U.S. State Taxation: Is the Repeal of Quill’s Physical Presence Principle Unavoidable?

By Pablo Garciga, Funaro & Co. PC

A major paradigm shift is on the horizon in determining sales tax nexus in the USA. Historically, physical presence has been required before a state has been permitted to impose its sales and use tax on transactions of out-of-state vendors. In an era when many states are insolvent, they have devised ways around this principle; the most recent of which is a direct attack opposing it.

Physical presence has been the lynchpin of a state’s power in imposing sales taxes. In the modern business environment, this concept of physical presence, which was extremely relevant when our economy was led by manufacturing of tangible goods and the distribution of these manufactured goods occurred through the use of the railroad system, is an antiquated concept. Business today is transacted in virtual markets, electronic in nature and without physical boundaries.

Quill and the Physical Presence Requirement

In Quill, the U.S. Supreme Court affirmed the principle that the Commerce Clause of the U.S. Constitution requires out-of-state vendors to have physical presence in a state before a state can require the vendors to collect and remit use tax. Quill was a corporation created under Delaware law and had offices, warehouses and employees in various states, but not within North Dakota (“ND”). In keeping with precedent, the U.S. Supreme Court decided that the Commerce Clause required the vendor to have physical presence in ND, before the state could impose its use tax obligations on Quill (an out-of-state vendor). Since that time, it has been understood that, in the context of sales and use taxes, the Constitutional standard of substantial nexus is met only if a physical connection exists with the state.

The concept has evolved throughout its history. The required physical presence was expanded to include agents acting on behalf of an out-of-state vendor; later nexus was deemed to exist through affiliate nexus principles. New York state then enacted the first version of the “click-through” nexus whereby having an instate entity referring internet customers to the out-of-state vendor’s webpage and paying the referring instate entity a fee over certain threshold amounts created the presumption of agency nexus, etc.

In a juxtaposed position: Economic Nexus

Depending on the underlying tax, the Commerce Clause’s Constitutional standard of “substantial nexus” is interpreted differently. In the context of income or franchise taxes, simply “availing” oneself of a state’s markets or “purposefully directing one’s efforts” towards a state’s markets may suffice to permit a state to impose its tax. This is termed “economic nexus” (meaning that nexus exists in the absence of physical presence). This economic nexus concept has only very recently been applied to sales and use taxes in the USA.

Justice Kennedy’s invite to challenge Quill and States’ Actions

The erosion of the physical presence requirement for sales taxes took an entirely new twist when, in 2010, Colorado (CO) enacted a statute which established a reporting requirement obligation for retailers that sell goods to customers in CO but do not collect or remit CO sales tax on those transactions. A case was soon filed challenging this law.

The Direct Marketing Association (DMA) filed a suit challenging the CO statute. This case has served as the impetus for states’ direct assault on the physical presence nexus requirement. After several appeals, including involvement by the U.S. Supreme Court, the U.S. Court of Appeals for the Tenth Circuit ruled in favour of the CO Department of Revenue (DOR). In reaching its decision, the court decided that Quill’s holding was limited to sales and use tax collection and concluded that CO’s remote seller reporting requirements do not discriminate against or unduly burden interstate commerce. Litigation is still possible and the final result remains to be seen, but in the interim, the lower court’s injunction against CO remains in place.

In a concurring opinion, U.S. Supreme Court Justice Kennedy stated that the Quill decision is “inflicting extreme harm and unfairness on the States” and (given the changes brought about by the internet) stated that “it is unwise to delay any longer a reconsideration of the Court’s holding in Quill.” J. Kennedy went on to say: “The legal system should find an appropriate case for this Court to re-examine Quill and Bellas Hess.” Encouraged by Justice Kennedy’s remarks, several states have taken actions in direct opposition to the physical presence requirement in an effort to force a re-evaluation of Quill.

