nexus issues in state taxation - mayer brown · nexus issues in state taxation seminar ... • the...

Nexus Issues in State Taxation

SEMINARRecent Developments:Tax Controversy and Tax Reform

Christine Cagnina

Partner, Charlotte

704 444 3631

[email protected]

Paul DiSangro

Partner, Palo Alto

650 331 2045

[email protected]

Leah Robinson

Partner, New York

212 506 2799

[email protected]


Nexus and the U.S. Constitution

• The requirements of both the Due Process Clause and the CommerceClause of the U.S. Constitution must be satisfied before a state may tax anout-of-state entity.

• The requirements of Due Process clause are easily satisfied under mostcircumstances.circumstances.

• Commerce Clause requires more, ‘substantial presence,’ but the reality isthat states are ignoring this part.

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Due Process Clause – Fairness Concerns

• Due Process Clause asks whether the connections with a state aresubstantial enough to allow the state to legitimately exercise its taxingjurisdiction.

Due Process Clause & Taxpayer's Right – U.S. Const. amend XIV, § 1• Due Process Clause & Taxpayer's Right – U.S. Const. amend XIV, § 1

[N]or shall any State deprive any person of life, liberty, or property,without due process of law...

• [Similar to U.S. Const. amend. V]

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Due Process Clause – Fairness Concerns

• Wisconsin v. J.C. Penney Co., 311 U.S. 435 (1940)

"The simple but controlling question is whether the state has given anything for which it canask return.“

• Allied Signal v. Dir., Div. of Taxation, 504 U.S. 768 (1992)• Allied Signal v. Dir., Div. of Taxation, 504 U.S. 768 (1992)

“. . . there must be a connection to the activity itself, rather than a connection only to theactor the State seeks to tax. . . . The constitutional question in a case such as Quill Corp. iswhether the State has the authority to tax the corporation at all.”

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Commerce Clause – Systemic Concerns

• Commerce Clause - Protects Interstate Commerce

• The Constitution gives Congress the power to “regulate Commerce … among theseveral States.” Article 1, Section 8, Clause 3. -

– Taxation is regulation

• The Supreme Court's contemporary standard:

Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)

– Commerce Clause prohibits a state from taxing an out-of-statebusiness unless that business has a substantial nexus with the state.

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• Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)

• State taxes sustained if:

– Applied to activity with substantial nexus

– Fairly apportioned– Fairly apportioned

– Does not discriminate against interstate commerce

– Fairly related to services provided by the state.

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• Quill Corp. v. North Dakota, 504 U.S. 298 (1992):

• For a state to have taxing jurisdiction over a person under Commerce Clause principles,the person must have substantial nexus with the state, which for sales and use taxcollection purposes equates with physical presence in the state.

• No such physical presence requirement applies for Due Process purposes.• No such physical presence requirement applies for Due Process purposes.

• Principles applicable to taxes other than sales / use tax?

• The United States Supreme Court has not addressed the physical presence nexus standardissue since its landmark decision in Quill twenty-five (25) years ago. Many argue that theSupreme Court in Quill could not and did not anticipate the internet boom and, with it, thevastly different way that business would be conducted.

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• Direct Marketing Association v. Brohl, 135 S.Ct. 1124 (2015)(ConcurringOpinion of Justice Kennedy)

• “In other words, the Quill majority acknowledged the prospect that its conclusion was wrong whenthe case was decided.”

• “In Quill, the Court should have taken the opportunity to reevaluate Bellas Hess not only in light of• “In Quill, the Court should have taken the opportunity to reevaluate Bellas Hess not only in light ofComplete Auto but also in view of the dramatic technological and social changes that had taken placein our increasingly interconnected economy. There is a powerful case to be made that a retailer doingextensive business within a State has a sufficiently “substantial nexus” to justify imposing some minortax-collection duty, even if that business is done through mail or the Internet.

• “As a result, a business may be present in a State in a meaningful way without that presence beingphysical in the traditional sense of the term.”

• “The legal system should find an appropriate case for this Court to reexamine Quill and Bellas Hess.”

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Economic Presence Nexus

• Economic presence nexus focuses on revenues derived from the exploitation of thestate’s economic market, evidenced by a purposeful direction of business towards astate.

• Is an in-state market established or maintained?

• States will look at frequency, quantity, and the systematic nature of a company’s• States will look at frequency, quantity, and the systematic nature of a company’scontacts within the state, without regard to physical presence.

