Volume 12, Number 4 - March/April 2003

Sales of goods and services on the Net are taxable. Not tomorrow, but today. Virtually all Internet buyers and sellers are surprised to learn this. Every day, many Internet sellers properly collect and report sales taxes on sales. But most do not, and that is a growing problem for both Internet sellers and the states.

Most consumers have bought goods on the Internet without paying sales tax and assume that these transactions are nontaxable. Most Internet sellers will vaguely cite the Internet Tax Freedom Act (ITFA) as the reason why they are not required to collect sales and use taxes (together, sales taxes) on sales made over the Internet.

These assumptions are incorrect and can be very costly for Internet sellers.

Sales of tangible and intangible goods on the Internet (e-commerce) are potentially subject to the sales and use taxes imposed by the nation's approximately 7,500 state and local taxing jurisdictions (the states).

From the perspective of multistate tax law, there are few truly mom-and-pop Internet sellers. Most of these sellers are as much 50-state businesses as McDonald's and Microsoft. The importance of determining exactly when an Internet seller (a remote seller) becomes subject to one or more taxing jurisdictions not its domiciliary jurisdiction should not be underestimated. If an Internet seller is itself liable for sales tax or at least responsible for collecting and remitting the taxes to various jurisdictions and fails to do so, an assessment for unpaid taxes on sales made over several years, plus interest and penalties, could be devastating for even a successful seller.

The risk of this has never been greater because, in an effort to stem the erosion of their tax bases caused by a weakened economy, states have become increasingly aggressive and clever in asserting their taxing jurisdiction over remote sellers. Often enough, these efforts contravene applicable federal constitutional restrictions on taxing jurisdictions.

It is not possible in the compass of this article to fully cover the issues raised by the application of multistate sales tax law, often radically different in conception and application, to electronic commerce. Instead, this article reviews the principal federal restrictions on state taxation of interstate e-commerce and commonly occurring situations in which the states are aggressive (and mostly successful) in asserting their tax jurisdiction over remote sellers.

A business is a remote seller if it is physically located in one state (its domicile) and has no facilities, substantial property or personnel in another state. The business is "remote" from the other states because it is not physically located in those states. Historically, the issue of whether remote sellers can be taxed arose when the residents of a state traveled across state lines to purchase goods in another state and arose again in the context of catalog merchandising.

The dramatic expansion of interstate e-commerce has brought renewed attention to the dormant Commerce Clause of the U.S. Constitution, which precludes a state from taxing a remote seller operating in interstate commerce unless the state has "substantial nexus" with the seller. Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977).

In Quill Corp. v. North Dakota, the U.S. Supreme Court reaffirmed the long-standing rule that, for sales tax purposes, a state has substantial nexus with a remote seller only if the seller is "physically present" in the state. 504 U.S. 298 (1992) (reaffirming National Bellas Hess Inc. v. Dept. of Rev. of Illinois, 386 U.S. 753 (1967)). Though the court seemingly established a bright-line rule that would reduce the amount of confusion and litigation in this area of law, left unanswered was the crucial question of what level of physical presence was required.

In Quill, the court held that a remote seller's delivery of goods into a state via common carrier could not be a basis for establishing nexus, and neither was it sufficient that it sent several tons of direct mail catalogs and fliers into the state.

In the earlier case of National Geographic Society v. California State Board of Equalization, however, the court held that a remote seller's two offices and permanently located personnel were sufficient to establish nexus with a state. 430 U.S. 551 (1977). In the same case, the court held that the "slightest physical presence" was insufficient to create nexus. The court did not explain what it meant by slight physical presence.

Between these two guideposts — personnel and physical facilities in a state create nexus, the slightest physical presence does not — the standards for the creation of nexus, and the application of these standards, vary widely among the states.

