#23744-a-JKK

2006 SD 18

                            IN THE SUPREME COURT
                                    OF THE
                            STATE OF SOUTH DAKOTA

                                   * * * *

DOCTOR’S ASSOCIATES, INC.,               Plaintiff and Appellant,

      v.

DEPARTMENT OF REVENUE
AND REGULATION,                          Defendant and Appellee.

                                   * * * *

                   APPEAL FROM THE CIRCUIT COURT OF
                       THE SIXTH JUDICIAL CIRCUIT
                     HUGHES COUNTY, SOUTH DAKOTA

                                   * * * *

                            HONORABLE MAX A. GORS
                                   Judge

                                   * * * *

TODD C. MILLER                           Attorney for plaintiff
Sioux Falls, South Dakota                and appellant.

HARVEY M. CROW, JR.
South Dakota Department of
 Revenue and Regulation                  Attorney for defendant
Rapid City, South Dakota                 and appellee.

                                   * * * *

                                         CONSIDERED ON BRIEFS
                                         ON JANUARY 9, 2006

                                         OPINION FILED 03/01/06
#23744

KONENKAMP, Justice

[¶1.]        Doctor’s Associates, Inc., headquartered in Milford, Connecticut, owns

the international Subway fast-food restaurant franchise. South Dakota has fifty-

three restaurants in the Subway chain. Subway collects an 8% “royalty” fee from

each franchisee’s weekly gross sales. After an audit, the Department of Revenue

and Regulation determined that Subway’s royalty fees constitute taxable gross

receipts. Since Subway failed to report these fees on its sales tax returns, the

Department issued a certificate of assessment for sales tax and interest. Subway

contested the assessment. Following an unsuccessful administrative appeal,

Subway now seeks review before us, claiming that its royalty fees are non-taxable

intangibles and that the Department failed in its burden of proving taxability.

Because Subway’s franchise agreement provides that its royalty fees are collected in

exchange for tangible personal property and services, these fees constitute taxable

gross receipts under South Dakota law. Therefore, we uphold the assessment.

                                    Background

[¶2.]        On August 17, 2000, the senior auditor for the Department sent

Subway a notice of intent to audit. As part of the notice, the Department requested

that Subway submit certain corporate records. The Department further informed

Subway in the notice of intent to audit that “(1) the audit period was July, 1997

through October, 2000; (2) the audit would commence on December 5, 2000; and (3)

Subway had sixty days from December 5, 2000 to present to the auditor ‘all

documents evidencing reduction, deduction or exemption from tax,’ and any such

records not presented would not have to be considered by the auditor.”


                                          -1-
#23744

[¶3.]         To operate as a franchisee, each Subway restaurant owner was

required to sign and accept, as is, Subway’s franchise agreement, pay a one-time,

non-refundable franchise fee, and thereafter, pay an 8% “royalty” fee on the

restaurant’s gross weekly sales. When Subway received the notice of intent to

audit, it provided the Department with financial information about the South

Dakota franchisees. Subway submitted “(1) a sales quarterly ledger detailing the

royalty fees paid to Subway each week; (2) a copy of the April, 1997, ‘Limited

Amnesty Program for the Franchise Industry,’ outlining the Department’s policy

regarding taxation of royalty fees beginning July 1, 1997; and, (3) a copy of the

Franchise Agreement.”

[¶4.]         The audit took place in Milford and began on December 5, 2000. It

lasted approximately six months. During the audit, the Department reviewed

Subway’s records and concluded that the 8% royalty fee received by Subway from its

franchisees constituted gross receipts and should have been reported in Subway’s

sales tax returns. In reaching its conclusion, the Department relied on the

language of the franchise agreement. Paragraph three states that Subway provides

tangible personal property to franchisees.1 Paragraph four indicates that services



1.      The language of paragraph three provides:
        The Company hereby grants to the Franchisee:
              a. access to the Company’s recipes, formulas, food preparation
        procedures, business methods, business forms, business policies and
        body of knowledge pertaining to the operation of a sandwich shop,
        including the loan of a copy of the Company’s Operations Manual;
              b. access to information pertaining to new developments and
        techniques in the Company’s sandwich business; and
                                                                  (continued . . .)
                                          -2-
#23744

are provided to franchisees. 2 Because the franchise agreement stipulates that the

royalty fees are consideration for allowing the franchisees access to Subway’s body

of knowledge, among other things, the Department deemed the royalty fees

collected by Subway to be taxable gross receipts under SDCL 10-45-2 and 10-45-4. 3

[¶5.]         Subway had the opportunity to submit any evidence to show that the

royalty fees should not be subject to sales tax. Beginning on December 5, 2000,

Subway had sixty days to present materials to the Department that would reduce,

____________________
(. . . continued)
                c. a limited license to use the Company’s rights in and to its
         service marks and trademarks in connection with the operation of one
         sandwich shop to be located at a site approved by the Company and the
         Franchisee.

