State taxation of interstate commerce.

In the past few years, the Supreme Court has decided a surprisingly large number of cases concerning the constitutionality of state taxes on interstate commerce.(1)

The High Court long has deemed unconstitutional any state taxes that burden interstate commerce. The ability to challenge state and local taxes on constitutional grounds is a powerful and important tool for business litigators. Recent Supreme Court decisions have clarified the test that is applied in evaluating the constitutionality of these taxes and also the procedures for objecting to them.

From 1873 to 1977, the Court applied the rule that a state may not directly tax interstate commerce.(2) The Court invalidated a wide variety of state taxes, including a gross receipts tax on interstate sales,(3) a sales tax on interstate sales,(4) and a license tax on solicitors of orders for interstate sales.(5) The justices, however, allowed taxes that were deemed to have only an "indirect burden" on interstate commerce.(6)

The historical approach was criticized for being arbitrary and unpredictable. The effect of a tax on interstate commerce is a matter of degree, and where the line is drawn between what is direct as opposed to indirect is inherently uncertain, critics argued.

In 1977 in Complete Auto Transit, Inc. v. Brady, the Court abandoned this historical approach and adopted a test that treats state taxation of interstate commerce like state regulation of interstate commerce.(7) The case concerned the constitutionality of a Mississippi tax on gross revenues for the privilege of doing business in the state. Complete Auto took cars shipped from out-of-state by General Motors and hauled them to car dealers. At issue was whether the Mississippi tax was unconstitutional because it was imposed on an activity that was a part of interstate commerce.

The Supreme Court unanimously upheld the Mississippi law and emphasized that "no claim is made that the activity is not sufficiently connected to the State to justify a tax, or that the tax is not fairly related to the benefits provided the taxpayer, or that the tax discriminates against interstate commerce, or that the tax is not fairly apportioned."(8)

The Court made it dear that this functional approach to evaluating state taxes involving interstate commerce was meant to replace the earlier rule, which it saw as having "no relationship to economic realities."(9)

Since 1977, the Court has consistently followed the four-part test articulated in Complete Auto. A state tax does not violate the Commerce Clause if (1) it is applied to an activity with a "substantial nexus" to the taxing state; (2) it is fairly apportioned so as to tax only the activities connected to the taxing state; (3) it does not discriminate against out-of-staters; and (4) it is fairly related to services provided by the state.

Rulings Under Complete Auto

Recent cases have clarified and applied the Complete Auto test. As to the first part of the test--the requirement of a substantial nexus to the taxing state-the Court held in Quill Corp. v. North Dakota that there is not a substantial nexus when an interstate seller solicits sales in a state only by mall and then ships orders into the state by mail or common carrier.(10)

The Court expressly found that because the company "has purposefully directed its activities at North Dakota residents, that the magnitude of those contacts [is] more than sufficient for due process purposes, and that the use tax is related to the benefits Quill receives from access to the State."(11)

The Court found that even though due process was met, the nexus test under the Commerce Clause was not satisfied. The Court said that a corporation may have the minimum contacts with a taxing state as required by the Due Process Clause, and yet lack the "substantial nexus" with the state required by the Commerce Clause. "The two standards are animated by different constitutional concerns and policies."(12)

The Court explained that due process is ultimately about the fairness of the government's activity but that the dormant Commerce Clause is about the effects of state actions on the national economy.

The Court concluded that there is not a sufficient nexus to the taxing state when an interstate seller solicits by mail and ships orders by mail or common carrier. The Court said that a company must have a physical presence in the state in order to have a substantial nexus and be subjected to its use tax.