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Economic Presence Nexus – Royalty Companies

• Geoffrey, Inc. v. South Carolina Tax Comm’r, 437 S.E.2d 13 (1993), cert. denied, 510 U.S. 992 (1993)

• “[B]y licensing intangibles for use in this state and deriving income from their use here, Geoffrey has a‘substantial nexus’ with South Carolina” for purposes of the state’s income tax.”

• The licensing of a trade name or trademark creates sufficient nexus between an out-of-state licenserand the state to meet both the “minimum connection” standard required by the Due Process Clauseand the “substantial nexus” requirement of the Commerce Clause.and the “substantial nexus” requirement of the Commerce Clause.

• A & F Trademark, Inc. v. Tolson, (N.C. Ct. of App., 2004; appeal denied, N.C. Sup. Ct. 2005; cert. denied, U.S.2005).

• NC Court of Appeals held that licensing intangibles for use in North Carolina was sufficient to establishincome tax nexus for an out-of-state trademark holding company, even though the holding companyhad no physical presence in North Carolina.

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Economic Presence Nexus – Royalty Companies

• Lanco, Inc. v. Director, Division of Taxation (2006), cert. denied, 127 S. Ct. 2974 (2007).

• Corporation Business Tax applied to income derived by an out-of-state intangible holding companyfrom licensing fees attributable to New Jersey.

• Follows Geoffrey rationale.

• Quill does not apply to income taxes.• Quill does not apply to income taxes.

• KFC Corp. v. Iowa DOR, (Ia. Sup. Ct., 2010, cert. denied, U.S. No. 10-1340, 2011).

• A franchisor had nexus with Iowa for corporate income tax purposes because it was directingeconomic activity at the state by entering into licensing agreements with franchisees.

• Revenue generated from use of intangibles (KFC logo) in-state was considered a “deemed presence”and created nexus.

• Commerce Clause does not require a physical presence in order to tax the income earned from use ofintangibles in Iowa.

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Economic Presence Nexus – Credit Card and FinancialInstitutions

• J.C. Penney National Bank v. Johnson, Appeal No. M1998-00497-COA-R3-CV (Tenn. Ct. App. Dec. 17, 1999), appeal denied,Tenn. Sup. Ct. (May 8, 2000), cert. denied, 121 S.Ct. 305 (2000).

• Court of Appeals invalidated Tennessee’s franchise and excise tax assessment against the out-of-state J.C. Penney NationalBank.

• The tax violated the Commerce Clause because JCPNB had no “physical presence” in Tennessee and therefore did not havethe required substantial nexus as required by Quill.

• The tax did not, however, violate the “minimum contacts” standard of the Due Process Clause.• The tax did not, however, violate the “minimum contacts” standard of the Due Process Clause.

• Tax Comm’r v. MBNA America Bank, N.A., 640 S.E.2d 226 (W.Va. 2006), cert. denied, 127 S.Ct. 2997 (2007).

• MBNA did not need physical presence to generate revenue in the state. The court found that a physical-presence standardfor substantial nexus was outdated in the modern economy.

• “The development and proliferation of communication technology exhibited, for example, by the growth of electroniccommerce now makes it possible for an entity to have a significant economic presence in a state absent any physicalpresence there. For this reason, we believe that the mechanical application of a physical-presence standard to franchiseand income taxes is a poor measuring stick of an entity’s true nexus with a state.”

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Economic Presence Nexus – Credit Card and FinancialInstitutions

• MBNA America Bank, N.A. v. Indiana Dept. of Revenue, 895 N.E.2d 140 (Ind. Tax Ct. 2008).

• Economic presence sufficient to establish substantial nexus for out-of-state credit card bank.

• Quill does not extend beyond sales and use taxes.

• Capital One Bank v. Commissioner of Revenue, 9 N.E.2d 76 (Mass. 2009), cert. denied, 557 U.S. 919 (2009).

• Out-of-state intangible holding company / credit card bank had substantial nexus with Massachusettsbased on economic presence.

• Capital One Auto Finance, Inc. v. Department of Revenue, Dkt. No. TC 5197 (Oregon Tax Ct. Dec. 23, 2016)

• Oregon Tax Court held that physical presence was unnecessary to establish nexus for corporate exciseand corporate income tax purposes.

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Economic Presence Nexus – Factor Presence Nexus

• Factor Presence Nexus:

› Quantitative measurement of economic presence within a state.

• Purest economic nexus theory, if you exceed a certain threshold, you have nexus.

