The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.
By June Summers Haas
Ms. Haas is a partner in Honigman Miller Schwartz and Cohn LLP where she specializes in state tax litigation, audit resolution and advice for multistate companies. She formerly was the Michigan Commissioner of Revenue.
The advent of widespread e-commerce creates new challenges for defining the applicable standard for state tax jurisdiction, particularly for the application of the due process clause (due process clause) U.S. Const. Amend XIV. The U.S. Constitution limits states' taxation of multistate business through two constraints: the due process clause and the commerce clause (commerce clause) U.S. Const. Art. I, §8, cl.3. After the U.S. Supreme Court issued its seminal decision on nexus in Quill Corp. v. North Dakota 504 U.S. 298 (1992), declaring that the requirements of due process are met irrespective of a corporation's lack of physical presence in the taxing state, the limitations of the due process clause appeared to be almost nonexistent. Many states enacted “economic presence” nexus standards to ensure that their taxing jurisdictions extend to the full extent constitutionally feasible. The due process clause has recently been interpreted to provide continuing limits on state taxation. This article discusses the history of due process nexus theory in tax cases, the re-definition of due process nexus tax principles by Quill, and hypothesizes on parameters of due process limitations as applied to Internet transactions yet to be defined.
The due process clause of the U.S. Constitution applicable to the states is contained in the Fourteenth Amendment and states:
Nor shall any State deprive any person of life, liberty, or property without due process of law. U.S. Const., amend. XIV, §1.
The due process clause incorporates the idea of restraint, territorial or otherwise, appropriate to the components of our federal system of government. Due process is concerned with whether a state has given anything for which it can ask for something in return. In the U.S. Supreme Court's analysis of due process for state taxing jurisdiction, the critical substantive question in the court's opinion is whether the tax in practical operation has a rational relationship to the opportunities, benefits, or protection conferred or afforded by the state.
In contrast, the commerce clause deals with the flow of commerce. Its purpose is to maintain and advance the national and international economy with the idea that state regulation violates the commerce clause if it creates an undue impediment to the operation of the economy. Due process requires “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax. The focus is on fair warning/notice and is governed by “traditional notions of fair play and substantial justice” Miller Brothers Co. v. Maryland, 347 U.S. 340 (1954).
When the U.S. Supreme Court first addressed the question of state jurisdiction to impose tax on corporations selling products into a state, the court did not differentiate between due process and commerce clause analysis. One of the first nexus cases, Felt & Tarrant Mfg. Co. v. Gallagher, 306 U.S. 62 (1939), questioned whether states could require tax collection when a corporation had two salesperson in an office in the state. The Supreme Court found no unconstitutional burden on either interstate commerce or the tax collector but did not directly discuss commerce clause or due process. Subsequently, in Nelson v. Sears Roebuck & Co., 312 U.S. 359 (1941), the Supreme Court upheld jurisdiction to require tax collection/connection to the state by retailers who operated in-state stores. The court noted that the mail orders were part of the company's Iowa business upon which the state can exact a tax burden. Id. In General Trading Co., v. Iowa State Tax Comm., 322 U.S. 334 (1994) the court addressed the concerns of state power to tax and the burden on commerce, but again without directly discussing the due process or commerce clause, stating:
the mere fact that property is used for interstate commerce or has come into an owner's possession as a result of interstate commerce does not diminish the protection which he may draw from a State to the upkeep of which he may be asked to bear his fair share. [Id. at 338.]
It was not until Miller Brothers Co. v. Maryland, 347 U.S. 340 (1954) that the court separately analyzed the due process and the commerce clause nexus. The court indicated that merely taking goods in interstate commerce into the state would not be consistent with the commerce clause. Moreover, the court specifically set forth the controlling principles for due process nexus stating, “due process requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” Id. at 344. The court held the tax unconstitutional for failing to meet this due process standard for connection to the state. Independent contractor sales solicitors were subsequently held to provide the definite link and minimum contact with the state to uphold taxing jurisdiction in Scripto Inc. v. Carson, 362 U.S. 207 (1960).
Application of an economic presence standard for due process nexus for tax imposition was argued for and rejected in National Bellas Hess, Inc. v. Illinois Dep't of Revenue, 386 U.S. 753 (1967), overruled in part by Quill. The taxpayer argued Illinois' imposition of use tax collection responsibility violated both the due process clause and the commerce clause by creating an unconstitutional burden upon interstate commerce. The Supreme Court noted that these two claims are closely related, stating, “the test whether a particular state exaction is such as to invade the exclusive authority of Congress to regulate trade between the States, and the test for a State's compliance with the requirements of due process in this area are similar.” Id. at 756. The court then provided an analysis that mixed the principles underlying both, without separate analysis, to forbid the imposition of tax collection. The due process and commerce clause analysis remained largely undifferentiated in tax nexus cases for the next twenty-five years.
