On November 17, 2016, the Ohio Supreme Court (Court) issued its much anticipated decisions in three consolidated tax cases — Crutchfield,¹ Newegg,² and Mason Companies³ — — and upheld the constitutionality of the Ohio Commercial Activity Tax's (CAT) bright-line factor presence nexus standard. In so holding, the Court concluded that physical presence in Ohio is not required because Quill⁴does not apply to business-privilege taxes, such as the CAT, and the $500,000 sales-receipts threshold complies with Complete Auto's⁵ substantial-nexus requirement.

Crutchfield represents the lead opinion in the consolidated cases. The Court's decisions in Newegg and Mason Companies, holding in favor of the Tax Commissioner, are based on its reasoning in Crutchfield the former case.

CAT bright-line nexus provisions

Ohio Rev. Code Section 5751.02(A) imposes CAT, measured by taxable gross receipts sitused to Ohio, on each person with "substantial nexus" for the privilege of "doing business" in Ohio. Ohio Rev. Code Section 5751.01(H) further provides that a person has "substantial nexus" for CAT purposes if any of the following applies:

— The person owns or uses a part or all of its capital in Ohio.

— The person is authorized to do business in Ohio.

— The person has bright-line presence in Ohio.

— The person otherwise has nexus with Ohio to the extent allowable under the Constitution of the United States.

Ohio Rev. Code Section 5751.01(I) further provides that a person has bright-line presence in Ohio if, at any time during the calendar year, it meets one of the following tests: (a) $50,000 of its property or payroll is in Ohio; (b) $500,000 of its gross receipts are sourced to Ohio; (c) at least 25% of its total payroll, total property, or total gross receipts are attributable to Ohio; or (d) it is domiciled in Ohio. 

Background

Crutchfield, Inc. (Crutchfield), Newegg, Inc. (Newegg) and Mason Companies (Mason) are unrelated on-line retailers that conduct all of their operations outside of Ohio with no physical presence in Ohio during the tax periods at issue. Each out-of-state retailer, however, sold more than $500,000 of products to Ohio customers.  As a result, the companies were assessed CAT for periods going back to the CAT's inception on July 1, 2005 and received final determinations on those assessments that were appealed to the Ohio Board of Tax Appeals (BTA). In early 2015, the BTA affirmed the Tax Commissioner's determinations, holding that each of the out-of-state retailers was subject to the CAT based solely on their each having exceeded the statutory $500,000 sales threshold.⁶ The companies then appealed to the Court with oral arguments heard on May 3, 2016. The out-of-state retailers challenged the assessments arguing that the CAT's bright-line nexus provision, which imposes the tax based solely on whether a putative taxpayer meets a statutory $500,000 gross receipts threshold from sales to Ohio customers, irrespective of whether the business has an in-state presence, was in violation of the substantial nexus requirement of the Commerce Clause.

Court's statutory analysis

The Court analyzed the application of Ohio Rev. Code Section 5751.02(A), the CAT imposition statute, to Crutchfield. The Court rejected Crutchfield's argument that its lack of physical presence in Ohio meant that it was not "doing business" in Ohio. The Court said that "doing business" broadly includes profit-seeking activities without an express "in-state activities requirement." The absence of a physical presence requirement along with the statute's insistence that the tax is imposed on persons based on the $500,000 sales-receipt threshold manifested a clear legislative intent to impose the CAT based on bright-line presence.

The Court also rejected Crutchfield's contention that Ohio Rev. Code Section 5751.02(F)(2)(ll),⁷ which provides an exclusion from "gross receipts" for any receipts "for which the tax imposed  … is prohibited by the constitution or laws of the United States," should be construed to preempt the imposition of the CAT based on the $500,000 bright-line receipts threshold. The Court concluded that Ohio Rev. Code Section 5751.02(A) invoked, by reference, the $500,000 threshold as part of the definition of "substantial nexus." As such, the gross receipts exclusion did not create an exception to the "substantial nexus" definition.⁸

Court's Commerce Clause analysis

The Court engaged in a "before and after" analysis of Commerce Clause caselaw with its "pivot point" being Complete Auto Transit. Crutchfield, citing among other cases Norton Co. v. Dept. of Rev.,⁹ argued that a "local incident" was required to support the imposition of CAT. In Norton, the United States Supreme Court held that a local incident was required to bring a transaction (in that case the Illinois retail business tax) within the state's taxing power. The Court observed that Norton was not a "substantial nexus" case, but one that reflected the interstate commerce immunity theory¹⁰ that existed prior to Complete Auto Transit. The Court rejected Crutchfield's argument that a "local incident" equates to "substantial nexus." Accordingly, the Court concluded that a "local incident" was not a prerequisite to the imposition of CAT.

