Taxing time for the Internet?
'Attributional nexus' may change the face of online retail
By Andrew W. Swain and Nathaniel T. Trelease
States have lost a lot of sales taxes thanks to the Internet. Is that about
to change?
Traditional retail businesses have evolved in order to sell to a customer
base expanded by the creation and growth of the Internet. Brick-and-mortar
retailers (in-state retailers) who might have once sold products in
mail-order catalogs have developed into so-called
"click-and-mortar" retailers, such as Borders Inc. These
retailers have in-state stores nationwide, but also sell products on the
Internet through separate but related online subsidiaries. The
click-and-mortar retailers compete with another species of online retailer,
the so-called "click-and-one-brick" retailers such as Amazon.com.
These retailers have a store or warehouse in one location while selling to
customers located throughout the nation.
States and their political subdivisions are growing increasingly concerned
about what they see as an erosion of their individual tax bases caused by
retailer evolution and the move of offline commerce onto the Net. Products
and services sold on the Internet avoid taxation because nonbusiness buyers
rarely remit the use taxes associated with their purchases. William Fox and
Donald Bruce of the University of Tennessee estimate that state and local
taxing authorities lost $16 billion in taxes in 2004 and that, based on
current rates, losses for 2008 will be between $21.5 billion and $33.7
billion. See Bruce & Fox, State and Local Sales Tax Revenue Losses
from E Commerce: Estimates as of July 2004(University of Tennessee,
July 2004).
Also, online retailers frequently attempt to structure their businesses to
avoid any tax collection duties. Many states fear that, if they take no
action to stop these trends, their tax bases will erode to the point that
they will be unable to finance basic governmental services. California has
recently broken new ground to ebb the erosion and catch up online retailers
in nexus' taxability net.
Regardless of whether a business is a mail-order, a click-and-mortar, or a
click-and-one-brick retailer, one question is the same for them all: Can
the local taxing jurisdiction into which the retailer sells and ships a
product require the retailer to collect a sales tax on the jurisdiction's
behalf? The dormant Commerce Clause of the U.S. Constitution (U.S. Const.
art. I, § 8, cl. 3) provides the legal context for answering the
retailer's question. Current doctrine holds that the clause, by its own
force and in the absence of congressional legislation, prohibits taxes that
impose an undue burden on interstate commerce. See, for example,
Associated Indus. of Mo. v Lohman, 511 U.S. 641, 647 (1995).
To determine whether a state's tax burdens interstate commerce, the U.S.
Supreme Court established a four-prong test in Complete Auto Transit
Inc. v. Brady, 430 U.S. 274, 279 (1977). Under the test's first prong,
a state tax does not violate the clause if the tax applies to an activity
with a "substantial nexus" with the taxing state.
Nexus is the term used to describe the minimal (and therefore sufficient)
physical connection required for a state (or other local taxing authority
such as a city or county) to legally assert jurisdiction over an entity and
impose on it a sales or use tax. "Substantial nexus" is
essentially synonymous with a state's taxing jurisdiction. If the nexus
between the remote seller and the market state is insufficient, the state
does not have the authority to impose tax liability or tax collection
obligations on the remote seller.
Everything turns on this threshold determination. Therefore, the critical
questions are what level of presence within a taxing jurisdiction is
required to constitute physical presence and how this physical presence is
practically manifested. The case law used to help answer this question
developed during the 20th century and concerned out-of-state catalog sales
and in-state deliveries of out-of-state purchases rather than sales made
through the Internet.
In 1998, the U.S. Congress enacted the Internet Tax Freedom Act (act), and
amended by the Internet Tax Nondiscrimination Act (ITNA). Many Internet
sellers mistakenly believe that the act and ITNA preclude state taxation of
e-commerce. Though they exclude certain Internet-related services
from the imposition of some (but not all) state taxes, the federal
provisions do not suspend the substantial nexus requirement.
Five years ago, members of four groups initiated the Streamlined Sales Tax
Project (SSTP) in order to, among other things, override the substantial
nexus requirement mandated in Complete Auto. Under the SSTP's
Streamlined Sales and Use Tax Agreement (SSUTA), remote vendors without
nexus to a market state would voluntarily register with the market state to
collect sales tax on sales sourced to the state.
