Taxpayers mailing catalogs into states.

Over the past few years, the imposition of use tax on catalogs and other promotional materials mailed into a state has been the subject of much litigation. While most of these cases have been victories for the states, two recent decisions in Massachusetts give renewed hope to retailers. The majority of "catalog" cases follow the same basic pattern: A retailer with nexus in a state arranges for catalogs to be sent, free of charge, to residents of that state. The catalogs are printed outside the state and sent by the U.S. Postal Service from outside the state to residents within the state. The issue is whether the retailer has made taxable "use" of the catalogs in the state sufficient to be taxed on the cost of the catalogs.

In D.H. Holmes Co. v. McNamara, 486 US 24 (1988), the U.S. Supreme Court upheld the imposition of a use tax On a Louisiana-based retailer that produced and mailed catalogs to Louisiana residents from outside the state. Because use included the act of distribution under Louisiana law, the case focused on where the distribution of the catalogs occurred. The Court ruled that the placement of the catalogs inside the residents' mailboxes constituted a taxable activity and, thus, a taxable use of the catalogs in the state.

D.H. Holmes involved application of a use tax statute that specifically included distribution as a taxable use. The recent catalog cases, in contrast, have addressed whether a tax can be imposed when a state's use tax statute does not specifically include distribution. While states have come to varying conclusions on this issue, the prevailing sentiment has been that distribution is a taxable use.

Recently, the Massachusetts Appellate Tax Board (ATB) held that two retailers were not liable for use tax on the cost of catalogs and other direct-mail materials distributed to Massachusetts residents from outside the state (J. C. Penney Co., Inc. v. Comm'r of Rev., Outdoor World Corp. v. Comm'r of Rev., Nos. F239234, F239236 (Mass. App. Tax Bd.,Jan. 29, 1999)). Under Massachusetts law, "use" is the exercise of a right or power over property; the use tax statute does not include the term "distribution." The ATB determined that all of the activities related to the production and distribution of the catalogs (such as design, printing, targeting or mailing) occurred outside Massachusetts. Thus, J.C. Penney's activities with respect to the catalogs could not be considered a use in the state, because "mere passivity or inaction" did not rise to an exercise of control over property.

In Sharper Image Corp. v. Dep't of Treasury of Michigan, 550 NW2d 596 (Mich. Ct. App. 1996), the Michigan Court of Appeals also held that a taxpayer did not have to pay use tax on catalogs distributed in the state. The decision in Sharper Image was based on the fact that the statutory definition of "use" in Michigan did not explicitly encompass distribution; thus, based on D.H. Holmes, such activities did not constitute a taxable use.

The Massachusetts and Michigan rulings constitute one end of the catalog case spectrum. Both cases are based on a narrow interpretation of the term "use." The courts' rulings required actual activity in the state as a prerequisite to a finding of liability. At the opposite end of this spectrum are cases in which it was determined that the term "use" automatically encompasses the concept of distribution, even if that term is not included in the statute. Thus, a retailer performing no activity within the state could be considered to have made a taxable use of catalogs merely by distributing them from outside the state.

For example, in another case involving Sharper Image, the Connecticut Supreme Court determined that the taxpayer had made a taxable use of catalogs by directing that the catalogs be sent to specific in-state residents (Sharper Image Corp. v. Miller, 692 A2d 774 (Conn. 1997)). Similar to the Massachusetts and Michigan use tax statutes, the Connecticut use tax statute makes no reference to the term "distribution" Nevertheless, the Connecticut Supreme Court interpreted the statute broadly, concluding that distribution implicitly qualified as a taxable use. Several other cases have been decided on the same grounds.

While the holdings of the catalog cases have gone both ways, they all involve a common theme--whether distribution triggers the use tax. Because many states have identical or similar definitions of "use" this issue is subject to varying interpretations at the state level. In the recent Massachusetts ATB rulings, the concept of use was interpreted literally to foreclose any activity other than an active use of property inside the state. Conversely, in the Connecticut Sharper Image case (as well as several other decisions), distribution activities conducted outside a state were held to be taxable use. However, if a taxpayer engages in no activity with regard to promotional materials in the state of distribution and the state does not specifically tax distribution, there is a strong argument that such activity should not be subject to tax in that state.

FROM MICHEL W. McLOUGHLIN, J.D., WASHINGTON, DC