The Court also analyzed whether a physical presence was required to support the imposition of CAT, focusing on the applicability of Quill.  Ultimately, the Court concluded that Quill's holding that a physical presence is a necessary condition to imposing a tax obligation does not apply to a business-privilege tax such as the CAT. The Court cited passages from Quill that indicated the United States Supreme Court had not articulated a physical presence requirement for other types of taxes that it had articulated for sales and use taxes. The Court observed that Complete Auto Transit and Jefferson Lines¹¹ established that business-privilege taxes should be distinguished from transaction taxes, such as sales/use taxes, when applying the four-pronged Commerce Clause test articulated in Complete Auto. The Court said that Jefferson Lines viewed a gross receipts tax "as occupying the same constitutional category as an income tax  … whereas a sales tax  … occupies a different category." In the context of other gross receipts taxes, such as the Washington B&O Tax, the Court rejected Crutchfield's reliance on Tyler Pipe,¹²reasoning that while a taxpayer's physical presence in a state is a "sufficient basis" for imposing a gross receipts tax, it is not a "necessary condition" to doing so. The Court concluded that under the Commerce Clause a physical presence is not required to impose the Ohio CAT.

Finally, the Court concluded its analysis by holding that the $500,000 bright-line receipts threshold serves as an adequate quantitative standard ensuring substantial nexus and that any burdens imposed by the CAT on interstate commerce are not "clearly excessive" in relation to Ohio's legitimate interest in imposing the tax evenhandedly. After concluding that the substantial nexus requirement was satisfied, the Court declined to address the Tax Commissioner's arguments that the taxpayers had, in fact, physical presence due to Crutchfield's use of cookies and other tracking software installed on its customers' computers.

Dissenting opinion

Two justices dissented. The dissenting opinion would have remanded the matter back to the BTA for a determination of whether Crutchfield had a physical presence under Quill. The dissent believed that there was no evidence that gross receipts taxes are "meaningfully different" from sales/use taxes for substantial nexus purposes. The dissent also viewed Tyler Pipe's reliance on physical presence "more indicative of a requirement than an option." The dissent also observed that gross receipts tax cases, such as Jefferson Lines, all involved a physical presence in the state. The dissent then noted that the physical presence requirement is grounded in the reasoning of the dormant Commerce Clause that is designed to prevent undue burdens on interstate commerce.

Implications

The Ohio Department of Taxation (Department) has historically enforced the bright-line nexus standard since the CAT's inception in 2005. No doubt, this decision lends support to the Department's efforts in this area. It would seem likely that the taxpayers will appeal the decision to the United States Supreme Court. If accepted, a resolution is still some time off in the distance and, in the meantime, the Department will likely continue to aggressively enforce this nexus standard.

The bright-line nexus standard is applied based on Ohio-sourced gross receipts. When considering its application to transactions such as dock sales, one could attain bright-line nexus with Ohio without engaging in any attempt to "purposefully direct" activity that would maintain a market in the state (such as went on in Crutchfield). Whether the bright-line nexus standard is still vulnerable to an as applied constitutional challenge on different facts remains an open question.

The Court's opinion seemed to acknowledge that Quill's physical presence standard is still applicable for sales/use taxes. Ohio recently enacted click-through nexus¹³ provisions. Until, and if, the United States Supreme Court decides to revisit the continuing efficacy of Quill, this decision seems to provide support for businesses wishing to challenge the new sales/use tax nexus standard.

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ENDNOTES

¹ Crutchfield, Corp. v. Testa, Slip Op. No. 2016-Ohio-7760 (Ohio S. Ct. Nov. 17, 2016).

² Newegg, Inc. v. Testa, Slip Op. No. 2016-Ohio-7762 (Ohio S. Ct. Nov. 17, 2016).

³ Mason Companies, Inc. v. Testa, Slip Op. No. 2016-Ohio-7768 (Ohio S. Ct. Nov. 17, 2016).

⁴ Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

⁵ Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

⁶ See Tax Alerts 2014-507, 2015-487  2015-807 and 2016-847.

⁷ During the audit period, the reference was Ohio Rev. Code Section 5751.01(F)(2)(jj).

⁸ The Court went on to observe that the exclusion removes the federal government and its instrumentalities from the imposition of CAT and that it was unnecessary to find additional legislative purposes for the exclusion.

⁹ Norton Co. v. Dept. of Rev., 340 U.S. 535, 71 S.Ct. 377, 95 L.Ed. 517 (1951).

¹⁰ Spector Motor Serv., Inc. v. O'Connor, 340 U.S. 602, 71 S.Ct. 508, 95 L.Ed. 573 (1951) (invalidating corporation franchise tax imposition on business carrying on excvlusively interstate transportation).

¹¹ Oklahoma Tax Comm. v. Jefferson Lines, Inc., 514 U.S. 175, 115 S.Ct. 1331, 131 L.Ed.2d 261 (1995).

¹² Tyler Pipe Industries, Inc. v. Washington State Dept. of Revenue, 483 U.S. 232, 107 S.Ct. 2810, 97 L.Ed2d 199 (1987).

¹³ Tax Alert 2016-1731.