Sales and use tax nexus - 1989.

Sales and Use Tax Nexus - 1989

Sales and use taxes are viewed by state lawmakers and state tax administrators as a fertile source of additional revenue. Aggressive and creative programs and policies are being pursued on various levels aimed at maximizing the taxes generated within the existing tax structure. These efforts include:

* Federal Legislation: State and local tax administrators are lobbying Congress to enact legislation to overrule the 1967 decision of the Supreme Court of the United States in National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967), which insulates certain mail order firms from use tax collection responsibility.

* Litigation: Through aggressive litigation, there has been a gradual erosion of the constitutionally required "nexus," or connection, between the state and the person or activity it seeks to tax, e.g., by the development of the "economic nexus" concept and the "alter ego theory."

* Multi-State Agreements: There has been a proliferation of information-sharing and other cooperative agreements between two or more states, including subtle and not-so-subtle pressure to gain voluntary sales tax registration.

* Aggressive Tax Enforcement: Programs, including the dissemination of nexus questionnaires, and sophisticated audit techniques are putting more taxpayers on the tax rolls and generating larger audit assessments.

As a result of these efforts, the states are testing the constitutional limits of "nexus" and, in so doing, are forcing business to make very difficult decisions involving competitive position and costly compliance burdens. For example, consider the following:

1. Your client or your company is undergoing a New York State sales tax audit and, in the course of the audit, the auditor questions interstate sales to New Jersey customers. The auditor advises that there is a collection agreement between New York and New Jersey and urges voluntary sales tax registration pursuant to this agreement, even though there is insufficient nexus to impose a legal requirement to register in New Jersey. The strong implication is that, if registration in New Jersey does not take place, the interstate sales deductions will be scrutinized and the names and addresses of New Jersey customers will be forwarded to New Jersey tax authorities to ensure that use taxes are paid.

If your client or company asks you whether they should register, what advice should you give them?

2. Assume the same scenario, except that the agreement is between border states both of which have enacted nexus-broadening statutes (such as North Dakota and South Dakota). Your client's or company's activities fall squarely within the ambit of the expanded definition of "engaged in business," which you believe, as applied to your client, is of doubtful validity.

What is your advice?

3. Suppose your company is one of the 200 direct marketing firms that received a letter from the California Board of Equalization, instructing them to register to collect tax on the ground that they satisfy statutory nexus by virtue of direct mail solicitation and customer payments for merchandise with credit cards issued by California banks.

What advice do you give your company's management?

4. Assume you are an interstate seller with substantial nexus in a state seeking to assess tax on promotional materials prepared by an out-of-state printer and distributed to prospective customers via the U.S. mail. The relevant statute does not include within its definition of taxable use "distribution" or similar broad language that was the basis of a Louisiana finding of "taxable use" of catalogs, which the Supreme Court upheld in D.H. Holmes, Ltd. v. McNamara, 108 S. Ct. 1619 (1988).

Do you tell your client to appeal the assessment?

A review of the development of the constitutional principles is helpful in understanding the evolution of the application of nexus standards to sales and use taxes but, as will be evident, such understanding does not provide definitive answers to these questions.

The Due Process Clause of the United States Constitution - which provides that "no state shall . . . deprive any person of life, liberty, or property, without due process of law . . ." - limits the states' jurisdiction to tax. In the context of state taxation, due process generally requires that two tests be satisfied:

* There must be some minimal connection or definite link between the state and the person or activity to be taxed.

* The income sought to be taxed must be reasonably related to the activities in the taxing state.

See Mobil Oil Corp. v. Vermont Commissioner of Taxes, 445 U.S. 425 (1980).

The requirements of the Due Process clause overlap three of the four requirements established to determine whether a tax impermissibly burdens interstate commerce. The Commerce Clause requirements are that (i) there be a "substantial nexus" between the state and the activity sought to be taxed, (ii) the tax be fairly apportioned, (iii) it does not discriminate against interstate commerce, and (iv) the tax be fairly related to services provided by the state. (See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).) Therefore, a challenge of a sales or use tax levy on Commerce Clause grounds will cover Due Process as well.

