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Panelists on the recent Analyzing nexus and filing options issues webcast hosted by Ernst & Young LLP (EY) provided a historical overview of state income tax nexus, focusing on the constitutional foundations of state taxation and the developments that contributed to current interpretations of states' power to impose tax. This is the first of a five-part series on tax concepts that will address limitations on tax liability under federal law, nexus theories, filing options, and international operational complexities of state filing options. In this segment, panelists discussed the historical background of state income tax nexus; the US Constitutional and federal limits on states' ability to impose income taxes on out-of-state businesses that derive income from the state; the historical context of Public Law (P.L.) 86-272 and what its limits on state income taxing authority mean in today's economy; and judicial developments leading to the seminal US Supreme Court (Court) ruling in Complete Auto Transit¹ and other key opinions. The webcast is now available for replay on the EY Thought Center website.

Historical overview of state income tax nexus

The US Constitution provides a legal framework for how the states operate with the federal government and with each other. Steve Wlodychak, EY Principal based in Washington, DC, and State and Local Tax Policy Leader, said the US Constitution is also a foundational document for determining state tax issues with respect to nexus and the ability of states to impose tax on those doing business in the states. It was adopted after the failure of the country's former legal framework, the Articles of Confederation (1781-1789), under which the states imposed predatory taxes and tariffs on each other to protect home businesses. "The founders of the Constitution said this is something that we can't have, we have to have a much more unified government," Wlodychak said.

Joe Huddleston, EY Executive Director based in Washington, DC, said large debts by the states from the American Revolution and later, the lack of provisions within the Articles of Confederation regarding formally repaying those debts, and high competition among the states contributed to support for a stronger national government, with issues of commerce requiring attention.

The Supremacy Clause provides that the US Constitution prevails over both federal laws and treaties, and state and local laws. Federal laws can pre-empt state and local laws, and to the extent that state tax laws do not conflict with federal laws, the taxing rules of the states are supreme within their jurisdictional boundaries. At the state level, where the state constitution is the law of the land (subject to the US Constitution and federal laws), state law can restrict local law. Additionally, the Tenth Amendment to the US Constitution provides that all the rights not enumerated to the federal government are reserved to the states. The US Constitution has no explicit limitation on state taxation, Wlodychak said, with the closest measures being the Compact Clause (prohibitions on states levying duties on tonnage) and the Import/Export Clause. However, implicitly a state has jurisdiction to impose a tax or tax collection duty on a taxpayer if the taxpayer has sufficient nexus with the state. Jurisdiction is a state's power to impose a tax, and nexus is a taxpayer's contacts with a state — each are embodied in constitutional provisions.

Constitutional limitations on state tax authority

"States can tax an out-of-state corporation only if the contacts with the state create constitutional nexus," Wlodychak said. The key US Constitutional clauses in addressing such an inquiry are the Commerce Clause (the standard set by Congress and interpreted by the courts, considering whether the state tax interferes with interstate commerce) and the Due Process Clause (for which the courts consider whether it is fair to impose tax).² In the context of state taxes, Wlodychak said the judicial standard for due process is whether the taxpayer purposefully directs its activities into a jurisdiction. There must be a minimal connection (nexus) between the interstate activities and the taxing state, and a rational relationship (fair apportionment) between the activities attributed to the state and the intrastate values of the enterprise. This nexus requirement embodies jurisdiction over the taxpayer and the taxpayer's activities or transactions. Additionally, due process encompasses two other aspects: (1) procedural due process (notice and the right to a hearing); and (2) substantive due process (protection against unfair governmental interference or taking of property).

"Procedural due process looks to fair notice — does the taxpayer have adequate and fair notice of what the requirements of the regulation are?" Huddleston said. Early court decisions, such as Shaffer v. Carter,³ found that Oklahoma had the right to impose income tax on an Illinois resident's commercial activities in Oklahoma. In regards to substantive due process, the US Supreme Court has also established a standard of fairness for the taxation of multistate entities.

Panelists also highlighted the Commerce Clause,⁴ the primary purpose of which is to assure fair-handed interstate trade, and explained its direct and implied powers. The direct powers come from the Commerce Clause itself, giving Congress the authority to regulate it. The implied powers have developed from judicial interpretations that the clause "of its own force" limits state taxes where Congress has been silent. This is known as the "negative" or "dormant Commerce Clause." However, this concept has not been universally accepted. "There's a big question mark out there now as to what our current court thinks of the dormant Commerce Clause," Huddleston said.

