Out-of-state companies make sales in the state, but they don't have stores there. How can states tax them? It's a question that is generating more and more court decisions. Time to get up to date.

Recent state court decisions have expanded the power of states to tax the income of corporations with which they lack physical nexus. Each of these decisions found that an "economic nexus" existed between the taxing state and the out-of-state corporation. The courts determined that an out-of-state corporation's in-state economic presence made its lack of physical presence irrelevant. The income that the corporation derived from the state's market was subject to the state's corporate income tax.

The U.S. Constitution's dormant Commerce Clause limits the income tax a state can impose on companies lacking a substantial in-state physical presence. In Complete Auto Transit Inc. v. Brady, 430 U.S. 274, 279 (1977), the U.S. Supreme Court held that, if an out-of-state corporation's in-state activities create a "substantial nexus" with a state, the state can tax those activities.

In Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the court elaborated on substantial nexus. North Dakota tried to force an out-of-state retailer to collect sales tax on goods delivered in-state by common carrier. Because the retailer lacked in-state physical presence, the court held that the state tax violated the dormant Commerce Clause. Courts long understood Complete Auto and Quill to limit the state taxation of corporations lacking a substantial in-state physical nexus.

This understanding was challenged by Geoffrey Inc. v. S.C. Tax Comm'n, 437 S.E.2d 13 (S.C. 1993), cert. denied, 510 U.S. 992 (1993). Several questions left unanswered by Quill made the challenge possible. Quill did not identify the starting point for nexus analysis: substantial nexus or physical presence. It is unclear whether Quill's "physical presence" is synonymous with Complete Auto's "substantial nexus." Nothing in Quill says whether physical presence is the same for sales and income taxes. Geoffrey was the first attempt to resolve Quill's unanswered questions.

South Carolina assessed Geoffrey Inc. (Geoffrey), a Delaware corporation lacking physical nexus with the state, for corporate income tax. The state supreme court affirmed the assessment, largely because Geoffrey was a passive investment company (PIC) created by Toys R Us, which itself had a physical nexus with the state.

The nature of PICs is key to understanding the holding in Geoffrey. PICs go by several names — passive investment subsidiaries, special-purpose entities, intangible holding companies, intangible property companies, trademark holding companies, and Delaware holding companies. PICs let corporations avoid otherwise valid state income taxes. They also provide tax savings through business expense and dividend deductions.

A PIC is a separate corporation created by a parent or an operating company. PICs are "physically" located in a tax-haven state such as Nevada or Delaware. Nevada has no corporate income tax. Delaware does not impose tax on companies deriving income from intangibles possessed or owned in-state. Ordinarily, a PIC is a "brass plate" headquarters with an address in the tax haven. This arrangement avoids creating a physical nexus between the PIC and a state taxing jurisdiction.

The parent company transfers intangible assets (trademarks, trade names, service marks, patents, copyrights, customer lists and goodwill) to the PIC. The PIC licenses use of the intangibles back to the company for a royalty. The company deducts this from state income tax as a business expense. The PIC often loans profits from the royalty payments to the company. The company deducts the interest payments on the loan from its state tax. The PIC may distribute dividends to the company, which the company claims as a dividend-received deduction. Meanwhile, the PIC pays no state income tax anywhere.

Many major companies use PICs, among them Home Depot, Sherwin-Williams, Circuit City, Staples and Burger King. Millions have been at issue in legal controversies arising when taxing jurisdictions challenged the tax-avoidance use of PICs. The amounts diverted by PICs from state coffers and the annual tax savings afforded the companies are likely enormous. The U.S. Census Bureau reports that, from 1979 to 2000, total state revenues attributable to corporate income taxes fell from 10.2 percent to 6.3 percent. PICs undoubtedly contributed to this.

In Geoffrey, Toys R Us Inc. had a substantial physical nexus with South Carolina. The company created a PIC, Geoffrey Inc., and transferred trademarks and trade names to it. Geoffrey licensed these intangibles to South Carolina retailers for royalties. The South Carolina Supreme Court held that, for income tax purposes, substantial nexus existed between Geoffrey and the state. That Geoffrey lacked tangible property or employees in the state was irrelevant.