As a practical matter, states equate nexus with a remote seller's doing business in the state, as the term is defined by state statute. These definitions are broadly drafted, generally not founded in the physical presence standard of Quill and frequently over-inclusive of circumstances under which a state can validly assert its taxing jurisdiction.

Texas, for example, defines doing business as including, among other things, the licensing of a remote seller's trade name to a party in the state, collecting royalties from the licensing of personal property to Texas customers, or the use of representatives to do canvassing and distribution functions. Tex. Admin. Code tit. 34, § 3.286(a)(1); see also Texas Tax Publication 94-108 (April 1999) (available at http://window.state.tx.us/taxinfo/ taxpubs/tx94_108.html) (providing guidelines to a remote seller regarding whether or not its activities create nexus).

It is important that the sale of both custom and off-the-shelf software in Texas is considered a sale of personal property and thus subject to the state's sales tax. Tex. Tax Code Ann. § 151.009; Tex. Admin. Code tit. 34, § 3.308. Therefore, a remote seller establishes nexus with Texas if it licenses either off-the-shelf or custom software to a Texas customer. Decision of the Texas Comptroller of Public Accounts, Hearing No. 36,237 (July 21, 1998).

Texas's approach is not unusual. Arizona broadly defines doing business as including all activities or acts, personal or corporate, engaged in or caused with the object of gain, benefit or advantage, either directly or indirectly, excluding casual sales or activities. Ariz. Rev. Stat. § 42-5001.1. At certain points of application, Arizona adopts an "economic presence" test for nexus (that is, the exploitation of a local consumer market, whether or not the remote seller is physically present, creates nexus) that was repudiated in Quill.

Similarly, so broad is Tennessee's definition of doing business that it includes businesses that import taxable property into the state or merely offer to sell taxable property in the state. Tenn. Code Ann. § 67-6-102(7)(A)-(M).

The most common basis for states asserting jurisdiction over a remote seller involves the visits made by the seller's personnel to the state. States generally take the position that, when a seller's personnel enter the state, however briefly and for whatever purpose, the remote seller is present. The states vary, however, on how many visits over a certain period of time are sufficient to establish nexus.

Often enough, what is sufficient to give rise to taxing jurisdiction in one state will be insufficient in another. In New York, for example, 12 visits over three years establishes nexus, but in Kansas, 11 visits in a single year is insufficient. See Orvis Co. Inc. v. Tax Appeals Tribunal, 612 N.Y.S.2d 503 (App.Div.3dDept. 1994); In re Appeal of Intercard Inc., 14 P.3d 1111 (Kan. 2000); Cole Bros. Circus Inc. v. Huddleston, No. 01-A-01-9301-CH00004, (Tenn. Ct. App. June 4, 1993) (29 visits over 2 1/2 years is sufficient); Department of Revenue v. Share International Inc., 676 So.2d 1372 (Fla. 1996) (three visits in one year is insufficient).

It is of potential significance to many remote sellers that Illinois has ruled that the presence of a remote seller's sales manager working solely from his home is sufficient to establish nexus with the remote seller. Illinois Department of Revenue, Letter Ruling No. ST 01-0052-GIL (March 2, 2001).

The common law distinction between employees and independent contractors is not respected for purposes of establishing nexus. Scripto v. Carson, 362 U.S. 207 (1960). The presence of either in a state can be treated as establishing the presence of a remote seller. This principle allows the states to reach remote sellers even though the sellers may innovatively structure their marketing programs to use independent contractors.

A classic case is the Scholastic Book Club, which recruits teachers nationwide to sell its books to their students. Teachers distribute catalogs, collect payments and distribute the books when they arrive in the mail. In exchange, the teachers receive "points" that may be redeemed for merchandise.

The teachers were not employees of the club, but the states are split on whether they are representatives of the club. If they are representatives under each state's law, the teachers' presence establishes nexus with the remote seller club. See, for example, Scholastic Book Clubs Inc. v. State Board of Equalization, 207 Ca.3d 734 (Cal.Ct.App. 1989) (teachers' presence sufficient to establish nexus); Freedom Industries v. Roger W. Tracy, Tax Commissioner of Ohio, Ohio Board of Tax Appeals, No. 92-C-597 (Dec. 12, 1994) (insufficient).