• General rule for income tax nexus as adopted by MTC 10/17/2002:

• More than $50,000 of property in the state, or

• More than $50,000 of payroll in the state, or

• More than $500,000 of sales in the state, or

• More than 25% of total property, payroll, or sales in the state.

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• Quantitative Provisions:

› MTC Factor Presence ($500K in sales)

› Alabama Code Sec. 40-18-31.2 ($500K in sales)

› Cal. Rev. & Tax Code § 23101 ($500K in sales)

› Colorado 39 Colo. Code Regs. §39-22-301.1 ($500K in sales)›

› Mich. Comp. Laws Ann. § 206.62 ($350K in sales)

› New York Tax Law §209(1) ($1M in sales)

› Ohio Rev. Code Ann. § 5751.01 ($500K in sales)

› Tenn Code Ann. § 67-4-2004(49)(A)(v) ($500K in sales)

› Wash. Rev. Code Ann. § 82.04.067 ($250K in sales)

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• Qualitative Provisions:

› Connecticut

• Conn. Gen. Stat. § 12-216a (“Any company that derives income from sources within this state and that has a substantialeconomic presence within this state, evidenced by a purposeful direction of business toward this state”).

• $500,000 quantitative threshold adopted by informal publication. Conn. Informational Publication No. 2010(29.1) (Dec.28, 2010).28, 2010).

› New Hampshire

• N.H. Rev. Stat. Ann. § 77-A:1(XII) (“substantial economic presence”).

› Virginia

• VA Code Ann. Tit 32, § 58.1-400 (“having income from Virginia sources”).

› Wisconsin

• Wisc. Stat. § 71.22(1r) (“regularly selling products or services of any kind or nature to customers in [Wisconsin]”).

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• Ohio Supreme Court issues first factor nexus determination:

Crutchfield Corp. v. Testa, Slip Opinion No. 2016-Ohio-7760 (Ohio 2016). (The Crutchfield decision was filedwith two companion cases with identical claims, Newegg, Inc. v. Testa and Mason Cos., Inc. v. Testa)

• Ohio Supreme Court upheld the constitutionality of Ohio’s factor presence nexus standard for purposesof the Ohio Commercial Activity Tax (“CAT”).

• Physical presence requirement in Quill does NOT extend to business privilege taxes such at the CAT.• Physical presence requirement in Quill does NOT extend to business privilege taxes such at the CAT.

• By Order dated January 31, 2017, the United States Supreme Court granted Crutchfield an extension oftime until April 16, 2017 to file a petition for certiorari.

• On April 14, 2017, the parties in Crutchfield Corp. v. Testa settled their dispute regarding theconstitutionality of Ohio’s factor-presence economic nexus test. As a result of the settlement,Crutchfield, Newegg, and Mason will register for and pay Ohio’s CAT.

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Economic Presence Nexus – P.L. 86-272 Limits

• Public Law 86-272, Title 1, §101, 73 Stat. 555 (codified as amended at 15 U.S.C. § 381 et seq. (1959)):

“No State, or political subdivision thereof, shall have power to impose, for any taxable year . . ., a netincome tax on the income derived from within such State by any person from interstate commerce if theonly business activities within such State by or on behalf of such person during such taxable year are either,or both, of the following:

1) The solicitation of orders by such person, or his representative, in such State for sales of tangible1) The solicitation of orders by such person, or his representative, in such State for sales of tangiblepersonal property, which orders are sent outside the State for approval or rejection, and, if approved,are filled by shipment or delivery from a point outside the State; and

2) The solicitation of orders by such person, or his representative, in such State in the name of or for thebenefit of a prospective customer of such person, if orders by such customer to such person to enablesuch customer to fill orders resulting from such solicitation are orders described in paragraph (1).”

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• Economic presence nexus does not negate P.L. 86-272.

• Applies to income tax.

• Statutory provision – no tax on income if:

› Not domestic entity;

› No office in state;›

› Only business activity in state is solicitation for sales of tangible personal property;

› Order accepted outside state;

› Goods shipped or delivered to state from outside state.

• Wisconsin Dep’t of Rev. v. William Wrigley, Jr., Co., 505 U.S. 214 (1992)

› Solicitation activities AND ancillary activities are protected.

› De minimis rule applies.

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• Congress enacted P.L. 86-272 in 1959 in response to a U.S. Supreme Court decision regarding a state’s ability to tax interstateactivities.

› Burden of compliance and lack of precise standards could lead to companies limiting their interstate activities.

• This ‘temporary solution’ has been the source of frequent litigation, legislative debate in Congress and in Statehouses, andinnumerable audits by state revenue departments.