From a historical perspective, the "duty to collect" cases are considered separately from the cases involving imposition of a direct tax. The Supreme Court's most recent "duty to collect" decision, National Geographic Society, Inc. v. California Board of Equalization, 430 U.S. 551 (1977), suggests that a more stringent "nexus" standard might be required to support imposition of a direct tax, than the nexus standard applied in cases in which a duty to collect tax is involved. In recent holdings, however, that distinction has been ignored and the less stringent "nexus" standard applied.

Duty to Collect Tax

The case law dealing with the degree of "nexus" required to impose on a vendor the duty to collect use tax on in-state sales begins with the 1941 decision in Nelson v. Sears, Roebuck & Co., 312 U.S. 359 (1941). The Supreme Court held in that case that the presence of retail stores within the state constituted a sufficient connection to require Sears to collect Iowa use tax on mail order sales handled by a division separate from the retail operations.

In a surprising five-to-four decision in 1954, the Court ruled in Miller Brothers v. Maryland, 347 U.S. 340 (1954), that Maryland could not require a Delaware retailer to collect Maryland use tax on deliveries to Maryland residents. The Court found insufficient nexus even though the retailer's advertising regularly reached Maryland customers and merchandise was delivered in their own trucks.

In 1960, the Court in Scripto, Inc. v. Carson, 362 U.S. 207 (1960), ruled that Florida could impose a tax collection duty on a Georgia firm whose only contact with Florida was the solicitation of sales of its products by independent contractors.

That decision prompted states to expand the scope of their jurisdiction and led to the Court's landmark 1967 ruling in National Bellas Hess. Illinois sought to require National Bellas Hess, a Missouri mail order firm whose Illinois activity was limited to soliciting sales through catalogs mailed to residents and shipping its merchandise to Illinois via the U.S. mail or common carrier, to collect use tax on its sales to Illinois residents. The Supreme Court ruled 6-to-3 that it could not. The dissenting opinion refers to the company's large-scale, systematic, and continuous solicitation of the Illinois consumer market and its substantial credit business, which could not be carried out without utilizing Illinois banking and credit facilities. Such in-state activities are contained in many of the recent state nexus-expanding legislation. National Bellas Hess is generally viewed as a Commerce Clause case, although some observers have concluded the decision is grounded in Due Process considerations. If Congress enacts legislation to overrule National Bellas Hess, a challenge is likely on the theory that, while Congress has authority to legislate in matters of Interstate Commerce, it is without power to do so where Due Process is concerned.

In the 1977 National Geographic case, the Court addressed a variation of the Sears facts, considering whether the presence in California of two advertising offices of National Geographic, which were unrelated to the mail order division, provided sufficient nexus to require National Geographic to collect tax on its mail order sales to California residents. The Court unanimously ruled that nexus need not be established for the particular activity sought to be taxed, but for the firm as a whole, and that it was satisfied here by the presence of two advertising offices.

The Court compared California's requirement that National Geographic collect tax on its mail order sales with the rule enunciated in Norton Co. v. Illinois Department of Revenue, 340 U.S. 534 (1951), regarding the requisite nexus for imposition of a direct tax. The Court in Norton ruled that Illinois's attempt to impose a direct tax on certain interstate sales must fail because a taxpayer's in-state activities, which are unrelated to the transactions sought to be taxed, do not create sufficient nexus to tax the unrelated activity. In distinguishing Norton, the Court in National Geographic stated that a less stringent nexus standard (based on an unrelated in-state presence) is warranted where a duty to collect tax is involved because the sole burden is an administrative one of collecting tax. The Court explained:

However fatal to a direct tax a showing that particular

transactions are disassociated from the local business . . .

such dissociation does not bar the imposition

of the use tax collection duty.

