts, new law, or a
more thorough analysis of any given issue, except with respect to the taxpayers to whom the rulings were
specifically addressed.

48
I also was persuaded by the testimony of the Department’s expert witness, Dr.

Rubin, who testified quite convincingly about how marketing and promotion is a

consistent element of modern franchising and how integral it is to the concept of

franchising. The promotion and marketing serve to enhance the value of the trademarks

and, indeed, the entire franchise system which the franchisees pay a fee to participate in.

As noted in the previous section of this decision, it is apparent from the wording of the

franchise agreements themselves, that what the franchisees are contracting for is the

entire Long John Silver’s franchise system. Advertising and promotion are an important

part of the system, without a doubt. There are many services and business systems which

are an important part of the Long John Silver’s system. Ultimately, however, it is the

franchise system which the franchisees are paying the franchise fees for. They may not

pick and choose which services or activities they wish to participate in and adjust the

franchise fees accordingly. They cannot opt out of management training. They cannot

choose their own restaurant designs and get a fee discount. They can’t design their own

menu and offer products not approved by Long John Silver’s. Nor can they design their

own advertising program and opt out of paying the advertising fee. It is a complete and

integrated restaurant management and promotion package that they sign up for, and that is

embodied in the concept of a franchise, which is intangible property employed by Long

John Silver’s franchisees in New Mexico.

49
THE GROSS RECEIPTS TAX PAID BY LONG JOHN SILVER’S NEW MEXICO
FRANCHISEES IS IMPOSED UPON A SEPARATE TRANSACTION

The last argument raised by Long John Silver’s with respect to the tax assessed is

that because Long John Silver’s franchisees already pay tax upon their sales in New

Mexico and because the franchise fees are calculated as a percentage of those sales, that

tax has already been paid to New Mexico and Long John Silver’s does not owe additional

tax upon its franchise fees. This argument is totally with out merit. We have two

separate taxpayers and two separate taxable transactions. We have the franchisees, who

have gross receipts from selling food and beverages in New Mexico, and we have Long

John Silver’s, which has gross receipts from leasing intangible property in New Mexico.

PENALTY IS PROPERLY IMPOSED

The final issue to be determined is whether the assessment of penalty was proper
in this case. The imposition of penalty is governed by the provisions of NMSA 1978,
Section 7-1-69(A)(1995 Repl. Pamp.), which imposes a penalty of two percent per month,
up to a maximum of ten percent:
In the case of failure, due to negligence or disregard of rules and regulations,
but without intent to defraud, to pay when due any amount of tax required to
be paid or to file by the date required a return regardless of whether any tax
is due,....

This statute imposes penalty based upon negligence (as opposed to a willful or fraudulent

intent) for failure to timely pay tax. Thus, there is no contention that Long John Silver’s

failure to report and pay taxes upon its New Mexico franchise fees was based upon any

willful attempt by the Taxpayer to underreport taxes. What remains to be determined is

whether the Taxpayer was negligent in failing to report its taxes properly. Taxpayer

50
"negligence" for purposes of assessing penalty is defined in Regulation 3 NMAC 1.11.10

as:

1) failure to exercise that degree of ordinary business care and prudence
which reasonable taxpayers would exercise under like
circumstances;
2) inaction by taxpayers where action is required;
3) inadvertence, indifference, thoughtlessness, carelessness, erroneous
belief or inattention.

Long John Silver’s offered no factual testimony whatsoever to explain why it had failed

to report taxes on any of its franchise fees during the audit period. Section 7-1-17(C)

NMSA 1978 provides that there is a presumption of correctness which attaches to any

assessment of tax by the Department. The presumption of correctness also applies to the

assessment of penalty. Tiffany Construction Co. v. Bureau of Revenue, 90 N.M. 16,

558 P.2d 1155 (Ct. App. 1976), cert. denied, 90 N.M. 255, 561 P.2d 1348 (1977). As

noted earlier, it has been established law in New Mexico since the AAMCO

Transmissions, Baskin-Robbins and American Dairy Queen cases were decided in

1979, that gross receipts tax was applicable to the fees paid by New Mexico franchisees

to their franchisors. Long John Silver’s offered evidence as to why they did not report

and pay any tax on any portion of the franchise fees they received2. Perhaps they were

not aware of the law in New Mexico. Even so, New Mexico has a self-reporting tax

system which requires that taxpayers voluntarily report and pay their tax liabilities to the

state. Because of this, the case law is well settled that every person is charged with the

reasonable duty to ascertain the possible tax consequences of his actions, and the failure to

2
In its Post-Hearing Brief, Long John Silver’s did argue that many other out-of-state franchisors treat
advertising and royalty fees paid by New Mexico franchisees as nontaxable for New Mexico gross receipts
tax purposes. This argument assumes facts not in evidence and will not be considered.