The Supreme Court considered the second part of the test--the requirement for fair apportionment--in Oklahoma Tax Commission v. Jefferson Lines, Inc.(13) is The issue was whether Oklahoma violated the Commerce Clause by collecting a sales tax on bus tickets from Oklahoma to another state. The Court said that "the difficult question in this case is whether the tax is properly apportioned within the meaning of the second prong of Complete Auto's test."(14)

In evaluating apportionment, the Court said it considered "internal consistency" and "external consistency." Internal consistency exists "when the imposition of a tax identical to the one in question by every other State would add no burden to interstate commerce that intrastate commerce would not also its bear."(15)

External consistency, in contrast, "looks not to the logical consequences of cloning, but to the economic justification for the State's claim upon the value taxed, to discover whether a State's tax reaches beyond that portion of value that is fairly attributable to economic activity within the taxing State."(16)

The Court found that there was no problem with internal consistency because if every state were to impose a tax identical to Oklahoma's, no sale would be subject to more than one tax.(17) The Court found that the requirement for external consistency was met because "a sale of services can ordinarily be treated as a local state event just as readily as a sale of tangible goods can be located solely within the State of delivery."(18)

Because the Court found that the other prongs of the Complete Auto test also were met, the justices upheld the Oklahoma tax as constitutional.

The third part of the Complete Auto test--the prohibition of discriminatory taxation--is perhaps the most important aspect of analysis. The Supreme Court has declared: "No State may, consistent with the Commerce Clause, impose a tax which discriminates against interstate commerce by providing a direct commercial advantage to local business."(19)

For example, in Oregon Waste Systems, Inc. v. Department of Environmental Quality, the Court declared unconstitutional an Oregon law that charged a $2.25 per ton surcharge on disposal of out-of-state waste but only an 85-cent per ton surcharge on waste generated instate.(20) The Court said there was no evidence that the tax was based on actual costs borne by the state in disposing of waste from other states.(21)

A recent case, West Lynn Creamery, Inc. v. Healy, illustrated how a facially neutral tax law could be deemed discriminatory based on its effects.(22) Massachusetts taxed all milk dealers, but revenue from the tax went into a fund to pay subsidies to in-state dairy farmers. The Court found the law was unconstitutional because its impact had the same effect as a discriminatory tax law.(23)

In essence, the state was taxing both in-staters and out-of-staters but refunding the taxes paid by in-staters through the subsidy system. The net result was that the tax borne disproportionately by out-of-staters was unconstitutional.

The final requirement under Complete Auto is that the tax must have a fair relationship to services provided by the state. A state can tax out-of-staters only if it is providing them some benefit so that it is fair to collect the tax.(24)

Essentially, this requires that the tax be based on the extent of the taxpayer's activities or presence within the state. The Supreme Court has explained, "When a tax is assessed in proportion to a taxpayer's activities or presence in a State, the taxpayer is shouldering its fair share of supporting the State's provision of police and fire protection, the benefit of a trained work force, and the advantages of a civilized society."(25)

This requirement is thus closely related to the first and second prongs of the test: If a taxpayer has a substantial nexus to the state and the tax is fairly apportioned, generally it should meet the fourth requirement as well. Yet, there is a difference between the requirement for fair apportionment and the requirement for a fair relationship to services provided by the state. Although both are ultimately about fairness, fair apportionment is primarily about preventing duplicative taxes on the same activity in multiple states; fair relationship to services provided is primarily about making sure the taxpayer has received some benefit to justify bearing the tax.

Under most circumstances, relief for unconstitutional state taxes must be sought in state court under state law causes of action. But Supreme Court review is available to ensure adequate remedies for constitutional violations. The Eleventh Amendment precludes suits against state governments in federal court.(26)

Also, the Tax Injunction Act prevents federal courts from enjoining the collection of any state tax "where a plain, speedy, and efficient remedy may be had in the courts of such State."(27) The Court has interpreted the act as also precluding federal court declaratory and injunctive relief against state taxes.(28)

Moreover, the Supreme Court has said that principles of comity and federalism prohibit federal courts from considering damage actions against state taxes when state law furnishes an adequate legal remedy.(29)

Recently, the Court extended this to say that state courts also could not award declaratory or injunctive relief under 42 U.S.C. [sections] 1983 against state taxes.(30) In National Private Truck Council, Inc. v. Oklahoma Tax Commission, the Court held that the section was not available in state courts to provide relief from state taxes that violate the dormant Commerce Clause when there is an adequate state remedy in the form of refunds of collected taxes.(31)