2.      Paragraph four provides:
        The Company agrees to:
              a. provide a training program for the operation of sandwich
        shops using the Company’s recipes, formulas, food preparation
        procedures, business methods, business forms and business policies.
        The Franchisee shall pay all transportation, lodging and other
        expenses incurred in attending the training program.
               b. provide a Company Representative that the Franchisee may
        call upon during normal business hours for consultation concerning the
        operation of his business; and
               c. provide the Franchisee with a program of assistance which
        shall include periodic consultations with a Company Representative,
        publish a periodical advising of new developments and techniques in
        the Company’s sandwich business, and grant access during normal
        business hours to specified office personnel for consultations
        concerning the operation of his business.

3.      Under the Recitals section of the franchise agreement, it is provided:
        The Franchise Fee, Royalty and promises by the Franchisee contained herein
        constitute the sole consideration to the Company for the use by the
        Franchisee of its body of knowledge, systems and trademark rights.
        (Emphasis added).

                                           -3-
#23744

deduct, or exempt the royalty fees from tax. When the sixty days ended on

February 5, 2001, Subway had not submitted any evidence. Subway then requested

an extension in order to present additional evidence. The extension was granted.

On February 23, 2001, the Department sent Subway a “listing showing the [r]oyalty

fees subject to sales tax to Subway for review.” When the extension expired on

March 5, 2001, Subway still had not presented any evidence. Then, in May 2001,

Subway requested another extension, this time “to review the South Dakota Code

and Regulations.” Because the extension was not requested for the purpose of

presenting additional evidence, the Department denied Subway’s request.

[¶6.]        In the end, the auditor received no evidence from Subway to reduce,

deduct, or exempt any portion of the royalty fees from sales taxation. Consequently,

the Department issued Subway a certificate of assessment for $270,660.70 on June

21, 2001. Subway requested a hearing and argued that the royalty fees should not

be taxed because they were not received as consideration for taxable services or

property contained within the franchise agreement. At the hearing in June 2004,

Subway attempted to offer new evidence that should have been submitted before

the sixty days expired under SDCL 10-59-7 or during the thirty-day extension. The

hearing examiner excluded the evidence and affirmed the Department’s certificate

of assessment.

[¶7.]        Subway appealed the decision to the circuit court. That court also

excluded Subway’s evidence for not having been timely presented within the

statutory time and affirmed the certificate of assessment. Subway now appeals to

this Court, claiming that the circuit court erred when it affirmed the hearing


                                         -4-
#23744

examiner’s decision that (1) the royalty fees paid by the fifty-three South Dakota

franchisees to Subway were taxable; (2) Subway failed to overcome the presumption

of correctness of the certificate of assessment; and (3) certain testimony and

documentary evidence were inadmissible.

                              Analysis and Decision

[¶8.]        Our review of an administrative appeal is governed by SDCL 1-26-36.

Watertown Coop. Elevator Ass’n v. S.D. Dept. of Rev., 2001 SD 56, ¶10, 627 NW2d

167, 171. “We give deference to the agency on factual matters, applying the clearly

erroneous standard of review.” Id. (citing Sopko v. C & R Transfer Co., Inc., 1998

SD 8, ¶6, 575 NW2d 225, 228 (citations omitted)). However, the agency’s

conclusions of law are reviewed de novo. W. Wireless Corp. v. Dept. of Rev., 2003

SD 68, ¶5, 665 NW2d 73, 75 (citing Sopko, 1998 SD 8, ¶6, 575 NW2d at 228).

[¶9.]        Subway first contends that the circuit court erred when it concluded

that the royalty fees, which Subway claims are intangibles, could be subject to sales

tax under SDCL 10-45-2 and 10-45-4. The Department, on the other hand, asserts

that the terms of the franchise agreement illustrate that Subway provided tangible

personal property and services to South Dakota franchisees in return for the royalty

fees. Thus, the Department deems the royalty fees in this case to be taxable under

SDCL 10-45-2 and 10-45-4.

[¶10.]       We begin by first examining the statutes in question. Whether SDCL

10-45-2 and 10-45-4 impose a sales tax under these circumstances is a question of

law, reviewed de novo. See S.D. Dept. of Rev. v. Sanborn Tel. Coop., 455 NW2d 223,

225 (SD 1990) (citations omitted). Under SDCL 10-45-2, “the gross receipts of all


                                          -5-
#23744

sales of tangible personal property consisting of goods, wares, or merchandise” are

subject to sales tax, and, under SDCL 10-45-4, a tax is imposed on “the gross

receipts of any person from the engaging in or continuing in the practice of any

business in which a service is rendered.”