The South Carolina Supreme Court said that Geoffrey's in-state activities satisfied Complete Auto's substantial nexus requirement in three ways. These ways have become known as "economic nexus." First, Geoffrey regularly exploited South Carolina's market by deriving income from using intangible property in the state. Second, South Carolina protected Geoffrey's activities within the state. Third, Geoffrey's activities in South Carolina entitled it to some state benefits. The court noted that Quill's "physical presence" requirement did not extend beyond sales tax to other taxes.

The court concluded that the presence in South Carolina of Geoffrey's intangibles was enough to establish substantial nexus. South Carolina could tax the income that Geoffrey derived from the intangibles licensed to Toys R Us retailers.

Geoffrey was followed by Kmart Props. Inc. v. Tax'n and Revenue Dep't of N.M., No. 21,140 (N.M.Ct.App. Nov. 27, 2001). In Kmart, a Michigan PIC had no physical presence in New Mexico. The appellate court nevertheless found that the PIC had substantial nexus with New Mexico for income tax purposes. The court held that the starting point for determining nexus for purposes of income tax was not Quill's "physical presence" requirement. Instead, it was Complete Auto's "substantial nexus" requirement. Finding significant differences between sales and income taxes, the Kmart court held that Quill did not extend its "physical presence" requirement beyond sales taxes.

Substantial nexus exists, said the court, when out-of-state PICs use their intangible properties to derive income from New Mexico's market. Kmart was transferred to the New Mexico Supreme Court, where it stalled when Kmart Corp. filed bankruptcy. But the state supreme court later issued Kmart Props. Inc. v. Tax'n and Revenue Dep't of N.M., No. 27,269 (N.M.Sup.Ct. Dec. 29, 2005). The court declined to rule on the economic nexus issue, letting stand the appellate court's decision. It ordered the appellate court's opinion filed concurrently with the supreme court's decision.

The Gap was the next to learn of state courts' increasingly nonphysical attraction to nexus. In Louisiana Dep't of Revenue v. Gap (Apparel) Inc., 886 So.2d 459 (La.Ct.App. 2004), a California PIC lacked physical nexus with Louisiana. Nevertheless, the appellate court held that the PIC's "connection" with Louisiana was sufficient to permit imposition of the state's corporate and franchise taxes.

The court found that the out-of-state PIC licensed intangible properties to its in-state parent, which used them to conduct Louisiana business. Consequently, said the court, the intangibles were integral to the parent's in-state business activities. By integrating the out-of-state PIC's intangibles with the parent's in-state activities, the intangibles acquired a Louisiana "business situs." The income derived from these intangibles was subject to state tax.

North Carolina next used "economic nexus" as a basis for a state's taxing jurisdiction. In A&F Trademark Inc. v. Tolson, 605 S.E.2d 187 (N.C.Ct.App. 2004), cert. denied, 126 S.Ct. 353 (2005), a Delaware PIC lacked a physical presence in North Carolina. It conducted no transactions with North Carolina residents. For franchise and income taxes, the appellate court relied on Geoffrey, finding that the state and PIC had substantial nexus. The court said that Quill did not apply the "physical presence" requirement to every state tax, and, indeed, the Quill court had noted that the "physical presence" requirement had been applied only to sales tax.

The North Carolina court accordingly distinguished a sales tax from an income tax. States impose a duty to collect sales tax on out-of-state businesses based on three considerations. First, the state considers whether the business performs activities within the state. Second, it considers whether these activities involve sales to in-state purchasers. Third, it considers whether the sales-related activity justifies duty of the out-of-state business to collect tax.

If substantial nexus is lacking, the out-of-state business cannot be required to collect sales tax. Nevertheless, the in-state purchaser remains legally liable for the tax and pays it, usually as use tax.

An income tax raises different considerations. An income tax is premised on the out-of-state corporation's using in-state business property to derive income from the state. Income tax differs from sales tax because, if substantial nexus is lacking for income tax, the tax is neither paid nor owed. A nexus analysis of income tax jurisdiction focuses on the state's inherent power to impose the tax. A nexus analysis of sales tax jurisdiction focuses on the state's right to impose a tax-collection duty, which is one step removed from the power to impose a tax.

These differences between sales and income taxes, said the North Carolina court, brought about different reporting requirements. As a rule, businesses that collect sales tax report and remit the taxes to multiple taxing authorities throughout the year, but report their income taxes annually. The court said that the multiple reporting requirements for sales tax resulted in unique administrative burdens that justified the stricter physical presence standard for substantial nexus analysis. On Oct. 3, 2005, the U.S. Supreme Court declined to review A&F Trademark.