The result is that federal courts and even federal law are generally not available for relief against states for taxes that violate the dormant Commerce Clause. Suits seeking to remedy unconstitutional taxes generally must be brought in state court. Nonetheless, the Supreme Court has made it clear that it will review state court decisions to ensure that states carry out their duty to compensate victims of unconstitutional taxes that violate the Commerce Clause.(32)

Supreme Court decisions concerning state taxation of interstate commerce are less likely to attract public--much less media--attention than virtually any other area of constitutional law. Yet, for business litigators, a crucial tool is the ability to challenge state tax laws on constitutional grounds. Recent Court cases have not dramatically changed the law but, rather, have clarified the test used and the procedures to be followed.

Notes

(1) See, e.g., National Private Track Council, Inc. v. Oklahoma Tax Comm'n, 115 S. Ct. 2351 (1995); Oklahoma Tax Comm'n v. Jefferson Lines, 115 S. Ct. 1331 (1995); West Lynn Creamery, Inc. v. Healy, 114 S. Ct. 2205 (1994); Oregon Waste Sys., Inc. v. Dep't of Envtl. Quality, 114 S. Ct. 1345 (1994); Quill Corp. v. North Dakota, 504 U.S. 298 (1992). (2) See, e.g., Spector Motor Serv. v. O'Connor, 340 U.S. 602 (1951). For a discussion of this rule and how it has been changed, see William B. Lockhart, A Revolution in State Taxation of Commerce? 65 MINN. L. REV. 1025 (1981). (3) Freeman v. Hewit, 329 U.S. 249 (1946). (4) McCleod v. J.E. Dilworth Co., 322 U.S. 327 (1944). (5) Mills v. Portland, 268 U.S. 325 (1925). (6) See, e.g., U.S. Glue Co. v. Oak Creek, 247 U.S. 321 (1918) (upholding net income tax on interstate businesses); McGoldrick v. Bertwind-White Coal Mining Co., 309 U.S. 33 (1940) upholding sales tax on interstate transactions). (7) 430 U.S. 274 (1977). (8) Id. at 287. (9) Id. at 279. (10) 504 U.S. 298. (11) Id. at 308. (12) Id. at 312-13. (13) 115 S. Ct. 1331. (14) Id. at 1338. (15) Id. (16) Id. (17) Id. (18) Id. at 1340. (19) Boston Stock Exch. v. State Tax Comm'n, 429 U.S. 318, 322 (1977). (20) 114 S. Ct. 1345. (21) Id. at 1352. (22) 114 S. Ct. 2205. (23) Id. at 2212. (24) Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940). (25) Commonwealth Edison Co. v. Montana, 453 U.S. 609, 624, quoting Exxon Corp. v. Wisconsin Dep't of Revenue, 447 U.S. 207, 228 (1980). (26) See generally ERWIN CHEMERINSKY, FEDERAL JURISDICTION 367-419 (2d ed. 1994) (describing the law concerning the Eleventh Amendment). (27) 28 U.S.C. [sections] 1341 (1994); see id. at 658-69 (discussing the Tax Injunction Act). (28) California v. Grace Brethren Church, 457 U.S. 393 (1982). (29) Fair Assessment in Real Estate Ass'n v. McNary, 454 U.S. 100, 109 (1981). (30) Earlier the Supreme Court had ruled that violations of the dormant Commerce Clause are a constitutional violation for purposes of [sections] 1983. Dennis v. Higgins, 498 U.S. 439 (1991). The Court has not in any way overruled this decision but has limited its impact by holding that suits against the state cannot be brought in federal or state court under [sections] 1983. (31) 115 S. Ct. 2351. (32) See, e.g., Harper v. Virginia Dep't of Taxation, 113 S. Ct: 2510 (1993); McKesson Corp. v. Florida Alcoholic Beverages and Tobacco Div., 496 U.S. 18 (1990).

Erwin Chemerinsky is the Legion Lex Professor of Law at the University of Southern California Law Center in Los Angeles.