Establishing nexus for state and local taxation in the US

States have limited powers under the US Constitution to impose taxes on taxpayers with no legal or physical presence in that state. Both the fourteenth amendment’s due process clause and the commerce clause restrict states from taxing income and sales where an insufficient legal or economic connection (nexus) exists between the state and the out-of-state company and/or transaction.

The supreme court has established two separate nexus requirements for a state to impose a tax on a person. First, there must be an adequate connection between the state and the corporation upon which tax is being imposed (substantial presence); and secondly, an adequate connection between the state and the transaction, income, or property being taxed (transactional nexus) must be demonstrated. States in recent years have expanded the interpretation of transactional nexus to impose taxes based on the attribution of an affiliated third party located in-state to the out-of-state seller. This concept of attributional nexus, labelled as the Amazon tax, is another area for discussion.

In Complete Auto Transit, Inc v Brady (1976) the US Supreme Court established the four-prong test for a state tax to be valid under the commerce clause. A state tax will be valid under the commerce clause if:

• there is substantial nexus between the corporation subjected to the tax and the particular state;

• the tax is fairly related to the services provided the taxpayer by the taxing state;

• the tax does not discriminate against interstate commerce; and (4)

• the tax is fairly apportioned.

In Mobil Oil Corp v Commissioner of Taxes (1980) the supreme court held that that for an application of state tax jurisdiction to be constitutional under the due process clause, there must be:

• nexus or some minimal connection between the taxing state and the activity from which the income is derived; and

• a rational relationship between the income attributed to the taxing state and the interstate values of the enterprise.

These two decisions thus established two types of nexus requirements; the need for some presence in the state and evidence of a nexus between the tax and the transaction.

The US Supreme Court in Quill Corp v North Dakota (1992) defined substantial nexus as a substantial physical presence. Quill, a Delaware corporation (domiciled in Illinois), sold office supplies nationwide through flyers, catalogues and telephone calls. Quill maintained no employees, significant property or even a local phone number in North Dakota and did not advertise in local publications or other media. Goods were shipped to North Dakota customers using common carriers. North Dakota enacted a statute to specifically tax these types of transaction in the state. Quill argued that its activities in the state did not meet the substantial nexus requirements as it had no employees or substantial property in North Dakota.

The supreme court determined that to have substantial nexus in the case of sales and use taxes from mail order sales, the taxpayer must be physically present in the state through maintenance of employees, agents, or significant property. Quill maintained negligible property in the state (a few computer disks) and thus did not meet the significant property test. Specifically, the court held that Quill's North Dakota business transactions met the adequate notice and fair play requirements of the due process clause but violated the commerce clause’s requirement of substantial nexus between the state and person, as the commerce clause was designed to eliminate interference with interstate commerce and the avoidance of multiple taxation .

Attributional nexus

Generally, only businesses with employees or property in a State must collect a State's sales tax, even if the company maintains only administrative or non-sales employees in the State and these employees are not directly involved in soliciting sales. However, a company may be physically present in a State through attribution (attributional nexus), if the company has arrangements with independent persons who are physically present in the State and if the in-State activities of those persons are important to establish and maintain the company’s in-State market (see for example, the supreme court’s holdings in Tyler Pipe Indus v Washington Department of Revenue (1987) and Scripto, Inc v Carson (1960)).

Under the Scripto and Tyler Pipe standards, nexus is established where the non-employees activities in the State are significantly associated with establishing and maintaining the company’s in-State market, through in-State solicitation or sales support. In Scripto, for example, the physical presence was found where 10 independent contractors solicited customers to secure a substantial flow of goods into the state. In Tyler Pipe, the physical presence test was held to be met where in-State independent contractors solicited local customers on a daily basis, making them necessary for maintenance of the company’s market and protection of its interests in the state.

Recently, states have aggressively pursued attributional nexus for online retailers (such as Amazon) who maintain no employees, offices or property in a state, but use marketing affiliates to promote sales on the company’s website. Amazon maintains no representatives in New York soliciting sales on its behalf. As part of its marketing strategy, Amazon allows independent third parties (associates) to advertise Amazon.com on their websites. These links enable visitors to click through to Amazon’s website from the associate’s website. The associates operate independently from Amazon and choose the timing, format and placement of the Amazon advertisements from their websites. These associates do not solicit sales on behalf of Amazon and have no agency relationship with Amazon. Associate advertisers are compensated by Amazon for purchases made by visitors whom they refer to Amazon’s website. Amazon has no ability to determine if potentially thousands of New York associate advertisers solicited sales for Amazon sufficient to establish nexus.

In April 2008, New York targeted online retailers with the enactment of a statute (NY Tax Law section 1101) that presumes a retailer solicits business in the state if any in-State entity is compensated for directly or indirectly referring customers to the retailer. The so-called Amazon tax is intended to force online retailers with independent affiliates in the state to collect New York sales tax on purchases made by New York residents, even though the retailer has no property or employees in New York. Similar laws were enacted by Rhode Island, Colorado and North Carolina in 2009. The principal argument by these states in support of this tax is the use of local marketing affiliates creates substantial nexus in that affiliates are used in place of employees.

Other States such as California have attempted the Amazon tax type legislation but these efforts were defeated by a governor’s veto. Some State legislatures have considered the Amazon tax legislation but failed to pass final provisions. Rhode Island enacted similar legislation but repealed it shortly thereafter.