The Court next considered the nexus question in a sales (or use) tax case in 1988, this time involving a Louisiana use tax imposed on catalogs mailed from an out-of-state location (D.H. Holmes Co. v. McNamara). In its analysis of nexus, the Court ignored any distinction between the nexus required when imposing a direct tax, such as against Holmes, and the National Geographic "duty to collect" situation.

Imposition of a Direct Tax

The case-law evolution of the nexus required for imposition of a direct tax can be divided into two periods: Pre-and Post-Complete Auto Transit v. Brady, 430 U.S. 274 (1977). Prior to this 1977 decision, any attempt to impose tax on the privilege of engaging in an interstate business was "per se" unconstitutional. See Spector Motor Services v. O'Connor, 340 U.S. 602 (1951). Complete Auto Transit overruled the Spector Motor holding and established a practical approach to determining whether a tax infringes on interstate commerce. The Court stated that a tax does not burden interstate commerce if it satisfies four tests:

* It is fairly apportioned.

* It does not discriminate against interstate commerce.

* It is fairly related to services provided by the state.

* There is a substantial nexus between the state and

the activity sought to be taxed.

It was not until D.H. Holmes Co., Ltd. v. McNamara was decided in 1988 that the Court took the opportunity to apply the Complete Auto Transit framework to a challenged sales or use tax levy. Holmes involved a constitutional challenge to a Louisiana use tax imposed on the value of catalogs printed out of state and mailed to the homes of Louisiana residents. The Court concluded that the tax satisfied each of the four tests and, accordingly, did not unconstitutionally burden interstate commerce. The Court had little problem finding "nexus aplenty" by virtue of Holmes's ordering, paying for, and directing where the catalogs were sent, in addition to Holmes's substantial retail presence in the state.

The significance of the Court's nexus analysis is two-fold. First, the Court considered all of Holmes's activities in Louisiana in its nexus inquiry, instead of restricting its focus to the activity sought to be taxed (i.e., distribution of the catalogues). Secondly, comparing Holmes's facts to those in National Geographic, the Court concluded that the nexus is greater in Holmes's situation because its connection with Louisiana "far exceeds that of the magazine with California in National Geographic."

By analogizing Holmes with National Geographic, the Court disregarded the statement in National Geographic that a different nexus standard might apply to a case involving the duty to collect tax than would be applied to one involving imposition of a direct tax. Can we infer from this that on the same facts the Court would find no constitutional barrier to a California use tax imposed on catalogs mailed by National Geographic to California residents?

What's Next?

Proponents of a nexus standard based on "economic" rather than a "physical" presence were encouraged by the Court's response to Holmes's analogizing its catalog distribution to the mail order solicitation in National Bellas Hess:

This argument ignores Holmes significant economic

presence in Louisiana, its many connections with

the state, and the direct benefits it receives from

Louisiana in conducting its business. (Emphasis

added.)

The concept of economic nexus is gaining favor in state courts. In Boeing Equipment Holding Co. v. State Board of Equalization, No. 87-31-11 (Tenn. Ct. App. 1987) (appeal to Tennessee Supreme Court dismissed), the Tennessee Court of Appeals stated in a 1987 decision that "the constitutionally required nexus between a taxpayer and the taxing state is an economic rather than a physical one." In an unpublished 1988 decision - Ash Properties, Inc., No. 87-CA-1288-S (Ky. Ct. App. 1988) - the Kentucky Court of Appeals rules that an Ohio corporation that leased tangible personal property to a Kentucky lessee was subject to use tax on lease payments by virtue of the "economic benefits" derived from leasing in Kentucky.

New York has applied an "alter ego" theory to require a non-nexus company to collect tax on New York sales where an affiliated company has an in-state presence. In a 1986 Advisory Opinion - Harfred Operating Corporation [July 18, 1986) - the Tax Department opined that the non-nexus subsidiary must collect tax on its New York destination sales because the parent company, which operated in New York, "so dominates or controls the subsidiary as an instrumentality of the parent that the subsidiary should be considered the alter ego of the parent." That rationale was applied in a recent Advisory Opinion - Thomas B. Bottiglieri (March 2, 1988) - advising that the subsidiary, which solicited sales of mail order merchandise, must collect New York sales tax because of the promotional and marketing activities conducted in New York by the parent. The Department applied the "alter ego" theory to disregard separate entity status even though the Department did not find the purpose of establishing the subsidiary was to avoid collecting New York sales tax.