The trend among states was plainly toward economic nexus as the justification for imposing their income tax on revenues earned by PICs. But, in Lanco Inc. v. Dir., Div. of Tax'n., 21 N.J.Tax 200 (2003), rev'd, the New Jersey Tax Court broke ranks and held that New Jersey could not tax the income of a PIC that lacked any in-state physical presence. Tax lawyers therefore greatly anticipated the Superior Court of New Jersey's review of the decision.

Lanco Inc. (Lanco) is a Delaware PIC that owns intangible properties (trademarks, trade names and service marks). In return for royalties, Lanco licensed the intangibles to its affiliate, Lane Bryant Inc., which used them in its retail business in New Jersey. Lanco lacked physical presence in New Jersey. Through its retail operations, Lane Bryant had a physical presence in New Jersey and paid the state's corporation business tax. Arguing that Lanco had economic nexus with New Jersey, the state assessed Lanco with income tax.

The state argued that because Lanco entered into a long-term contract with Lane Bryant, a New Jersey retailer, it derived significant benefits from deliberate, continued, in-state economic activity. The Lanco-Lane Bryant relationship created economic benefits that exceeded those enjoyed by the out-of-state business in Quill. In Quill, the out-of-state retailer benefited merely from the U.S. mail and common carriers, which shipped products into the state.

New Jersey also argued that the PIC's licensing agreement increased Lane Bryant's in-state retail sales. This increase burdened the state by increasing traffic, requiring police and fire protection, and imposing demands on local labor. Finally, the state argued that the licensing agreement conferred numerous state benefits on the PIC. The courts protected the Lanco-Lane Bryant contract and Lanco's intangible property. They protected the tangible property to which the intangibles, Lane Bryant's trademarks, were affixed. The state supplied police and fire protection for the tangible property that bore the trademarks, and Lanco benefited from state-maintained highways and a state-educated work force.

In Lanco Inc. v. Dir., Div. of Tax'n., 879 A.2d 1234 (N.J.Super.Ct.App.Div. 2005), the Superior Court of New Jersey reversed the tax court's decision.

Lanco offered no new legal analysis of economic nexus. It simply followed what it called the "better reasoned" cases of those that had followed Geoffrey, and quoted extensively from A&F Trademark's discussion of Kmart and Gap. The court agreed that Quill applied only to sales taxes, but it did not explain why the facts peculiar to Lanco established nexus. Presumably, the facts identified by the state satisfied Geoffrey's requirements for economic nexus.

Neither did Lanco resolve Quill's unanswered questions — whether "physical presence" is synonymous with "substantial nexus." Lanco relied on A&F Trademark and Kmart, which emphasized the PIC's exploitation of a state's market through an in-state affiliate. Lanco also relied on Gap, which said that a PIC's intangibles "integrated" with an in-state affiliate's business by exploiting the state's market. This integration gave the intangibles an in-state business situs.

In the cases Lanco cited,economic nexus turned on an affiliate's in-state presence and its relationship with the out-of-state PIC. What none of the cases addressed, including Lanco, was fundamental Commerce Clause jurisprudence. None of the courts explained how states could impose income taxes on physically absent corporations without harming the U.S. economy by interfering with interstate commerce. According to Quill, analyzing this interference is fundamental to identifying violations of the Commerce Clause.

Lanco and the cases preceding it use economic nexus as a proxy for physical presence. A physically present, in-state affiliate had to exist for economic nexus to exist. It was the affiliate's in-state activities that "integrated" with the out-of-state PIC's intangible property. In this respect, "economic nexus" is another way to "attribute" the in-state affiliate's physical nexus to the out-of-state PIC. "Attributional nexus" might more precisely describe such nexus.

Seen this way, economic nexus could fail the way similar theories of sales tax have failed. Courts refuse to impose a sales-tax collection duty on out-of-state retailers based on only their affiliation with in-state retailers. 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). It remains to be seen whether they will reject "economic nexus" for income taxation as attributional nexus by another name.

Lanco tells us only what "substantial nexus" is not. Consequently, the opinion provides no understanding of cases such as J.C. Penney Natl. Bank v. Johnson, 19 S.W.3d 831 (Tenn.Ct.App. 1999) or America Online Inc. v. Johnson, No. M2001-00927-COA-R3-CV, 2002 WL 1751434 (Tenn.Ct.App. July 30, 2002). In these cases, states tried imposing income tax on out-of-state businesses that lacked an in-state affiliate that exploited the state's market. If these cases and Lanco are found to conflict, economic nexus does not turn on the difference between sales tax and income tax. It turns on whether an out-of-state business uses an in-state affiliate to exploit a state market.