In Quill , the Supreme Court provided the modern analysis and distinction between due process and commerce clause analysis. Quill was a direct marketer of office and business supplies whose only contacts with the state were through catalogs and the shipping of goods by common carrier. The state sought to require Quill to collect taxes on goods shipped into the state. The U.S. Supreme Court had to determine whether economic presence, absent any other presence, was sufficient under the U.S. Constitution to authorize a state to impose a use tax collection duty upon an out-of-state mail order business under both the due process and commerce clauses. North Dakota argued that “economic presence,” i.e., an in-state presence that did not rely upon the “physical presence” of the out-of-state mail order firm, satisfied both the due process and commerce clause concerns.
The court noted that due process jurisdiction has evolved substantially in the 25 years since National Bellas Hess was decided. The due process jurisprudential relevant inquiry is whether the defendant had minimum contacts with the state so that traditional notions of fair play and substantial justice are not offended by maintenance of suit in the state. Quill at 307. Under this standard, the court has adopted a flexible inquiry of the in-state “presence” so that physical presence is not necessary. The court quoted its prior decisions noting,
[I]t is an inescapable fact of modern commercial life that a substantial amount of business is transacted solely by mail and wire communications across state lines, thus obviating the need for physical presence within a State in which business is conducted. So long as a commercial actor's efforts are ’purposefully directed’ toward residents of another State, we have consistently rejected the notion that an absence of physical contacts can defeat personal jurisdiction there. Burger King Corp. v. Rudzewicz, at 476 (emphasis in original). [Quill at 308.]
Thus, the court held that economic presence through “continuous and widespread solicitation of business” within a state by a mail-order house was sufficient. Id. In overruling, in part, the holding in National Bellas Hess, the court held that the due process concerns of “fairness” were satisfied where the out-of-state seller “purposefully avails itself of the benefits of an economic market in the forum State.” Id. at 307.
Such a corporation clearly has ‘fair warning that its activity may subject it to the jurisdiction of a foreign sovereign.’ Shaffer v. Heitner, 433 U.S., at 218 (Stevens, J., concurring in judgment). In ‘modern commercial life’ it matters little that such solicitation is accomplished by a deluge of catalogs rather than a phalanx of drummers: the requirements of due process are met irrespective of a corporation's lack of physical presence in the taxing state. [Id. at 308.]
The court then determined that the commerce clause nexus requirement was not identical to the due process clause nexus requirement. The due process clause is concerned with “notice” or “fair warning,” while the commerce clause prohibits discrimination against interstate commerce and bars state regulation that unduly burdens interstate commerce. The court affirmed the National Bellas Hess bright line physical presence test based on stare decisis and the mail order industry's reliance on being insulated from use tax collection duties where it only had in-state contact via U.S. mail or common carrier.
Subsequent to the Quill decision, nexus case analysis focused primarily on commerce clause physical presence standards. Due process nexus analysis was met by any “widespread solicitation within the state” as directed by the Quill court. This standard was largely presumed to be easily met and required little analysis. However, new forms of business have revitalized the due process clause analysis and demonstrate the need for more in-depth analysis.
Beginning in the early 2000s, the due process clause nexus was revitalized in a series of cases aimed at preventing enforcement of the Prevent All Cigarette Trafficking Act (PACT Act). The PACT Act was enacted to prevent cigarette and tobacco smuggling and untaxed mail order sales. 15 U.S.C. §376a(a)(3). Under the PACT Act, all delivery sellers must pay excise taxes and obey licensing and tax-stamping requirements the same as in-state tobacco product retailers. To that end, the statute bars any sale or delivery of tobacco products until any state or local excise tax has been paid and bars delivery of cigarettes or smokeless tobacco through the US Postal Service. 15 U.S.C. §376a(d)(1); 18 U.S.C. § 1716E(a)(1). Violators are subject to civil and criminal penalties, including up to three years imprisonment and a $5000 fine for the first violation. 15 U.S.C. §377(a)(1).
RedEarth, a New York tobacco retail business located on an Indian reservation in the territory of the Seneca Nation of Indians in New York state, challenged the PACT Act on the basis that a single sale into a state did not make due process juris prudent. The district court found that the mandate that sellers pay the state taxes without regard to their contact with the state effectively legislated the due process requirement out of the equation. The Second Circuit affirmed. Red Earth LLC v. United States, 728 F. Supp. 2d 238 (W.D.N.Y. 2010), aff'd, 657 F.3d 138 (2d Cir. 2011).