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do so has been held to amount to negligence for purposes of the imposition of penalty

pursuant to Section 7-1-69 NMSA 1978. Tiffany Construction Co., supra.

Long John Silver’s also argued that because it was cooperative with the

Department’s auditor and furnished the Department with all information requested in a

timely manner during the audit that this demonstrates that they were not negligent. I am not

aware of any law which provides that it is a defense to the imposition of a negligence

penalty to have cooperated during audit. Indeed, taxpayers are required to make their

records available to the Department, and the secretary is given enforcement powers when

they fail to do so. Section 7-1-4 NMSA 1978. Long John Silver’s has failed to present any

evidence or arguments which rebut the presumption of correctness of the penalty

assessment and the imposition of penalty is proper.

CONCLUSIONS OF LAW

1. Long John Silver’s filed a timely, written protest to Assessment No. 1880539

pursuant to § 7-1-24 NMSA 1978 and jurisdiction lies over both the parties and the subject

matter of this protest.

2. Long John Silver’s has substantial nexus with New Mexico for purposes of the

Commerce Clause.

3. Long John Silver’s leases intangible property in New Mexico in the form of its

franchise system and its trademarks and trade names to its New Mexico franchisees who

employ such property in New Mexico.

4. Pursuant to Long John Silver’s Franchise Agreement, Long John Silver’s

Franchisees acquire the right to use and become a part of the Long John Silver’s franchise

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system, which includes the right to use the Long John Silver’s trademark and other

proprietary marks in conjunction with the franchise system.

5. Long John Silver’s franchise system is an integrated whole which cannot be

considered separately, by its various components of intangible property, tangible property

and services.

6. Because Abbott Advertising is Long John Silver’s designee to receive payment

of the 5% advertising fee portion of Long John Silver’s franchise fees and to act on behalf

of Long John Silver’s in fulfilling its obligation to do marketing and advertising for the

Long John Silver’s franchise system and its franchisees, Long John Silver’s has received

other consideration for purposes of the imposition of gross receipts tax in the amount of the

5% advertising fee.

7. The initial fees and opening fees Long John Silver’s received from its New

Mexico franchisees constitute gross receipts to Long John Silver’s from leasing property

employed in New Mexico.

8. While both licenses and franchises are intangible property, the terms are not

synonymous.

9. The 1991 amendments to § 7-9-3(J) NMSA 1978 do not alter the fact that Long

John Silver’s has gross receipts from leasing property in New Mexico to its New Mexico

franchisees.

10. Under New Mexico tax law, advertising is characterized and treated as a service.

11. The 5% advertising fee is not a fee for services performed outside of New

Mexico but is part of the franchise fees paid to in order to use and be part of the Long John

Silver’s franchise system.

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12. The Department is not estopped by regulation 3 NMAC 2.1.7.5 from treating the

franchise fees received by Long John Silver’s from its New Mexico franchisees as gross

receipts from the leasing of property in New Mexico.

13. The predominant ingredient test found in § 7-9-3(K) has no applicability to this

case because New Mexico law has established that franchise fees are gross receipts from the

lease of property employed in New Mexico.

14. The payment of gross receipts tax on the gross receipts of Long John Silver’s

New Mexico franchisees from their sale of food and beverage does not relieve Long John

Silver’s from payment of gross receipts tax upon its receipts from leasing property in New

Mexico. There are two separate taxpayers and two separate taxable transactions.

15. Long John Silver’s has failed to overcome the presumption of correctness of the

penalty assessment and the imposition of penalty is proper.

For the foregoing reasons, Long John Silver’s protest IS HEREBY DENIED.

DONE, this 2nd day of April, 1998.

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