[¶11.]        In examining SDCL 10-45-2 and 10-45-4 together, we see that the

royalty fees will be subject to sales tax if they constitute gross receipts for the sale of

tangible personal property or service. “Gross receipts” is defined in SDCL 10-45-1(6)

as the “consideration, including cash, credit, property, and services, for which

tangible personal property or services are sold, leased, or rented, valued in money,

whether received in money or otherwise. . . .” And “tangible personal property” is

defined as “personal property that can be seen, weighed, measured, felt, or touched,

or that is in any other manner perceptible to the senses.” SDCL 10-45-1(14).

Finally, the definition of “service” is contained in SDCL 10-45-4.1, which includes

“all activities engaged in for other persons for a fee, retainer, commission, or other

monetary charge, which activities involve predominantly the performance of a

service as distinguished from selling property.”

[¶12.]        By applying these statutory definitions to the facts of this case, the

royalty fees received by Subway were properly considered gross receipts from the

sale of tangible personal property and services. This determination is based on the

records Subway provided the Department for the audit, specifically the franchise

agreement. First, in the section entitled Agreement, paragraph three states that

Subway “grants” the franchisee access to, among other things, “the Company’s

recipes, formulas, food preparation procedures, business methods, business forms,


                                            -6-
#23744

business policies and body of knowledge. . . .” From this language it is clear that

Subway is providing its franchisees with “tangible personal property” as defined in

SDCL 10-45-1(14). Then in paragraph four, Subway agrees to “provide” franchisees

a “Company Representative that the Franchisee may call upon during normal

business hours for consultation concerning the operation of his business[.]” Based

on the language of paragraph four, Subway is providing its franchisees with

“services” as defined in SDCL 10-45-4.1. Finally, in the Recitals section of the

agreement, we see that Subway receives consideration, i.e. “royalty,” constituting

“gross receipts” under SDCL 10-45-1(6), for the tangible personal property it grants

under paragraph three and the services it provides under paragraph four.

[¶13.]       Accordingly, Subway provides tangible personal property and services

in return for the royalty fee, and SDCL 10-45-2 and 10-45-4 apply to impose sales

tax on these receipts. This finding, however, does not automatically obligate

Subway to pay sales tax on the entire royalty fee collected from the fifty-three

Subway franchisees across South Dakota. Subway was afforded an opportunity to

present evidence to reduce, deduct, or exempt the royalty fees, or a portion thereof,

from taxation, within sixty days of the commencement of the audit. See SDCL 10-

59-3; SDCL 10-59-7; AT&T Corp. v. S.D. Dept. of Rev., 2002 SD 25, ¶18, 640 NW2d

752, 757 (citing In re Pam Oil, Inc., 459 NW2d 251, 257 (SD 1990)). This Subway

failed to do until more than two years later. Thus, the circuit court did not err when

it concluded that the entire royalty fee was subject to sales tax under SDCL 10-45-2

and 10-45-4. See AT&T Corp., 2002 SD 25, ¶18, 640 NW2d at 757; Pam Oil, Inc.,

459 NW2d at 257.


                                          -7-
#23744

[¶14.]       Subway’s next contention is similar to its first claim, that royalty fees,

as a whole, are not taxable. Subway asserts that the certificate of assessment is per

se incorrect because the Department “did not seek a reasonable value of services

and tangible personal property that the Department deemed taxable.” For that

reason, Subway insists that the circuit court erred when it held that Subway failed

to overcome the presumption of correctness of the certificate of assessment. It is

well settled that certificates of assessment are presumed correct and thus the

burden was on Subway to overcome that presumption. See SDCL 10-59-8. Subway

must present evidence that there was a mistake of fact or error of law in the

conduct of the audit which resulted in the assessment. See SDCL 10-59-9.

[¶15.]       Subway does not suggest that the certificate contains a mistake, or

that the Department’s calculations or figures in the certificate of assessment were

inaccurate. Rather, Subway argues that SDCL 10-46-18.2 imposes a burden on the

Department to determine the “reasonable value” of the services and tangible

personal property Subway sold in return for the royalty fees. Specifically, Subway

alleges that SDCL 10-46-18.2 requires the Department to categorize the items listed

in paragraphs three and four as either tangible personal property or services.

Subway further claims that the Department was required to “verify whether

Subway actually performed any services for the [fifty-three] franchisees in the State

of South Dakota” in order to determine what, if any, tax should be assessed.

[¶16.]       The problem with this argument is that SDCL 10-46-18.2 is a use tax

statute. Here Subway was assessed a sales tax under SDCL 10-45-2 and 10-45-4.

The Department reviewed Subway’s financial records and franchise agreement and


                                          -8-
#23744

determined the amount of tax applicable to the 8% royalty fees Subway received.

Subway has not contested these calculations under the sales tax statutes. Nor has

Subway presented competent evidence that the certificate of assessment contained

a mistake of fact or error of law. As such, the circuit court did not err when it held

that Subway failed to overcome the presumption of correctness for the certificate of

assessment.

