State tax nexus.

The term "nexus" is used to describe the amount and degree of business activity that must be present before an entity's activities can be subject to state tax. The issue of nexus is a complex one, relying on the application of constitutional, judicial and state and Federal statutory provisions to a unique factual situation in order to determine whether an entity is subject to state taxation. The AICPA Tax Division's State and Local Taxation Committee has developed a publication, State Tax Nexus Checklist/Practice Guide, containing a brief summary of nexus and the issues involved, as well as a checklist of the most frequently asked questions that appear in states' nexus questionnaires. The checklist, intended for use as a broad reference tool and as an aid in addressing nexus issues, can also serve as a practice aid for soliciting and analyzing information from clients. It should be noted, however, that there may be different nexus standards for different types of taxes, and that the laws and policies of each state should be verified for application to specific cases. The Practice Guide also contains a compilation of specific nexus checklist questionnaires used by several states and a summary of nexus attributes unique to each of those states.

In general, a state will have the power to impose a tax or tax collection duty on a taxpayer if the taxpayer has sufficient contacts or nexus with the state. Various Federal constitutional and statutory doctrines and constraints, as well as those for individual states, must be considered in determining whether nexus exists. Because state statutes are not uniform, an uninformed taxpayer may fail to recognize when these constitutional and statutory restrictions may be invoked to make the filing of a return and remittance of taxes necessary. It has become increasingly important for corporations with multistate operations to identify the nature and extent of their contacts with the states and to verify that all filing obligations are satisfied. Not filing when required can result in taxpayers paying more than their share of taxes; the statute of limitations for claiming a refund from the state to which the income was attributed may be closed by the time the state with which the taxpayer did not file assesses tax.

Constitutional Provisions

The Due Process Clause and the Commerce Clause are generally considered to be the primary constitutional limitations on state taxation. Despite early U.S. Supreme Court decisions that placed broad constitutional restrictions on the states' powers to tax multistate operations, the Court since that time has increasingly limited these restraints, in effect expanding states' taxing jurisdiction.

Due Process. The Fourteenth Amendment prohibits states from denying any person "life, liberty, or property, without due process of law." This provision, known as the Due Process Clause, has historically encompassed two aspects--procedural due process, which guarantees fair procedures (such as notice and the right to a hearing), and substantive due process, which protects against unfair governmental interference or taking of property.

Taxation is regarded as the deprivation of a person's property. A state whose laws provide protection, security and opportunities to individuals, property and businesses may exact a toll in the form of taxes to support the government, but not without due process of law.

The U.S. Supreme Court has clarified and limited the jurisdictional requirements set forth in the Due Process Clause. For a state to have jurisdiction to impose a tax on a taxpayer, there must be a "`minimal connection' between the interstate activities and the taxing state." In Quill Corporation v. North Dakota, 504 US 298 (1992), the U.S. Supreme Court conceded that the jurisprudence of due process had evolved to the point that a corporation need not be physically present in a state. According to Quill, the due process inquiry should focus on whether it was "reasonable, in the context of our federal system of government, to require [a taxpayer] to defend the suit in that state." Therefore, an out-of-state corporation that avails itself of the benefits of an economic market in the taxing state may be subject to that state's tax jurisdiction.

Allied-Signal v. Director, Div. of Rev., 504 US 768 (1992), distinguished the two components of due process. It is not enough that a state had authority to levy and collect a tax against an out-of-state entity (procedural due process analysis). The principle of fairness (the substantive due process analysis) required that a state also must have jurisdiction over the income or activity sought to be taxed. The inquiry therefore focused on whether the tax on the income or activity is justified by the protection, opportunities and benefits provided by the state.

Commerce Clause. The Commerce Clause delegates to Congress the power "[t]o regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes." The primary purpose of the Commerce Clause is to assure fair-handed interstate trade. Unlike the Due Process Clause (which specifically restricts states' actions), the Commerce Clause delegated certain powers to the Federal government. In several areas, Congress has not specifically exercised this power, but the courts have determined that if a state tax unduly interferes with interstate commerce, it runs afoul of the unexercised power of Congress to regulate commerce. This type of restriction is known as the "dormant commerce clause" principle.

In Western Live Stock v. Bureau of Rev., 303 US 250 (1938), the Court held that "[s]tate taxation falling on interstate commerce ... can only be justified as designed to make such commerce bear a fair share of the cost of the local government whose protection it enjoys." To pass muster under modern Commerce Clause scrutiny, a state tax must be applied only to an activity with a substantial nexus with the state (Complete Auto Transit v. Brady 430 US 274 (1977)).

Overlap in Due Process and Commerce Clause protections. The two constitutional protections and the underlying issues are often intertwined; in some instances, the courts have failed to distinguish clearly the appropriate constitutional inquiry. This distinction between the constitutional protections is important; however, a state tax declared unconstitutional under the Commerce Clause may be legislatively allowed by Congress, whereas one found unconstitutional under Due Process may not. In Quill, the U.S. Supreme Court distinguished the minimum contact requirement of the Due Process Clause from the substantial nexus requirement of the Commerce Clause. According to the Court, the Commerce Clause requires that a seller have a physical presence in the state before a state may impose a use tax collection responsibility; no such physical presence requirement applies for Due Process purposes. Unfortunately, the Court did not address whether the Commerce Clause also requires a physical presence for other types of taxes.