Alabama (AL) promulgated a controversial regulation which appears to contradict the physical presence requirement affirmed in Quill. The regulation took effect on 1 January 2016 and requires out-of-state sellers who lack AL physical presence, but have retail sales of tangible property to customers in AL in excess of USD 250,000 per year and conduct one or more activities enumerated in their statutes (e.g., soliciting orders for tangible property by mail if substantial and recurring, etc.) to collect sales and use tax on the AL sales.

On 9 June 2016, Newegg Inc., a large online retailer of computer hardware, software, and other electronics, filed an appeal in the AL Tax Tribunal challenging the AL DOR’s recent regulation. AL asserts that Newegg has a “substantial economic presence” in the state. Newegg argues that AL’s conclusion is based solely upon the fact that it has more than USD 250,000 of retail sales to customers in AL. In response, the AL Revenue Commissioner published a statement explicitly stating that after decades of Federal Congressional inactivity in granting relief to states from Quill’s harsh effects, AL “will continue to lead the charge to overturn Quill.”

On 22 March 2016, South Dakota (SD) enacted legislation requiring remote sellers that do not have a physical presence in SD to collect sales tax on sales made in the state. The SD statute is noteworthy for expressing the state’s clear directive to quickly produce a test case to challenge Quill’s physical presence requirement.

Certain remote sellers that sell tangible property, products transferred electronically or services for delivery into SD will be required to collect and remit sales taxes as if they had physical presence in the state. Remote sellers will be subject to these new provisions if they meet one of two thresholds in either the previous calendar year or the current calendar year: (1) sales to SD customers exceed USD 100,000; or (2) the seller engaged in 200 or more separate transactions with SD customers.

The SD law itself recognises that it is in opposition to current Constitutional standards and explicitly stays the remote sellers’ obligations created by the law “until the constitutionality of this law has been clearly established by a binding judgment, including . . . a decision from the Supreme Court of the United States abrogating its existing doctrine. . . .” Declaratory judgments and a case have already been filed. The case, filed by the state, claims SD has jurisdiction over the defendants (out-of-state entities) under the state’s long-arm statutes and states that “were the State to prevail, the Act will immediately apply to Defendants, requiring them to collect and remit the state sales tax on a going-forward basis”(emphasis added). Several statements throughout the complaint mention that upon the overturning of Quill, SD will not impose sales tax obligations retroactively.

In addition to SD, both Oklahoma (OK) and Louisiana (LA) have enacted laws aimed at collecting more sales tax from online purchases. OK’s law is very similar to CO’s notification and reporting requirements law, supra. LA’s law requires many internet businesses earning more than USD 50,000 in the state to collect the sales tax if they have substantial ties to a LA business or sell products similar to what can be purchased in-state.

Other states are also following suit and adopting rules which apply economic nexus principles to sales and use tax collection responsibilities imposed on out-of-state sellers. Tennessee has proposed new regulations which would administratively create an economic nexus threshold for out-of-state dealers. Additionally, as at 16 June 2016, at least 11 different bills have been introduced by state legislatures in eight different states.

In response to this trend, the Federal government may take action to codify the physical presence requirement. On 14 July 2016, the No Regulation Without Representation Act of 2016 (H.R. 5893) was introduced in the U.S. House of Representatives. The bill seeks to codify Quill’s physical presence requirement. In the absence of this or similar action, it seems that Quill’s physical presence requirement will soon be overturned.

J. Pablo Garciga

J. Pablo Garciga

Funaro & Co. PC, New York, USA
T: +1 212 947 33 33
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Funaro & Co. PC provide a wide range of services, including accounting and auditing, tax reporting and compliance, tax advisory, management consulting, and transaction advisory.

Pablo Pablo specialises in state and local taxes (SALT), with an emphasis on multi-state corporate income/franchise taxes and sales and use taxes. He has over 20 years of cumulative SALT experience with Funaro and Big Four Public Accounting firms. He is a CPA, JD with an LLM in Taxation

Published: October 2016 l Photo: Tomasz Zajda - Fotolia.com

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