• For years, P.L. 86-272 and “physical presence” were not only in sync, but P.L. 86-272 offered more protection.

• When a business is not covered by P.L. 86-272, Due Process and Commerce Clause guidance governs whether a state may taxthe income of a multistate business, and then state laws themselves.

• Hierarchy:

› Federal Constitution

› Federal Law (P.L. 86-272)

› State Constitution

› State Law (Economic Nexus)

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• P.L. 86-272 only applies to tangible personal property.

• If you are selling “intangible” property, or if you are selling a service, then P.L. 86-272 does not protect you.

• A lot has changed since 1959– digital books, movies, music, software.

› Things that were tangible personal property are much harder to touch.

• Not much guidance. P.L. 86-272 itself does not define TPP.

• Few definitions of TPP for income tax purposes across the states.• Few definitions of TPP for income tax purposes across the states.

› Utilizing sales tax definitions of TPP is initially helpful, as states have moved to protect the sales tax base (e.g., software)

› Illinois DOR General Information Letter IT 98-0077-GIL, 10/07/1998; Illinois DOR Private Letter Ruling No. IT 90-007-PLR,(January 8, 1990).

• Canned computer software is TPP and custom software is intangible property for P.L. 86-272 purposes.

• Relied on sales tax statutory definition of TPP.

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• AccuZIP, Inc. v. N.J. Division of Taxation, 25 N.J. Tax 158 (Aug. 13, 2009)

› AccuZIP, a Nevada Corporation with offices in California, marketed its products via print ads and a web page. Customers placed ordersvia telephone, e-mail, or fax with an AccuZIP employee in California. Products were shipped via common carrier from California.AccuZIP did not have employees in New Jersey and did not own or rent any real property in New Jersey.

› Customers of AccuZIP bought a license to use the software (rather than own it outright). AccuZIP retained the copyright and the rightto terminate the license agreement. The Director of Taxation found that AccuZIP was “doing business” in New Jersey because itretained intangible property in the state (title to licensed software).

• In a prior case, New Jersey’s highest court held that physical presence was not required for substantial nexus except in the salesand use tax context.

› The Tax Court concluded the nature and extent of AccuZIP's activities in New Jersey, were de minimus. Accordingly, AccuZIP was notdoing business in New Jersey and there was no substantial nexus between AccuZIP and New Jersey.

› The Tax Court assumed that if AccuZIP was found to be doing business in New Jersey, AccuZIP would nevertheless fall under theprotections of P.L. 86-272.

• The software was clearly TPP under New Jersey sales tax law, but NJ claimed that it was intangible property for purposes of P.L.86-272. The court found that the software was TPP for P.L. 86-272 purposes.

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• Application of P.L. 86-272 to gross receipts taxes and other non-income based taxes:

› Certain states impose a combined franchise tax with several alternative bases (income,capital, minimum) and require the taxpayer to pay the higher of the taxes. Other states,e.g., Texas, Michigan and Ohio, have enacted business taxes imposed on gross receiptsinstead of net income.

› Some of the states with multiple bases have taken the position that P.L. 86-272 protects the› Some of the states with multiple bases have taken the position that P.L. 86-272 protects thetaxpayer from net income taxes only. See INOVA Diagnostics, Inc. v. Strayhorn, No. 03-04-00503-CV (Tex. Ct. App. May 26, 2005).

› MTC has also supported the repeal of P.L. 86-272 in states that enact the factor-based nexusstandard.

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Economic Presence Nexus – Sales Tax Nexus

• Sales Tax -

• South Dakota

• Effective May 1, 2016, an out-of-state retailer must collect sales tax if in the previous or current calendar year: (1) theseller's gross revenue from the sale of tangible personal property, any product transferred electronically, or servicesdelivered into South Dakota exceeds $100,000; or (2) the seller sold tangible personal property, any product transferredelectronically, or services for delivery into South Dakota in 200 or more separate transactions.

• State of South Dakota v. Wayfair, Inc., S.D. Cir. Ct., No. 32 Civ. 16-000092 (Mar. 6, 2017)• State of South Dakota v. Wayfair, Inc., S.D. Cir. Ct., No. 32 Civ. 16-000092 (Mar. 6, 2017)

• South Dakota Sixth Judicial Circuit Court granted Wayfair’s motion for summary judgment, finding South Dakota’sremote sales tax statute unconstitutional under Quill.

• South Dakota may NOT impose sales tax collection and remittance obligations on sellers who do not have an in-statepresence in accordance with Quill requirements.