Many states also establish nexus on the basis of a remote seller's licensing or leasing property to residents. The general theory is that even if the property is shipped into the state for a short period of time by common carrier and returned to the seller on the expiration of the license or lease, the seller still retains a substantial reversionary interest in the property — all rights, title and interest in the property less the term of the license or lease — and that this interest somehow constitutes a physical presence in the state.

Here too, though, the states vary as to how long the property must be in the state on a lease or license for the contact to be sufficient to establish nexus. In Alabama, the in-state presence for 48 hours of a licensed film was sufficient to establish nexus with the remote seller. Boswell v. Paramount Television Sales Inc., 282 So.2d 892 (Ala. 1973). However, in Connecticut, the in-state presence of a licensed film for three days was held insufficient to establish nexus. Cally Curtis Co. v. Groppo, 572 A.2d 302 (Conn. 1990). As noted above, Texas takes the position that the licensing of software to the state's residents is sufficient to establish nexus.

Because of the growing difficulty of breaking through online marketing "noise" to reach potential customers, Internet sellers have started using traditional forms of offline advertising — television and radio ads, mail drops and billboards.

Whether advertising alone constitutes a sufficient basis for establishing nexus is somewhat unclear. In Quill, the Supreme Court effectively established a "safe harbor" for direct mail drops of catalogs and fliers. In at least one state, Tennessee, courts have invalidated the portion of the doing-business statute that established nexus through in-state advertising. Bloomingdale's By Mail Ltd. v. Huddleston, 848 S.W.2d 52, 57 (Tenn. 1992).

Other courts have used advertising as a basis for upholding the assertion of nexus, but most of these cases have also involved the in-state presence of personnel or some form of property. See, for example, National Geographic Society v. California Board of Equalization, 430 U.S. 551 (1977); Cole Bros. Circus Inc. v. Huddleston, No. 01-A-01-9301-CH00004, (Tenn. Ct. App. June 4, 1993). Whether the in-state presence of billboards — in which the remote seller has some form of property interest for a lengthy period of time — is sufficient to establish nexus has not been addressed.

Whatever bases they use to establish nexus, several states expressly deem certain Net-related activities insufficient to establish nexus with the state. California, for example, has established that nexus is not established by a remote seller maintaining a Web site on a computer server located in the state, having purchase orders taken by an in-state Internet Service Provider, having limited attendance at in-state trade-shows, or having contracts with in-state, unrelated third-party contractors to handle repair and warranty services. Cal. Code Regs. tit. 18, § 1684(a).

Other major states have similar computer server exemptions. See, for example, Texas Comptroller of Public Accounts, Letter Ruling No. 9802118L (Feb.10, 1998); New York State Department of Taxation and Finance, Memorandum TSB-M-97(1)C ((Jan. 24, 1997); TSB-M-97(1)9S (Jan. 24, 1997).

States use a variety of "attributional nexus" theories to create nexus. In "affiliate nexus" cases, states try to attribute the physical presence of an affiliate to a remote seller. In the context of e-commerce, taxing jurisdictions attempt to attribute a retail store's physical presence in the jurisdiction to the formally separate out-of-state online unit.

In most instances, these assertions of nexus are defeated in court, because, without reason to "pierce the corporate veil," the attribution violates the axiomatic principle of corporate law that the existences of separate entities will be respected. See, for example, SFA Folio Collections Inc. v. Bannon, 585 A.2d 666 (Conn. 1991).

In "agency nexus" cases, states try to attribute the activities of independent contractors or business partners to a remote seller. One of the more interesting and troubling applications of this theory came in a recent decision of the California Board of Equalization (CBOE). Borders Online Inc., SC OHA 97-638364 56270 (Sept. 26, 2001).