Legislation introduced in the U.S. Congress that would suspend nexus
requirements and allow states that have adopted the SSUTA to require remote
sellers to collect sales taxes has repeatedly failed. There is no
indication that Congress will, in the near future, suspend nexus
requirements.
The beginning point for analyzing a business' nexus profile is Quill
Corp. v. North Dakota, 504 U.S. 298 (1992) (reaffirming Nat'l
Bellas Hess Inc. v. Dep't of Rev. of Ill., 386 U.S. 753 (1967)). In
Quill, 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.
The court in Quill held that a mail-order catalog retailer's
delivery of goods into a state by common carrier could not alone serve as
the basis for establishing nexus.
Most states have statutes that impose tax or tax-collection obligations on
sellers "doing business" in the marketing state. See, for
example, Neb. Rev. Stat. § 77-2703(2)(a). The statutes list a series
of activities in a market state that establish nexus in a manner consistent
with U.S. Supreme Court decisions and the mandates of the dormant Commerce
Clause.
Doing business is generally established by:
maintaining an office or other place of business in a
jurisdiction, owning real property in a jurisdiction, an employee's, agent's, wholesaler's, jobber's or independent
contractor's presence within a jurisdiction so that he can solicit sales or
install or repair property, temporary storage (unless exempted) of tangible personal property
within the jurisdiction, and the presence of a related business entity in the jurisdiction.
A frequently listed activity is attributional nexus, a technique that
taxing authorities use to assert that a retailer who does not have a
physical presence in the taxing jurisdiction is doing business in the state
and, therefore, has substantial nexus with it. Attributional nexus takes
the physical presence of an in-state entity and attributes that presence to
the out-of-state retailer in order to subject the remote retailer to
taxation. The critical question here is what relationship must exist
between in-state and out-of-state entities in order to support a state's
application of attributional nexus?
Taxing authorities developed attributional nexus from the U.S. Supreme
Court's decisions in Scripto v. Carson, 362 U.S. 207 (1960), and
Tyler Pipe Indus. v. Dep't of Rev., 483 U.S. 232 (1987). In
Scripto, the court upheld Florida's imposition of its use tax on a
Georgia retailer based on the retailer's use of independent contractors
(jobbers) to solicit sales in the taxing state.
Twenty-seven years later, in Tyler Pipe, the court elaborated on its
holding in Scripto. The court held that the in-state activities of
sales representatives were sufficient to permit Washington's imposition of
its Business and Occupation Tax on an out-of-state retailer. The court held
that the critical factor for constitutionally permitting the attribution of
an in-state entity's in-state presence to an out-of-state retailer for the
purpose of permitting a state to impose taxation is whether the in-state
entity's activities both establish and maintain the remote retailer's
market.
Taxing jurisdictions have traditionally used attributional nexus as a
technique to subject remote mail-order retailers to a state's taxing
jurisdiction.
Some states have provided in their statutory schemes that a remote
retailer's mere affiliation with an in-state retailer means that the remote
retailer does business in the state and, therefore, has nexus with it. For
example, Arkansas requires a remote retailer to collect the state's sales
tax on sales to Arkansas customers if the remote retailer is affiliated
with the in-state retailer and both sell a substantially similar line of
products. See Ark. Code Ann. § 26-53-124(a)(3)(A) and (B)(effective
Jan. 1, 2002).
The constitutionality of statutes that confer the status of "doing
business" on a remote retailer based solely on the remote retailer's
affiliation with an in-state retailer is questionable. Courts have
routinely rejected taxing authorities' attempts to confer a tax collection
duty on remote retailers based on nothing more than an affiliation with an
in-state retailer. See, for example, Current Inc. v. Cal. Bd. of
Equalization, 24 Cal. App. 4th 382, 29 Cal. Rptr. 2d 407 (1st Dist.
1994); and SFA Folio Collections Inc. v. Tracy, 652 N.E.2d 693 (Ohio
1995).
At the same time that taxing authorities developed attributional nexus
techniques based on Scripto (but before the U.S. Supreme Court's
clarification of the case in Tyler Pipe), they also created agency
nexus techniques. They asserted that the in-state activities of a related
retailer results in the imposition of a sales tax collection duty on a
remote retailer if the in-state retailer acts as the remote retailer's
agent as agency is defined under state law.