• On March 8, 2017, South Dakota filed a Notice of Appeal requesting the Supreme Court of South Dakota to reconsiderthe March 6th Order Granting Defendants' Summary Judgment.

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• Sales Tax -

• Alabama

• Effective January 1, 2016, per Alabama Regulation 810-6-2-.90.03, an out-of-state seller that lacks a physical presence inAlabama but makes retail sales of tangible personal property to state residents must collect and remit Alabama salestax if it has a “substantial economic presence” in Alabama.

• An out-of-state seller has a substantial economic presence if its retail sales in Alabama during the prior calendar year• An out-of-state seller has a substantial economic presence if its retail sales in Alabama during the prior calendar yearexceeded $250,000, and the seller conducted any one or more of certain enumerated activities.

• The Alabama Department of Revenue issued a press release announcing that the online retailer Newegg Inc. filed anappeal on June 8, 2016, challenging an assessment under the department's newly enacted regulation that requires largeremote sellers to collect state sales and use tax regardless of whether the seller has a physical presence in the state.

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• Sales Tax -

• In addition to Alabama (the first regulatory action) and South Dakota (the first statutory action), several other states have taken up the challenge to Quill.

› Massachusetts Department of Revenue issued a policy directive requiring qualifying internet vendors to collect sales and use tax beginning July 1, 2017.

› The North Dakota legislative assembly enacted an economic sales and use tax nexus law similar to South Dakota’s economic nexus law. However, the North Dakotaprovision only becomes effective contingent on the U.S. Supreme Court overturning Quill or otherwise confirming that a state may constitutionally impose a salesand use tax on remote sellers.

› The Tennessee Department of Revenue promulgated a regulation requiring remote sellers without physical presence who made over $500,000 of sales to registerby March 1, 2017 and begin collection by July 1, 2017. That regulation must be finally approved by the Tennessee General Assembly. Additionally, The Tennesseeby March 1, 2017 and begin collection by July 1, 2017. That regulation must be finally approved by the Tennessee General Assembly. Additionally, The TennesseeDepartment of Revenue has agreed not to enforce the nexus rule following a complaint filed by two remote retailers in Tennessee Chancery Court on March 30,2017. The department and taxpayers jointly agreed to an injunction of the rule, granted on April 10, 2017.

› Vermont enacted a statute similar to South Dakota that becomes effective the later of July 1, 2017 or after the U.S. Supreme Court or federal legislation abrogatesthe physical presence requirement established by Quill.

› The Wyoming legislature enacted an economic sales and use tax nexus law on March 1, 2017, effective on July 1, 2017. That law requires remote sellers to collectand remit sales tax on sales to Wyoming customers if, within the current or preceding calendar year, the sellers’ gross revenue from the sale of tangible personalproperty, admissions or services delivered into the state meet specific thresholds for sales or separate transactions made into the state.

› All 50 state legislatures are scheduled to be in session in 2017. A number of economic sales and use tax nexus laws have been proposed in the first two months ofthe year, including Arkansas (which has since died in committee), Georgia, Indiana, Mississippi (died in committee, with reports that the state department ofrevenue will consider rulemaking on the issue), Nebraska, North Carolina, North Dakota, Utah and Washington, among others.

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Nexus – Chicago Lease Transaction Tax

• Chicago imposes a lease transaction tax on the use of leased personal property within city limits.

› Hertz Corp. v. City of Chicago, 2017 IL 119945 (Jan. 20, 2017).

• Chicago imposed a tax on car rental companies within 3 miles of city limits, if the vehicles were rented by city residents.

• Unless there was written proof to the contrary, if a suburban car rental firm leased to a Chicago resident, the city assumed the driver used thevehicle more than half of the time in the city and would tax the transaction.

• The Illinois Supreme Court ruled that Chicago could not impose the tax on suburban car rentals because it violated the Illinois Constitution.

– Given the number of local governmental units, particularly in the Chicago area, unrestrained extraterritorial exercise of thepowers of taxation and zoning in other areas could create serious problems.

– At the time of the lease transaction, the use of the leased vehicle has not taken place and may never take place withinChicago’s borders. There is no delivery of the leased vehicles into Chicago, and the lease transactions take place whollyoutside Chicago.

› Lease Tax Ruling #12 (June 9, 2015).

• Chicago extended the lease transaction tax to cloud computing.

• Since the providers of the cloud computing services are often located outside Chicago’s boarders, the ruling is potentially subject to challengeafter Hertz.

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Questions?

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