The Tennessee Court of Appeals ruled on January 2, 2013 that a tenant was required to pay its landlord's Tennessee excise tax liability, based on the terms of the applicable lease agreement. J-Star Holdings, LLC v. The Pantry, Inc., Appeal No. M2012-01035-COA-R3-CV (Jan. 2, 2013). Based on this decision, tenants should carefully review real property rental agreements for property in Tennessee to make sure that the terms of those agreements accurately reflect the understanding of the parties with respect to taxes.
In J-Star Holdings, the lease agreement included the following provisions related to taxes:
4(d). Tenant [Pantry] acknowledges and agrees that it is intended that this Lease will be, except as otherwise expressly stated herein, a "net lease" to Landlord [J-Star].
10(a). Tenant shall pay ... as additional rent, all taxes, assessments, license fees, ... and other charges (collectively referred to as "Taxes" levied or assessed against all merchandise, personal property, real property, buildings and improvements and any other obligations which are or may become a lien or levied against the premises.... or any other tax, fee or excise, however described.
10(b). Tenant shall not be required to pay any municipal, county, state, or federal income or franchise taxes of Landlord.
The question posed to the Tennessee Appeals Court was whether the Pantry was required to pay the Tennessee excise tax assessed against its landlord, J-star. Based on the provisions agreed to by the parties, the court concluded that the Tennessee excise was "within the list of taxes enumerated" to be paid by the tenant as "any other tax, fee, or excise, however described." The court further concluded that exclusion of state income or franchise taxes did not include the excise tax. The court stated that "[a]lthough the franchise and excise taxes are part of the same taxing scheme, they are separate taxes, [and] the express exclusion of the franchise tax from the required payments by the lessee implies the inclusion of the excise tax."
While the court might be correct in stating that the excise tax is not an income tax, the excise tax is a tax on the privilege of doing business in Tennessee by any "person," defined to be most forms of organization that provided limited liability to the owners, and the tax is measured by net income, generally determined in the same manner as federal taxable income with certain additions and subtractions. It is hard to distinguish an income tax from an excise tax that is equal to the tax rate multiplied by net income, but the Court strictly construed the terms of the agreement in reaching its decision.
This decision could be a problem for tenants with leases that are intended to exclude the landlord's income tax from the taxes required to be paid by the tenant. If the exclusion in Section 10(b) of the lease had excluded any tax "based on net income" rather than simply an "income tax," the tenant would have likely prevailed. For those drafting leases for property in Tennessee, this is a cautionary tale that the exclusion should specifically contemplate the Tennessee excise tax.
As this is a Court of Appeals decision, the Pantry is likely to request the Tennessee Supreme Court to review the decision. An application for appeal must be filed by the first of March, but because that review is discretionary, the Supreme Court may not grant a review. The attorneys of Bradley Arant Boult Cummings LLP will continue to monitor this issue closely for further developments.
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