The Borders bookstore chain maintained formally separate entities for its chain of stores (retail unit) and its online bookstore (online unit). The online unit represented on its Web site that the retail unit was an authorized representative for merchandise returns. In practice, the retail unit accepted returns of merchandise from customers of the online unit in exchange for cash refunds. The retail unit also accepted returns from competitors' customers in exchange for store credit.

On the basis of this disparity in its return policy, the retail unit's activities were attributed to the online unit because, the CBOE held, the process of accepting returns is integral to the selling process and thereby encompassed within the term "selling" as used in Cal. Rev. and Tax Code § 6203(c)(2).

The CBOE's interpretation of selling is arguably too broad because the statute leaves out other specific activities — for example, order taking and product installation — that are arguably more integral to the sales process than accepting returned merchandise. The decision is on appeal, but it shows the potentially broad and troubling application of some form of agency theory that can be used to pierce the corporate veil without satisfying the traditional requirements of that extraordinary remedy.

Furthermore, the decision could have application to third-party, joint-marketing partners. For example, if an online bicycle shop entered into a joint marketing agreement with a national chain of sports stores where the stores distributed the Internet seller's coupons in its customers' merchandise bags, could the activities (and thus the physical presence) of the stores' employees be attributed to the Internet seller? Perhaps. If so, the Internet seller would have nexus in all of the states where the national retail chain had stores or employees.

Because of the increasing importance of these questions, Internet sellers and their clients are encouraged to take three practical steps to begin identifying what continuing tax collection obligations and historic tax liability the sellers may have:

 The first step is to begin collecting geographic-based information on the seller's operations, including all the states into which it sends its products, how those products are distributed, and what type of commercial relationships it has with co-marketers, salesmen, distributors, manufacturers and suppliers in those jurisdictions. The information should be collected for both current and historical operations.

 The second step is for the seller's legal advisers to identify potential liability in at least the major jurisdictions in which the seller operates. For instance, if the seller makes sales of $1 million in three states, with nominal sales in all the rest, it makes eminent sense for the seller's legal advisers to ascertain the state of sales tax law in each of those three states. Counsel should focus on determining whether tax liability is imposed on the seller or the consumer, whether there is an arguable claim by the state that the seller has nexus in the state, how aggressive the state department of revenue is in pursuing current and historic assessments against Internet sellers, and the likelihood of audit.

If tax liability is imposed in the first instance on the consumer, but the consumer (as is very likely) does not self-assess and remit those taxes, the seller may find itself liable for those taxes, even though it could have avoided liability had it collected the taxes from the customer.

 The third step is for the seller to factor in the findings of its legal advisers into its competitive analysis. For instance, if one or several states where the seller completes substantial sales will have an arguable claim of nexus, it may make sense for the seller to implement a tax-collection system for online sales. Or, if the claim of nexus is founded on activities in the state or relationships with partners in the state that are unnecessary or can be restructured, the seller may want to consider reorganizing its operations.

If a seller has nexus in a state, it should also explore with its legal advisers whether it can effectively "withdraw" from nexus and re-enter the state through means that will not make it amenable to nexus. See Florida Dept. of Rev., Tech. Asst. Advisement No. 00A-020 (April 25, 2000) (vendor that terminated its physical presence but then solicited in-state orders through Web site did not have nexus).

The ultimate question for Internet sellers is whether effective exemption from sales tax liability is central to their respective business plans. If so, restructuring its operations to avoid nexus in as many states as possible may make sense. For other sellers, however, expanding and deepening commercial relationships with offline marketing partners will make sense.

In either case, the time when Internet sellers and their customers could confidently assume that the Internet was a tax-free zone is gone. The long arm of multistate tax law reaches deep into cyberspace and Internet sellers have every incentive to clarify and discharge their tax-collection obligations.