The owner of the Subway restaurant franchise must pay South Dakota sales tax on the royalty fees it charges to owners of the 53 Subway restaurants in the state, the South Dakota Supreme Court ruled Thursday.

The 8 percent royalty fee charged on each restaurant’s gross sales is subject to the state sales tax because the franchise agreement provides that the fee is collected in exchange for property and services, the high court said in a unanimous ruling.

The decision upholds the state Revenue Department’s 2001 ruling that found Doctor’s Associates Inc., owner of the Subway franchise, owed $270,661 in sales taxes on the royalty fees. The tax assessment followed an audit that covered July 1997 through October 2000 for the company headquartered in Milford, Conn.

Court records indicate that Doctor’s charges franchisees an initial fee of $7,500 and a weekly royalty fee of 8 percent of gross sales at a franchisee’s sandwich shop.

The royalty agreement grants a franchisee access to the company’s knowledge, recipes, food preparation procedures, business methods and business forms. The company also agrees to provide franchisees with a company representative available for consultation.

The Supreme Court agreed with the state Revenue Department and a circuit judge that the royalty fees are subject to the state sales tax because the company is providing franchisees with tangible personal property in the form of recipes, preparation methods, business procedures and other items. The consultation with a company representative is a service that is subject to the sales tax, the justices said.

However, the company might not be obligated to pay a sales tax on the entire royalty fee collected from South Dakota franchisees because some of the services might not be subject to the tax, the high court said. For example, training of franchise employees takes place in Connecticut and may not be taxable in South Dakota, the court said.

But Subway missed the deadline for providing evidence to reduce, deduct or exempt the royalty fees from taxation, the Supreme Court said. The company had to provide such evidence during the Revenue Department’s audit, but it did not do so, the justices said.

The company argued that a circuit judge should have allowed it to present evidence on the value of services and property subject to taxation, but the Supreme Court said the evidence must be excluded because it was not submitted before the deadline during the Revenue Department’s audit.
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