“Factor Presence” Gone Wild

“Factor Presence,” which is the standard first proposed by the Multistate Tax Commission in 2002 for determining nexus for business activity taxes, means that a company has nexus in a state if its sales in the state exceed a specified threshold, or if the company maintains payroll or property in the state above specified amounts. Nexus based on mere sales alone is shorthand, of course, for “economic presence.” Economic presence is in contrast to the nexus requirement under the Commerce Clause, as confirmed in the U.S. Supreme Court’s 1992 decision of Quill v. North Dakota, 504 U.S. 298 (1992), that a company not only make sales to the state, but also maintain a physical presence in the state, to be subject to sales tax collection obligations of the state.

The states launched their assault on Quill’s physical presence standard in connection with state income tax obligations of a company that sells services or licenses intellectual property. This is so, because under Public Law 86-272, sales alone would not be sufficient to impose state income tax obligations on a company selling only tangible personal property. Based on language in Quill taken out of context, the states have argued that Quill is limited to sales and use tax cases.

In the area of gross receipts taxes, Ohio led the charge, when in 2005 it created a gross receipts tax, known as the Commercial Activity Tax (“CAT”), in which it imposed the CAT on out-of-state companies that had annual sales of at least $500,000, even though they had no physical presence in Ohio. On June 1, 2010, Washington adopted an economic presence test for determining whether an out-of-state company that sells services or licenses intellectual property is subject to the state’s longstanding B & O tax, which is a tax on gross receipts. Effective on September 1, 2015, the Washington legislature expanded the reach of the B & O Tax to any wholesaler of tangible personal property if its sales exceed $267,000 in the prior calendar year. Similarly, in 2015, Tennessee enacted for the first time a tax on gross receipts, called the Business Tax. Like the Ohio CAT, the Business Tax bases nexus on a Factor Presence test, so that sales of $500,000 alone are sufficient to establish nexus for the Business Tax. Tennessee also adopted a tax on a company’s net income, called the Franchise Tax, which has a similar factor presence test for determining nexus. Nevada as well legislated in 2015 the Commerce Tax, a tax on gross receipts, in which a similar factor presence test for measuring nexus was used. Unlike the Tennessee Business Tax, however, the Commerce Tax legislation states that the reach of the statute is only as broad as permitted under the U.S. Constitution.

On behalf of several clients, including Newegg, Crutchfield, Inc. and Mason Shoe, Brann & Isaacson has challenged the constitutionality of Ohio’s application of its economic nexus standard to assess the CAT based on mere sales into Ohio. Brann & Isaacson and the Ohio Department of Taxation are in the process of briefing the issues for each of these companies, and we expect oral argument before the Ohio Supreme Court on these cases in early 2016. Each of these companies argues that under a long line of U.S. Supreme Court decisions, including Tyler Pipe Industries, Inc. v. Washington State Department of Revenue, 483 U.S. 232 (1987), a company must have a physical presence in a state, through activities performed in the state on its behalf, in order to be subject to a gross receipts tax like the CAT. The Quill Court specifically cited these gross receipt tax cases, such as Tyler Pipe, with approval.

Now, Alabama has taken one additional step. The Alabama Department of Revenue asserts that Quill is no longer good law and has adopted Rule 810-6-2-.90.03, which sets forth a nexus standard for sales tax collection in Alabama based upon mere sales into the state. In particular, under the Rule, which is effective on January 1, 2016, any company that had retail sales into Alabama of more than $250,000 is required to collect the Alabama sales and use tax on all of its Alabama retail sales.

The Rule is striking in several respects. First, it ignores an opinion of a majority of the U.S. Supreme Court, Quill v. North Dakota, that physical presence is required to impose sales and use tax obligations. Instead, as reported in State Tax Notes, September 21, 2015 edition, the Commissioner of Revenue points to the concurring opinion of Justice Kennedy in Direct Marketing Association v. Brohl, as a basis for use of a company’s economic presence in Alabama to subject it to sales tax collection. It fails to recognize that in the recent case of Comptroller of Maryland v. Wynne, 135 S.Ct. 1787, 1798-99, 1808-09, 191 L.Ed.2d 813 (2015), the Supreme Court cited Quill multiple times, including for the proposition that the Commerce Clause places limits on the authority of a state to regulate interstate commerce, even where the requirements of the Due Process Clause are satisfied. The Court held in Quill that while solicitation of sales from outside a state without a physical presence may be adequate to satisfy the Due Process standard, it rejected such an “economic presence” standard as sufficient to meet the requirements of the Commerce Clause. 504 U.S. at 306-08, 311-12.

Second, it is only up to the U.S. Supreme Court and not a state, let alone a state tax agency, to determine whether Quill is still good law. Moreover, as the Court noted in Quill, Congress has the power to change the result of Quill and permit states to impose sales tax obligations on companies without a physical presence. The fact that Congress has not seen fit to do so is no basis for a state, in the words of the Alabama Commissioner of the Department of Revenue, to “make some paradigm shift” by its own rule and therefore not “remain under the Quill ruling.” (quoted in State Tax Notes, September 21, 2015 edition).

By Martin Eisenstein