"In its simplest form, Congress has the power to regulate interstate commerce granted by the Commerce Clause, and they have done it in very limited situations," said Mark McCormick, EY National Director of State Income and Transaction Tax. "So we have a lot of judicial developments out there where the courts have stepped in to say these state taxing structures impose an undue burden on interstate commerce. Under the dormant Commerce Clause, the courts have taken that power that was really granted to Congress," McCormick said. The dormant Commerce Clause harnesses state taxes imposed on interstate and foreign commerce, and protects the rights of other states. The standard has evolved toward expanding the powers of the states to tax. Before the seminal Northwestern States Portland Cement⁵ for Commerce Clause purposes, activities such as the regular presence of sales representatives in a state would be considered sufficient to require collection of the use tax even though the representatives did not live in the state and the company had no place of business in the state.⁶

McCormick asked if a party has a physical presence in a jurisdiction, or something that creates enough activity to establish nexus under a due process clause analysis, is there is any additional materiality threshold? For example, in the context of a sales tax collection obligation, is there a threshold that comes into play, or is nexus a bright-line event so that if a party has it, they are subject to all those rules?

"That is an interesting question, because clearly those standards are in flux right now," Huddleston said, noting that states such as Ohio, California, the Dakotas, and Alabama have asserted nexus based on economic activity. Whether those provisions are valid is yet to be determined, but Huddleston said we clearly see the states going in that direction.

Federal limitations on state tax authority

Panelists addressed what they think is a common misconception — that P.L. 86-272 is an anti-nexus provision. "You don't need the public law unless you have nexus," McCormick said. "It only becomes relevant once you have Due Process and Commerce Clause nexus, now it is a limitation on a state's ability to tax you." Generally, the terms of P.L. 86-272 provide that a state may not impose a net income tax on an out-of-state corporation if its only in-state activity is the solicitation of orders by an employee or representative for sales of tangible personal property. Orders are sent outside the state for approval, and they must be filled by shipment from a point outside the state. McCormick emphasized that P.L. 86-272 does not apply to services.

In considering the historical aspects of federal limitations on state tax authority, Wlodychak pointed out two cases in which the courts found that the solicitation of sales in a jurisdiction constituted activities that could be subject to tax.⁷ Six months after the second case, Northwestern States Portland Cement, Congress enacted P.L. 86-272, providing a federal exception from state income tax. "Many people look to that as a watershed case for a lot of activity on the state tax scene, whether it was the establishment of national organizations to protect the states from federal preemption, or the establishment of organizations at the national level to pursue more restrictions on the states as they tried to expand their taxing authority," Huddleston said.

P.L. 86-272 was supposed to be a temporary stop-gap measure limiting the ability of states to impose a net income tax if a taxpayer's in-state sales activity is limited, but it still in place 60 years later. The less remembered purpose was to authorize Congress to study and simplify the state taxation system, which resulted in the Willis Report in the 1960s. Huddleston said that in the last 15 years, there have been fairly serious efforts in Congress to expand P.L.86-272 to services, but those efforts have not succeeded.

Wlodychak said P.L. 86-272 is narrowly construed, and it may be difficulty to apply based on changes in the economy. For example, unprotected taxpayers and activities under P.L. 86-272 include corporations organized under the laws of the taxing state, foreign commerce (but states are free to extend protection to foreign commerce), sales of services, sales of real or intangible property, leasing or licensing property, and any tax that is not an income tax.

Judicial developments leading to Complete Auto Transit

In Scripto v. Carson,⁸ the Court found that solicitation by independent agents (rather than employees) created constitutional nexus. Then, in 1967 in National Bellas Hess,⁹ (a precursor to Quill) the Court found that states cannot require a seller (such as a mail order company) to collect sales and use tax if the only contact with the state is through the use of a common carrier. The Court found that physical presence is required for sales and use taxes, but offered very little distinction between the Commerce Clause and the Due Process Clause.

Today, Complete Auto Transit¹⁰ is thought by many to be the single most important state and local tax case. In it, Mississippi imposed a privilege tax based on either sales into the state or gross proceeds from commercial activities there. Based on Spector Motor Services,¹¹ the transit company (which shipped cars from Michigan to Mississippi by rail, to be deposited at dealers' locations) argued that it was engaged in purely interstate activity and thus not subject to tax. However, the Court reversed Spector Motor Services and found that a tax on interstate commerce is valid if it is applied to an activity having a substantial nexus with the taxing state, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the state. "You have to meet all four standards in order for the tax to be valid," Wlodychak said, and noted that the Court threw out the requirement from Spector Motor Services that a taxpayer be engaged solely in interstate activities.