Even though "nexus" has been sharply eroded in recent years, not every state's attempt to extend its jurisdictional reach has been successful. In L.L. Bean, Inc. v. Commonwealth, No. 28956 C.C. 1984 (Pa. Commonwealth Ct. 1986), the court ruled that L.L. Bean did not have nexus in Pennsylvania by virtue of magazine and direct mail advertising, the use of a toll-free telephone number, and the sale of discontinued merchandise by an unaffiliated Pennsylvania retailer.

In 1987, the California Court of Appeals reached a similar conclusion in an opinion designated by the court "Not for Publication." In District Photo, Inc. v. California State Board of Equalization (Calif. Ct.App. - 3d App. Dist.), the court declined to find nexus based on District Photo's solicitation of business by advertising in California magazines and newspapers and maintaining two California post office boxes.

The limits of constitutionally required nexus continue to be tested by broader statutory definitions of "engaged in business," aggressive audit positions, and novel legal theories. As a result, it is difficult to advise your companies with any degree of certainty whether the nexus threshold has been crossed. The courts must be looked to for guidance.

One case that many thought would provide some answers was North Dakota v. Speigel, Inc., which was filed last year in North Dakota District Court. The case involved how far state legislatures may go in extending a state's jurisdictional reach to require sales tax registration by out-of-state vendors. Although some commentators predicted the case would reach the Supreme Court, it was settled before trial.

Consequently, guidance will have to be found elsewhere. In this regard, it is anticipated that a suit will soon be filed in California by the Direct Marketing Association which will test the validity of California's expansion of the term "engaged in business in California" to include soliciting orders through the mail if the vendor also accepts payment by credit cards issued by California banks.

Another nexus case with potentially far-reaching implications involves the legality of Alabama's excise (privilege) tax on banks. Alabama v. Citibank, et al., No. CV 88-288-G (Montgomery Cty Cir. Ct.). The State levied the tax of Chase, Citibank, and other out-of-state national banks whose activities in Alabama consist of soliciting credit card accounts, which in turn results in the extension of credit and the realization of interest income. Alabama had argued that regular solicitation of credit card accounts and the benefits derived from fees and interest paid by Alabama card holders constitutes "economic nexus" sufficient to satisfy Due Process.

Assuming these cases are decided by the courts - and, perhaps ultimately, reviewed by the Supreme Court - tax executives and tax advisers will be able to give advice concerning nexus with more certainty and assurance. Until that time, however, state lawmakers and state tax administrators can be expected to complicate the job of the tax executive and adviser by enacting new laws and advancing novel and creative theories designed to expand jurisdiction over out-of-state taxpayers.

John J. Cronin is the National Director, State and Local Tax Practice for Touche Ross & Co. Prior to joining Touche Ross, Mr. Cronin was employed by J.C. Penney Company as the Manager of Tax Compliance and Audits. He was a member of Tax Executives Institute for more than 20 years and served as 1987-1988 Chairman of the Institute's State and Local Tax Commitee. Mr. Cronin, who received his B.A.A. degree from Iona College, is a frequent author and lecturer on state and local tax subjects.

Michael A. Pearl is a Senior Manager specializing in multistate taxation with the accounting firm of Touche Ross & Co. Prior to joining Touche Ross in 1988, Mr. Pearl served for 13 years as a General Attorney for J.C. Penney Co.; at Penney, he was responsible for the legal aspects of state and local tax planning and litigation. Before that, Mr. Pearl served as Tax Counsel to the New York Chamber of Commerce and Industry. He has also served in the Peace Corps and taught tax law at the University of Liberia Law School from 1967 to 1969. Mr. Pearl received his law degree from St. John's University and his LL.M. degree from New York University.