In Geoffrey, Inc. v. South Carolina Tax Comm'n, 437 SE2d 13 (1993), the South Carolina Supreme Court held that a Delaware holding company that owned only intangible property (trademarks) used in South Carolina was subject to income tax. The Court rejected Geoffrey's claim that it had not purposefully directed its activities toward South Carolina's economic forum, and held that by licensing intangibles for use in the state and receiving income in exchange for their use, Geoffrey had the minimum connection and substantial nexus required by the Due Process and the Commerce Clauses. In addition, Geoffrey's receivables were found to have a business situs in South Carolina. The U.S. Supreme Court subsequently denied certiorari in Geoffrey (114 S.Ct. 50 (1993)), making the case applicable only in South Carolina. Many states, however, have incorporated through statute or regulation the principles of economic nexus regarding intangibles in the nature of trademarks and trade names as outlined in Geoffrey.

P.L. 86-272

Pursuant to its power under the Commerce Clause to regulate interstate commerce, Congress enacted P.L. 86-272 in 1959. The statute, codified as 15 USC Section 381, limits the states' power to impose income taxes on certain out-of-state sellers.

The term "solicitation," however, is not defined in P.L. 86-272. Thus, the scope of activities that constitute protected solicitation has been left to the courts to decide. Because of the myriad of state court decisions, no uniform definition or rules have emerged. Some states (such as Indiana, New York and Pennsylvania) define solicitation broadly, permitting companies to conduct many activities in the state and still fall within the protective arm of the Federal statute. Still others (such as California and Ohio) define solicitation narrowly, offering immunity only to companies that limit their activities to the specific act of asking a customer to purchase a product.

In Wisconsin Dep't of Rev. v. William Wrigley, Jr. Company, 112 S. Ct. 2447 (1992), the U.S. Supreme Court considered the scope of activities that constitute protected "solicitation" under P.L. 86-272. In Wrigley, the Court rejected a strict interpretation by holding that solicitation includes not only actual requests for purchases, but also other activities entirely ancillary to requests for purchases of goods, so long as the activities "serve no independent business function apart from their connection to the solicitation of orders." It is not enough to facilitate sales; an activity must facilitate the requesting of sales. Although solicitation of orders may now encompass the entire order-taking process, it does not include independent business functions the company had reason to engage in anyway but which are conducted by its sales force. The Court further concluded that, absent language to the contrary P.L. 86-272 incorporates a de minimis standard. Specifically, activities that constitute a trivial additional connection with the taxing state will be considered de minimis.

P.L. 86-272 also states that goods may be delivered into a state by an out-of-state seller, whose activities in the state do not exceed solicitation, without subjecting that seller to the state's taxing jurisdiction. Like solicitation, the term "delivery" is not defined. In an emerging trend, the Multistate Tax Commission (MTC) and several state taxing authorities have taken the position that use of a seller's trucks, whether owned or leased, to make deliveries of its goods into a taxing state is not protected activity under P.L. 86-272. Although the high courts in Massachusetts and Virginia have held that the use of company-owned vehicles to deliver products in the state does not exceed the protections granted by P.L. 86-272 (National Private Truck Council v. Comm'r of Rev., 688 NE2d 936 (1997), and National Private Truck Council v. Virginia Dep't of Tax., 480 SE2d 500 (1997)), case law and administrative interpretations among the states are inconsistent and provide little guidance in this area.

MTC Guidance

The MTC has issued lengthy guidance under P.L. 86-272, "Information Concerning Practices of Multistate Tax Commission States Under Public Law 86-272" (adopted July 11,1986), "Statement of Information of Multistate Tax Commission and Signatory States Under Public Law 86-272 as Revised January 22, 1993" and "Statement of Information of Multistate Tax Commission and Signatory States Under Public Law 86-272 as Adopted July 29, 1994," have all been issued. These documents include a list of activities that the MTC considers protected under P.L. 86-272, as well as a list of unprotected activities that will cause taxpayers to lose their protection.

Working through the MTC, 26 states issued Nexus Program Bulletin 95-1, targeting the computer direct marketing industry. The bulletin takes the position that, because in-state repair services are not immune from taxation by reason of P.L. 86-272, the use of independent contractors or other representatives of a computer company to provide such repair services creates nexus for a computer company. Although the nature of the bulletin is informational and educational rather than regulatory, it has met much opposition from industry and mixed reaction from the states. In fact, after initially signing on to the bulletin, California has rejected the bulletin as a policy statement. The California State Board of Equalization voted on March 14, 1996 to rescind California's inclusion on the list of 26 states that have adopted Bulletin 95-1.

In addition, the MTC has developed a nexus program that assists businesses involved in multistate commerce in voluntarily resolving potential state sales/use and income/franchise tax liabilities in which nexus is the central issue. The program acts as a coordinator through which companies may approach the 39 member states (AL, AK,AZ,AR, CA, CO, CT, DC, FL, HI, ID, IA, KS, KY, LA, ME, MD, MA, MI, MN, MO, MT, NE, NH, NJ, NM, NC, ND, OH, OK, OR, RI, SC, SD, TX, UT, WA, WV, WI) anonymously and seek resolution of potential liabilities arising from past activities.

Conclusion

This article is intended to serve as an overview to the issue of nexus; it in no way fully addresses the many issues inherent in a state nexus question. Looking forward, the complexities surrounding nexus stand only to increase. The advent of electronic commerce further complicates matters, as does the trend toward globalization of the economy. The AICPA's State Tax Nexus Checklist/Practice Guide is a useful tool for navigating the complexities surrounding this issue of nexus.

Note: Copies of the 430-page guide can be obtained by calling [phone], dept. 1. Tax Section members should request Product No. 061058VC; others should request Product No. 061058. It is free for Tax Section members, $30 for AICPA members and $40 for non-AICPA members.

Editor's note: Ms. Boucher chairs the AICPA Tax Division's State and Local Taxation Committee. Mr.Keeter is a member of the committee.

If you would like more information about this article, contact Mr. Keeter at [phone].

Karen J. Boucher, CPA Arthur Andersen LLP Milwaukee, WI

Neil P. Keeter, CPA James A. Samans, J.D. Ernst & Young LLP Washington, DC