"None of these are as clear cut as they would seem to be when you begin to dig into the facts," Huddleston said. He said the reasonableness is not in question — it is the constitutional validity. It always rises to the question of what is meant by nexus, apportionment, discrimination, and fairly related, and those are driven by the facts. McCormick said he has always interpreted substantial nexus to be aligned with the Commerce Clause nexus — much more than a minimal connection.

Nexus has a foreign component, too, Wlodychak said. Under Japan Line,¹² in which a county imposed personal property tax on containers owned by a Japanese shipping company that were already subject to tax in Japan, the Court provided two additional requirements to be satisfied when foreign commerce is affected by a tax: the tax must not create a substantial risk of multiple international taxation, and must not prevent the federal government from "speaking with one voice" when regulating commercial relations with foreign governments. In 1993 in Itel Containers¹³ (a case in which Huddleston was a named party as the Tennessee Revenue Commissioner), the facts were identical except that the tax involved was a sales tax on the lease of a container at a Tennessee location, rather than a property tax. The state won unanimously, and could impose the tax. Besides that the tax was imposed on the transaction, Huddleston said the other major distinguishing factor was there was no risk of multiple taxation, because a credit was provided. Finally, Huddleston said both cases illustrate that within certain frameworks, states are not bound by international treaty obligations.

Conclusion

"For all of us as taxpayers, it's the fundamental starting questions — where am I doing business, and where am I subject to tax?" McCormick said.

"I think the biggest point is that nothing is settled," Huddleston said. "The nature of commerce now is so substantially different than it was in the 18th century that we should never shy away from questioning these concepts."

Wlodychak said the body of law related to these concepts is complicated, and it is constantly changing as technology and the demands of our society change. "The fundamental thing is states have a right to raise revenue and they are sovereign, but on the other hand, we want to encourage free trade among the states, we don't want to have artificial barriers created by the states to inhibit a free flow of trade in our economy — that is what has made our economy a great place to do business," Wlodychak said.

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Contact Information For additional information concerning this Alert, please contact:   State and Local Taxation Group • Joe Huddleston (202) 327-7785 • Mark McCormick (404) 541-7162 • Steve Wlodychak (202) 327-6988

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ENDNOTES

¹ Complete Auto Transit v. Brady, 430 U.S. 274 (U.S. S. Ct. 1977).

² "[N]or shall any State deprive any person of life, liberty, or property, without due process of law … "

³ Shaffer v. Carter, State Auditor, 252 U.S. 37 (U.S. S. Ct. 1920), citing Michigan Trust Co. v. Ferry, 228 U.S. 346 (U.S. S. Ct. 1913).

⁴ U.S. Const., Art. I, Sec. 8, cl. 3: "The Congress shall have the Power … To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes."

⁵ Northwestern States Portland Cement v. Minnesota, 358 U.S. 450 (U.S. S. Ct. 1959).

⁶ General Trading Co. v. State Tax Comn., 322 U.S. 355 (U.S. S. Ct. 1944)(use tax collection responsibility upheld) and International Shoe Co. v. Washington, 326 U.S. 602 (U.S. S. Ct. 1945)(imposition of unemployment tax upheld).

⁷ Brown-Forman Distillers Corp. v. Collector of Rev., 101 So. 2d 70 (La. S. Ct. 1958), cert denied (U.S. S. Ct. 1959); Northwestern States Portland Cement v. Minnesota, 358 U.S. 450 (U.S. S. Ct. 1959).

⁸ Scripto v. Carson, 362 U.S. 207 (U.S. S. Ct. 1960).

⁹ National Bellas Hess, Inc. v. Illinois, 386 U.S. 753 (U.S. S. Ct. 1967).

¹⁰ Complete Auto Transit v. Brady, 430 U.S. 274 (U.S. S. Ct. 1977).

¹¹ Spector Motor Services, Inc. v. O'Connor, 340 U.S. 602 (U.S. S. Ct. 1951)(tax not permitted if party is exclusively engaged in interstate commerce).

¹² Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434 (U.S. S. Ct. 1979).

¹³ Itel Containers International Corp. v. Huddleston, 507 U.S. 60 (U.S. S. Ct. 1993).