The decision in Readers Digest Ass'n Inc. v. Mahin, 44 Ill. 2d 354,
255 N.E.2d 458 (1970), illustrates this nexus technique. The Illinois
Supreme Court held that an agency relationship existed between Readers
Digest Association (RDA), a Delaware corporation, and its subsidiary,
Readers Digest Sales & Service (RDS&S), an Illinois business,
because RDS&S solicited sales in Illinois on RDA's behalf. The duty to
collect Illinois tax arose because of the existence of the agency
relationship between the parties, not on the mere fact that the parent
company owned, and was affiliated with, the subsidiary.
In order to avoid any constitutional infirmities caused by the reliance on
mere corporate affiliation, and in an attempt to catch remote online
retailers in states' nexus nets, taxing authorities have returned to the
holding in Tyler Pipe and, combining it with the agency nexus
techniques upheld in cases such as Readers Digest, developed a
modified version of attributional nexus — that is, a sort of
"agency plus" technique.
This technique requires that an in-state entity act as the out-of-state
retailer's agent, as well as establish and maintain the remote retailer's
market. California has recently found a use for this technique in the
context of online book retailers in order to attribute an in-state
retailer's presence and activities to a separate but related remote online
retailer, thereby assigning to the latter a duty to collect taxes.
In Borders Online, LLC v. State Bd. of Equalization, 129 Cal.App.4th
1179, 29 Cal. Rptr. 3d 176 (1st Dist. 2005), Borders Online, LLC (Online),
a limited liability company (LLC), sold books, CDs, videos, magazines and
other tangible goods through its Internet Web site, . The LLC
was formed under Delaware law and headquartered in Michigan. Online sold
its products to customers throughout the nation, including California,
delivering its products to customers using a common carrier. During the tax
years in question, Online did not maintain a place of business in
California, own or lease property in the state, locate employees in it, or
hold bank accounts there. Online did not collect sales taxes associated
with its sales to California customers.
Borders Group Inc. (Borders Group) owned Online. Borders Group also owned
Borders Inc. (Borders), the company that owns the "main street"
retail bookstores located nationwide and, most significantly in this case,
in California. Through their common parent company, Online and Borders were
affiliated subsidiaries, though they were separate and distinct legal
entities. Borders had its own Web site, www.bordersstores.com, which
provided advertising and promotional information, as well as a list of
store locations. Online's Web site could not be accessed from Borders. The
two companies shared directors and corporate officers, and they filed tax
returns on a combined reporting basis. The companies did not share
assets.
Online and Borders sold comparable products. They engaged in cross-selling
techniques such as:
imprinting on Borders stores' receipts the phrase, "Visit
us online at www.Borders.com" (emphasis added), sharing a logo, financial data and market information, Online providing a link on its Web site to Borders' Web site, Borders' employees encouraging customers to access Online, and Borders accepting returns of Online's products, either crediting charge
cards or permitting merchandise exchanges.
For 11 months during the disputed period, Online stated on its Web site
that products purchased from it could be returned to Borders stores. Even
after Online removed this notice from its site, Borders willingly accepted
returns of Online's products. The company did not charge Borders Online for
this service. Borders stores also accepted returns of products purchased
from competitors but gave customers only a store credit.
The California State Board of Equalization (SBE) issued Online a notice of
determination for $167,000 in unpaid taxes from April 1998 to September
1999. Online petitioned for a redetermination, but the SBE denied it in a
memorandum opinion, Borders Online Inc., SC OHB 97-638364 (Cal.
State Bd. Equal., Sept. 26, 2001).
[One year later and in a similar case, the SBE attributed the presence and
activities of Barnes & Noble bookstores in California to the separate
but affiliated online retailer, bn.com, because the retail outlets
distributed the online unit's discount coupons for several months.
Barnes & Noble.Com, SC OHB 97-732835 (Cal. State Bd. Equal.,
Sept. 12, 2002). The SBE characterized this distribution as a
"selling" activity in which the retail unit
"represented" the online unit.]
Online paid the tax, sought a refund, and appealed the SBE's refund denial
to the San Francisco Superior Court. The trial court upheld the SBE's
decision. The California Court of Appeal affirmed the trial court, basing
its decision on three grounds, two involving state law, and the third
involving the dormant Commerce Clause.