After Lanco, the Oklahoma Court of Civil Appeals decided Geoffrey Inc. v. the Okla. Tax Comm'n, No. 99,938 (Okla. Civ. App. Dec. 23, 2005) (Geoffrey II). The Oklahoma court approved the state's theory of economic nexus as the justification for imposing income tax on a physically absent PIC. In so doing, the court answered key questions left unanswered by prior cases.

The Oklahoma court agreed with Lanco and A&F Trademark on two points. First, the starting point for nexus analysis is "substantial nexus," not "physical presence." Second, the "physical presence" requirement applies only to sales and use taxes. The court then turned its attention to the benefit received by the PIC, which was not market exploitation via in-state affiliates. It was income derived from Oklahoma customers. This was the sole justification for Oklahoma's imposition of income tax liability on the out-of-state PIC.

As for the Commerce Clause analysis, the court placed the burden of persuasion on the taxpayer. The court said that the PIC failed to explain how a different nexus standard for different taxes burdened interstate commerce. The court appears to have presumed that evidence of economic nexus is rebutted by evidence of a Commerce Clause violation. Be this as it may, Geoffrey II suggests that an affiliation between in-state and out-of-state businesses does not, by itself, create economic nexus.

State legislatures are not waiting for their courts to invoke "economic nexus" to tax the income of out-of-state PICs. Ohio and other states have adopted legislation denying gross income deductions for interest, royalties and licensing fees paid to PICs. See, for example., Ohio Rev. Code Ann. § 5733.042. States such as California have adopted unitary combined reporting. This requires a parent and its PIC to combine their income to calculate total taxable income apportionable to a state. Unitary-combined reporting eliminates the PIC's tax advantages because a company's royalty-expense deductions offset the PIC's royalty income. It creates one taxable entity that, in effect, both uses and owns the intangible. The transaction becomes a "wash" for income-tax purposes.

Indiana, New York, and other noncombined reporting states see their fair share of PICs. To combat these tax-avoidance strategies, these states use Geoffrey and a theory of economic nexus to directly impose tax on the remote PIC, asserting that there exists contact with the state sufficient to establish tax jurisdiction.

Lanco, Geoffrey and similar decisions give states an upper hand in countering what they consider tax avoidance. But the starting point for a state's taxation of out-of-state corporations' in-state activities remains the dormant Commerce Clause. Even if a state income tax comports with the clause, it must also comport with federal law.

Public Law 86-272 (15 U.S.C. § 381) limits state power to impose a net income tax (or a franchise tax measured by net income) on certain income earned by out-of-state corporations. States cannot tax income from sales of tangible personal property if the corporation's activities within the state amount to nothing more than soliciting sales from in-state customers. Federal law has deemed solicitation a protected activity, an in-state activity that an out-of-state corporation can perform without subjecting itself to income tax. Geoffrey and the cases that followed do not change this.

Geoffrey and its progeny make plain that future cases must grapple with Quill and "substantial nexus" by concentrating more on economic substance. Courts must pay more attention to how, and how extensively, out-of-state corporations exploit a taxing jurisdiction's market. Whether a corporation's lack of physical presence poses a significant barrier to market penetration must be considered. Courts must ask themselves whether the nature of the out-of-state corporation requires it to have no more than a de minimis physical presence in any state.

As the courts' distinction between sales and income tax shows, questions about the economic and legal incidences of a tax are relevant. Most important (indeed, this is the elephant in the room), courts must eventually address whether economic nexus impermissibly burdens interstate commerce.

Answers to these questions will require more sophisticated proofs than the taxpayer's mere claim of having no presence in the state. They require both economic and policy analysis. Practically, in the short term, Geoffrey and its increasing progeny, plus the U.S. Supreme Court's refusal to grant certiorari in A&F Trademark, will persuade taxpayers to settle existing litigation and avoid it in the future.

Because of the questions left unanswered, Lanco, Geoffrey II, and their predecessors' long-term effect is unknown. Chances are that the answers will not be long in coming. For now, it is clear that economic nexus, not Quill's physical presence requirement, is the jurisdictional touchstone for state income tax.