The Tricky Intersection of State Tax and Electronic Transactionsby
The intersection between regulation and commerce is an exciting but tricky place to be. For multistate sellers of products and services that occur entirely electronically, such as cloud computing, state taxes are a potential minefield. In each state, sellers must consider both the sales and use tax implications and the corporate income tax implications of the electronic products and services they sell. Concerns overlap between the two taxes, but the issues that arise and the tax treatment are distinct.
With states figuring it out as they go, there is often little guidance and less uniformity. Staying on top of these complicated, sometimes vexing areas is difficult but imperative.
The initial question for both taxes is “nexus,” or whether the state has a sufficient connection with the seller or transaction to give the state jurisdiction to impose tax. The US Constitution prevents a state from taxing or imposing tax-collection duties on an out-of-state company unless the state has a sufficient nexus with or connection to the seller. Determining whether this connection exists is complicated, in part because the US Supreme Court has not ruled on the issue in almost 25 years.
The court last set nexus precedent in a 1992 sales and use tax case, Quill v. North Dakota, which established that a seller had to have some “physical presence” in a state before the state could require the company to collect tax on its sales to customers there.
The case predated Internet sales but involved a mail-order company that solicited sales in North Dakota through catalogs, accepted orders from customers long-distance, and shipped items ordered to the customers. Because the company lacked a physical presence in the state, the court ruled that North Dakota did not have nexus and could not require the company to collect tax on its sales to customers in the state.
In the corporate income tax environment, companies have a layer of protection that they lack for sales and use tax purposes. A federal law, P.L. 86-272, grants corporate income tax immunity to a company whose sole activity in a state is solicitation of orders for sales of tangible personal property. In the years following Quill, however, many state courts ruled that the physical presence requirement established by the US Supreme Court for nexus purposes only applies in the sales and use tax context and not for corporate income taxes.
These decisions follow the 1993 decision of the South Carolina Supreme Court, in Geoffrey v. South Carolina, that a significant economic presence in a state through use of intangibles in the state is sufficient to create corporate income tax nexus. These cases typically have involved leasebacks of trademarks or licenses of franchises from holding companies outside the state to related retailers doing business in the state. Although many companies have appealed, the US Supreme Court has consistently declined to hear these cases.
In recent years, an increasing number of states have enacted “factor presence” nexus laws that assert jurisdiction to tax a company if it makes, for example, more than $250,000 of sales into the state, regardless of the company’s lack of other connections with the state. These laws have tremendous liability implications for large remote sellers of purely electronic products and services.
Even in the sales and use tax context, the physical presence requirement has been eroded. Older US Supreme Court case law establishes that a company can have attributional sales and use tax nexus in a state based on the activities of its agents, including independent contractors and related companies.
More recently, though, New York passed a “click-through nexus” law establishing a rebuttable presumption that a company has nexus with the state if it enters into an agreement with a state resident to, for example, post links to the company’s products on the resident’s website in exchange for compensation from any resulting sales. New York’s high court upheld the law, and the US Supreme Court declined to hear the case. Since then, many states have adopted laws modeled on New York’s.
Now, two states are trying to force the US Supreme Court to revisit Quill, or to force Congress to act, by disregarding Quill’s physical presence rule and carrying the economic presence test into the sales and use tax environment.
A South Dakota law enacted this spring requires an out-of-state seller to collect sales tax from South Dakota customers if the seller’s gross revenue from taxable sales (including sales of products transferred electronically) delivered in South Dakota exceeds $100,000, or if the seller makes more than 200 deliveries of these sales in South Dakota annually. The law follows a regulation adopted last year by the Alabama Department of Revenue, with the support of the state’s governor, that also targets remote sellers having what the regulation calls “a substantial economic presence in Alabama.”
Litigation is already ramping up in both states, and we will be following the outcome every step of the way.