California defined a "retailer engaged in business in [the]
state" as a representative or agent authorized by its principal to
sell personal property in the state. See Calif. Code § 6203(c)(2). The
court had to determine under California law whether: (1) Borders acted as
Online's agent, and, if so, (2) Borders stores sold property on Online's
behalf. First, the court concluded that an agency relationship existed
because Borders accepted returns of Online's products. Borders did not need
to have the subjective belief that it acted as an agent, but needed only to
effectuate the return policy posted on Online's Web site.
Second, the court concluded that Borders sold property on Online's behalf.
The court adopted the SBE's definition of "selling" to mean
"all activities that are an integral part of making sales."
Inducements to purchase a product constitute an integral part. The court
concluded that Online's return policy was intended to make Internet sales
more convenient and, therefore, more appealing to potential customers, not
merely to maximize returns. Also, giving Online's customers a store credit
or allowing them to exchange products when making a return satisfied
California's definition of selling. See Calif. Code § 6006(a).
Combined with the parties' other cross-selling techniques, these factors
led the court to conclude that Borders sold products on Online's
behalf.
Finally, the court tackled the dormant Commerce Clause issue. Relying on
Tyler Pipe, the court said that, in order to attribute an agent's
in-state physical presence to an out-of-state retailer, Borders' in-state
activities must be significantly associated with Online's ability to
establish and maintain a market in California. This standard is broader
than either actually making or soliciting a sale in the market state.
The court held that Border's role in the cross-selling techniques
significantly associated it with Online's ability to establish and maintain
a market in California. The court held that Border's in-state activities
therefore should be attributed to Online.
At least one state had already adopted the nexus technique espoused in
Borders Online. In 2002, Minnesota amended its definition of a
retailer maintaining a place of business in the state to mean having an
in-state affiliate who establishes or maintains a sales market that
includes accepting returns, resolving customer complaints, or providing
other services. See Minn. Stat. § 297A.66.4(a)(1)(effective May 18,
2002).
Though Borders Online, and statutes like Minnesota's, involve
related or affiliated party relationships, the nexus techniques they
espouse could easily be used against the third-party relationships common
to Internet sellers. A market state could assert nexus when an Internet
seller has a co-promotional arrangement with an unrelated offline business
in the state.
For example, if a Colorado-based online retailer of coffee beans
established a co-promotional relationship with a chain of unrelated,
specialty coffee cafes in California involving the distribution of the
online company's marketing material at the in-state retailer, California
could argue that the Colorado business has nexus with it. The promotional
material could be as simple as the online retailer's address appearing on
the shopping bags distributed by the California retailer. If other states
assert this nexus technique, the Colorado business would have nexus in
every state in which it has entered into similar promotional
arrangements.
Would an "affiliate program," like the one used by Amazon.com,
give rise to attributional nexus? Amazon invites specialized Web sites
(such as those devoted to a writer or musical artist) to include an Amazon
icon on their Web pages. In exchange, Amazon agrees to pay the specialized
Web sites a small portion of any revenue generated when a user hyperlinks
from the specialized site to Amazon's Web site. Should the physical
locations of Amazon.com (its offices and distribution facilities) be
attributable to the operators of the specialized Web sites? Should the
physical presence of these operators be attributable to Amazon.com under an
agency theory? If co-promotional activity is a proper basis for
establishing nexus, the answer is yes.
Borders Online bears significant attention because of California's
singular importance in the developing Internet economy. States will likely
use Borders Online to impose a tax-collection duty on otherwise
unreachable remote online retailers. Business, technology and tax lawyers
must remember that their clients are already potentially subject to
tax-collection obligations in thousands of jurisdictions. These obligations
can easily arise from a business's expansion or common business operations
such as cross promotions.
If these obligations exist, the financial and administrative impact on the
enterprise can be substantial.
Swain is special counsel to the Indiana attorney general and oversees
the tax litigation section, in Indianapolis. His e-mail is
aswain@atg.state.in.us. Trelease is a corporate tax lawyer at WebCredenza
Inc., in Denver. His e-mail is ntrelease@webcredenza.com.
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