Pushing to the Edge of the Envelope - Economic Nexus

William Delaney, EA
Westwood, MA

The Quill case is a sales and use tax case.  It stands for the proposition that substantial nexus (as opposed to mere economic activity) is required in order to grant a state the power to impose a tax on an out-of-state (i.e. foreign) business entity.  Quill reaffirmed the physical presence requirement for nexus to be present as articulated in National Bellas Hess v. Dept. of Revenue of the State of Illinois, 386 U.S. 753 (5/8/1967).

“Unless a company has offices, employees, or other property in a state, it does not have nexus under Complete Auto and cannot be subject to use tax obligations.”  [See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (3/7/1977)]

Since these cases are sales and use tax cases, states argue that either the same concepts do not apply to income tax assessments or what they seek to assess is a franchise and/or permission to do business type of non-income based tax.  This is a convenient argument designed to rope you in so that more tax revenue may be collected.

A beyond the edge of the envelope concept was successfully argued by the West Virginia Tax Commissioner when the Supreme Court of Appeals of West Virginia decided that the Quill decision “applies only to state sales and use taxes and not to state business franchise and corporation net income taxes,  Rather than a physical presence standard, this Court believes that a significant economic presence test (emphasis added) is a better indicator of whether substantial nexus exists for Commerce Clause purposes.” [See Tax Comm. Of West Va. V. MBNA America Bank, N.A., S. Ct. of Appeals of W. VA. No. 33049, 11/21/2006]. This state decision stands for the proposition that a foreign company, with no presence in the state, is subject to taxation if all it has is some customers within the state (i.e. accounts receivable).

This is, essentially, an attempt at an end run around the Dormant Commerce Clause and the Commerce Clause in general.  Unfortunately, other states have followed suit.

So, we now have any number of states (35 at least), who do not apply the Quill
principle to taxation other than sales and use.  They walk on both side of the street at the same time, or try to, by applying all or most of the MBNA decision theory.  What is also consistent in their application, however, is the need for there to be an intangible property element in order to pull an otherwise entirely out-of-state business into a state for tax purposes.  Intangible property is generally defined as a copyright, trademark, patent, or the like (legal tangible property).  It is difficult, if not impossible, to argue that an income preparation service provided to an in-state resident by an out-of-state preparer (individual or entity) includes the transfer or existence of an intangible property.

Absent an intangible, most of these economic nexus statutes do not apply to the preparation of income tax returns.  And, even if one could successfully argue that the mailing or electronic filing of an income tax return meets the definition of the transfer of intangible property, there are large minimum amounts which the economic activity must exceed (either expressed in sales dollars or as a percentage of total sales dollars) in order for an income tax preparer to be subject to an economic nexus income or franchise tax assessment.

At this time, there is a very interesting case being appealed to the U.S. Supreme Court,
Direct Marketing Assn. v. Brohl, 10th Cir, No. 12-1175 (8/20/13).  It has to do with a Colorado statute which requires out-of-state vendors, even if they are not subject to any type of CO tax, to notify the state of all sales made to CO residents (transaction notices) and to send annually to all customers who purchase $500 or more a notification of their obligation to report the sale to CO and pay a use tax.  The state even specifies the minimum size of the type to be used.

The issue is whether or not this is an impermissible crossing of the line and a violation of the Dormant Commerce Clause doctrine.  The 10th Circuit Court of Appeals upheld a federal District Court injunction and the state appealed to the U.S. Supreme Court.

Extracts from oral arguments heard December 8, 2014:

May the state mandate on a vendor the obligation to notify the state of economic activity (transaction notice)?  May it also mandate on a vendor the obligation to  notify a customer of an obligation to declare and pay a state tax?

Quoting Justice Kagan:  “Essentially the State is saying we’re not going to be able to collect this tax…unless we tell people that they…owe the tax and unless we have a mechanism to make sure that people who don’t pay the tax are identified…That’s how we’re going to collect it.”

Justice Sotomayer:  “…but this injunction is not stopping you from collecting the tax.”

State Response:  “…it is stopping us from using the tool…”

Justice Breyer:  “…Henry Friendly (a prominent Judge of the Second Circuit Court of Appeals, now deceased) some years ago said of course you can use the term collection to refer to any method of helping to secure payment.”   “…once we start down your road,” continued Justice Breyer “there is no stopping place.”

State Response:  “The injunction makes it impossible for Colorado…to do any form of assessment, any form of collections on hundreds of thousands---“  Interrupted by Justice Breyer:  “Really, you can’t ask your citizens the same way that the Federal government asks us?  Pay, that’s their polite way of saying it.”

Stay tuned.  This decision may be very important indeed.