Common language in the affiliate tax bills includes the following:

“A person with no physical presence in the state is presumed to be engaging in business in the state if:

1. that person enters into an agreement with an in-state resident under which the resident, for a commission or other consideration, directly or indirectly refers potential customers, whether by link or an Internet web site , to that person; and

2. the cumulative gross receipts from sales by that person attributable to referred customers by all residents with such an agreement are greater than $10,000 during the preceding 12-month period ($5,000 for Rhode Island)

The nexus presumption would be rebuttable by proof that the resident made no solicitation in the state that would satisfy U.S. constitutional nexus requirements on behalf of the person presumed to be engaging in business in the state.”

The nexus presumption standards of New York, North Carolina and Rhode Island are rebuttable where the seller establishes that the only activity of its in-State representative is a link provided on the representative’s website to the seller’s website and none of the in-State representatives engage in any solicitation activity in the state targeted at potential in-State customers on behalf of the seller.

Amazon challenged the New York statute as violating the US Constitution, arguing principally that substantial nexus is not created by the presence of local affiliates responsible for only a small percentage (1.5%) of the company’s sales revenue in the state and; the statute violates the due process clause of both the US and New York Constitutions in that it creates an irrebuttable presumption of solicitation and is overly broad and vague and; the statute violates the equal protection clauses of both the US and New York Constitutions because it intentionally targets Amazon.

The supreme court of New York (trial court), found for the state and ruled that the law was constitutional. In its ruling, the court refused to consider the lack of significance of the affiliates in promoting Amazon’s sales in New York. Instead, the court held that because Amazon gained economic benefits from the relationships, nexus was established. The law is on appeal before the appellate division of the New York supreme court.

Establishing nexus with intangible property

The Quill physical presence test dealt specifically with sales and use taxes where physical property was located in the State. State taxing authorities have ruled that income taxes and franchise taxes may be assessed against companies without a physical presence in their States, but where licensing agreements exist between an out-of-State company and a company in-State that uses the license or other intangible property to produce revenues.

In Geoffrey Inc v South Carolina Tax Department., 437 SE2d 13 (SC 1993), cert. denied, 510 US 992 (1993), the South Carolina supreme court, held that Geoffrey, a Delaware corporation, was subject to the State's income tax even though the company had no physical presence in the State. Geoffrey owned the Toys ‘R’ Us trademark and licensed this intangible to its parent company Toys ‘R’ Us, Inc in return for royalty payments. Following the opening of the Toys ‘R’ Us retail store in South Carolina, the tax commission assessed taxes on royalties Geoffrey had received from Toys ‘R’ Us related to South Carolina retail sales.

Geoffrey argued the imposition of the tax violated the due process standard, as Geoffrey had not purposefully directed its economic activities into South Carolina since the licensing agreement was executed between Geoffrey and Toys ‘R’ Us before the store opening and generation of retail sales. This argument was rejected by the South Carolina supreme court, which concluded that the Quill purposeful direction standard was met as it was foreseeable to Geoffrey that its license would lead to the opening of the Toys ‘R’ Us store. Other states (Florida, North Carolina, Wisconsin, Arkansas and Tennessee) announced soon after Geoffrey that the licensing of intangibles would be considered sufficient nexus for local tax jurisdiction over the licensor. In addition, in 2009, Massachusetts courts found a similar arrangement was sufficient to create nexus for excise taxes when Geoffrey licensed property to Toys ‘R’ Us and Babies ‘R’ Us stores in the state.

Economic Nexus: Excise, income and franchise taxes

Following Quill in 1993, many state legislatures and state departments of revenue created economic nexus standards independent of in-state physical presence. For example, under Georgia’s statute, a taxpayer is subject to tax if it derives:

“income from sources within this state to the extent permitted by the United States Constitution. A corporation shall be deemed to be doing business within this state if it engages within this state in any activities or transactions for the purpose of financial profit or gain whether or not .. the corporation maintains an office or place of doing business within this state. Ga. Code Ann. § 48-7-31(a).”

The State of Illinois imposes "a tax measured by net income on . . . [every] corporation for the privilege of earning or receiving income in... [the] state," 35 Ill Comp Stat 5/201(a), and does not require a physical presence in the state. Louisiana imposes its corporation income tax on net income earned or derived from sources within the State and also does not require a physical presence.

In 2009, the Supreme Judicial Court of Massachusetts held in Capital One Bank v Massachusetts Comr of Rev that the physical presence requirement in Quill does not apply to an income-based excise tax such as the financial institutions excise tax. Instead, the court used the four-prong test under the supreme court’s ruling in Complete Auto Transit Inc v Brady, (1977) to gauge the constitutionality of the tax. The court held that the banks’ credit card activities created substantial nexus with the state to warrant taxation. Other States have enacted similarly expansive economic nexus rules.

Looking forward

In their search for revenues, state revenue departments are aggressively interpreting nexus rules for application to sales, use, income, excise and franchise taxes. Corporate tax planners must carefully evaluate these tax rules in decisions regarding domicile, location, licensing and the use of local contractors and affiliates in marketing arrangements.

Bruce Clememts (aclement@kennesaw.edu) is associate professor of accounting and taxation in the Michael J Coles College of Business at Kennesaw State University in Kennesaw, Georgia and a practising certified public accountant.