[¶17.]        Subway’s final argument on appeal is that the circuit court erred when

it disallowed testimonial and documentary evidence that would have established

the value of services and personal property subject to taxation. The evidence

Subway offered, Exhibit D, is a statistical summary prepared by Subway in 2003,

containing values for 2002, 2001, 2000, 1999, and 1998. Subway also attempted to

offer the testimony of Mike Dolishny, who was not employed by Subway during the

time of the audit, but would have testified concerning Exhibit D. The circuit court

affirmed the hearing examiner’s decision to exclude Exhibit D and Dolishny’s

testimony because Subway failed to present the evidence during the audit. See

SDCL 10-59-7.

[¶18.]        Nonetheless, Subway insists that SDCL 10-59-7 is inapplicable under

the circumstances. Subway argues that Exhibit D was not required to be kept by

law and therefore should have been allowed at any time and that Dolishny should

have been permitted to testify about Exhibit D. Subway also claims that Exhibit D

and Dolishny’s testimony were not offered to prove a “reduction, deduction or

exemption” from tax. Instead, Subway offered Exhibit D to show how royalty fees

were intangibles and should not be taxed in the first place. Subway also claims that


                                          -9-
#23744

the Department arbitrarily denied its request for an extension of time, and as a

result, the evidence should be allowed.

[¶19.]         We start with Subway’s assertion that the Department arbitrarily

denied its second request for an extension of time to submit further evidence. This

argument is not supported by the evidence. A review of the record shows that

Subway sent a letter to the Department requesting a second extension of time for

the purpose of reviewing the “South Dakota Code and Regulations.” Because the

extension was not for the purpose of submitting additional evidence, the

Department denied Subway’s request. We fail to see how this decision was

arbitrary, especially when the Department had earlier granted an extension.

[¶20.]         We next address Subway’s argument that SDCL 10-59-7 does not

apply because Exhibit D, a statistical summary, was not a document required to be

kept by law and was not offered as evidence of a reduction, deduction or exemption

from tax under SDCL 10-59-7. 4 Subway was fully aware that the Department

considered the fees taxable based on the language of the franchise agreement. Yet,

Subway failed to present Exhibit D to the Department during the audit, or during

the extension granted by the Department. Although Subway indicates that Exhibit

D existed at the time of the audit, Subway did not present this material until more



4.       SDCL 10-59-7 provides, in relevant part:
         Any documents or record required to be kept by law to evidence reduction,
         deduction, or exemption from tax not prepared for presentation to the auditor
         within sixty days from the commencement date of the audit do not have to be
         considered by the auditor or secretary.

         (Emphasis added).


                                          -10-
#23744

than two years later. Nevertheless, Subway claims Exhibit D was not required to

be kept by law, and thus it should now be allowed.

[¶21.]         Under SDCL 10-45-45, Subway is required to “keep records and books

of all receipts and sales, together with invoices, bills of lading, copies of bills of sale,

and other pertinent papers and documents.” (Emphasis added). Here Subway is

offering Exhibit D as evidence that the royalty fees should not be subject to tax

under SDCL 10-45-2 and 10-45-4. Exhibit D is therefore a pertinent document.

Because Exhibit D is a pertinent document it was contemplated under the statutory

time frame set out in SDCL 10-59-3 and 10-59-7. Also, because the purpose of

Exhibit D wa s an attempt to remove the royalty fees from tax under SDCL 10-45-2

and 10-45-4, it is certainly evidence purporting to reduce, deduct or exempt the

royalty fees from tax. Exhibit D should have been presented to the Department as

required under SDCL 10-59-3 and 10-59-7.

[¶22.]         Because Subway failed to submit the evidence during the sixty days

required under SDCL 10-59-3 and 10-59-7, plus the thirty-day extension, Subway

had no right to later offer this material. See AT&T Corp., 2002 SD 25, ¶18, 640

NW2d at 757; Pam Oil, Inc., 459 NW2d at 257. To allow late submittal of these

materials long after the audit has ended would make the audit process interminable

and unworkable. As a result, the circuit court did not err when it affirmed the

hearing examiner’s decision to exclude Exhibit D and Dolishny’s testimony

pertaining to Exhibit D. 5



5.       Some of the services Subway provides to its franchisees in exchange for the
         royalty fees may not be subject to sales tax. For example, the training for
                                                                    (continued . . .)
                                            -11-
#23744

[¶23.]      Affirmed.

[¶24.]      GILBERTSON, Chief Justice, and SABERS, ZINTER, and

MEIERHENRY, Justices, concur.




____________________
(. . . continued)
         franchisee employees takes place in Connecticut. However, Subway failed to
         timely submit proof of valid deductions and therefore they could not be
         considered in this audit.

                                        -12-