Subsequently, Musser’s Inc. challenged the PACT Act on due process grounds as well. Musser’s, Inc. v. United States, Civil Action No. 10-4355, 2011 U.S. Dist. Lexis 109629 (E.D. PA. Sept. 26th 2011). Musser’s operated retail stores in Pennsylvania and an online retail store, selling tobacco products via the Internet and telephone to customers located in all 50 states. Some online sales were to military personnel stationed all over the world, and delivery was by U.S. Postal Service.
Relying on Quill and Red Earth, Musser’s argued that the PACT Act's requirement, that sellers collect and remit state and local taxes, violated the due process clause when there is not sufficient contact.2 Musser’s claimed that the operation of its online website did not provide sufficient contacts to create due process nexus in every state and locality. Musser’s further argued that the PACT Act violates due process because it forces remote sellers to identify, collect, and pay state sales taxes regardless of whether those sellers have a substantial nexus with the taxing jurisdiction.
The U.S. District Court disagreed, reasoning that Taxpayer did more than maintain a public website because it did business over the Internet in all 50 states. The court found that selling products over the Internet and knowingly conducting business over the Internet was enough to satisfy due process concerns. The U.S. District Court also rejected Musser's arguments that the PACT Act is causing substantial irreparable harm to its business. In doing so, the court noted that Musser’s provided no information about the percentage of sales affected by the PACT Act. Because Musser’s had not shown a likelihood of the success on the merits nor hardship or other public interest factors to justify an injunction, the court denied the Taxpayer's motion for a preliminary injunction.
On rehearing the District Court found that Musser's met the minimum contacts requirements of the due process clause through an analysis of Musser's business activities and contacts with states. Musser's Inc. v. United States, 1 F. Supp. 3d 309 (2014). The court held that Musser's did more than maintain a public website on which it merely posted or exchanged information. The court used the sliding scale due process contacts analysis of Zippo Mfg. Co. v. Zippo Dot Com Inc., 952 F Supp 1119 (W.D. Pa 1997). Musser's website was a full e-commerce site in which customers could place orders, pay for the products and have them delivered to the states in which they lived. The court found that “selling products over the Internet and knowingly conducting business over the Internet in a state is a sufficient contact to satisfy due process concerns.” Musser's 1 F. Supp. 3d 316. The court held that state jurisdiction is proper where the party purposefully availed itself of doing business in the state. Id. As in Zippo, that the company repeatedly and intentionally interacted with state residents is sufficient to render it subject to that state's jurisdiction. Thus, the court found that Musser's had failed to state a plausible claim for relief. Id.
A similar challenge was filed with the federal district court for the District of Columbia. Gordon v. Holder, 632 F.3d 722 (D.C. Cir. 2011), on remand, 826 F. Supp. 2d 279 (2011). The federal district court concluded on remand that the plaintiffs were likely to succeed on the merits of their claim that the PACT Act's provision requiring out-of-state tobacco sellers to pay state excise taxes, without undertaking any nexus analysis, violates the due process clause.
Plaintiff Robert Gordon, a Seneca Indian and a delivery seller of tobacco products, filed suit in federal district court in the District of Columbia to prevent enforcement of the PACT Act's tax collection provisions. Gordon argued that the PACT Act violates the due process rights of nonresident tobacco retailers by subjecting them to taxes in state and local forums without regard to whether they have minimum contacts with the taxing jurisdiction.
On remand, the federal district court for the District of Columbia concluded that a preliminary injunction was proper due to the likelihood of Gordon’s success on the merits, and the Court of Appeals agreed. Gordon v. Holder, 721 F. 3d 638 (2013). The district court found potential due process violations because “[a]t this stage in the proceedings, the court cannot find that each of Gordon’s sales establishes the requisite minimum contacts”. Gordon, 826 F. Supp. 2d 291. The court's holding focused on the Quill requirement of a definite link and connection to the state. The court noted that “minimum connections” are demanded because a taxation regime that does not rest on “minimum connection” lacks democratic legitimacy. Gordon, 721 F 3d at 648. Thus, a federal duty to collect a state tax may not transgress the due process limitations on taxation power. Like the court in Red Earth, the court rejected the Government's contention that each sale into a state creates minimum contacts necessary to meet due process standards. The District Court stated that even if a single sale of tobacco to a resident of another state creates the requisite minimum connection, it “cannot find that the tax on Gordon's products is rationally related to values connected with the taxing state” Gordon, 826 F. Supp. 2d 291, quoting Quill, 504 U.S. 308. There was nothing in the record to show that Gordon purposefully directed its activities at residents of the taxing states. The court was unable to determine what, if any, “protection, opportunities, [or] benefits” Gordon received from the state. Gordon, 826 F. Supp. 2d 292.
The PACT Act cases did not provide further specification of the tests to use to determine whether the due process constraints on state taxation are met, and these cases suggest that both taxpayers and tax administrators should re-examine the due process constraints on state taxation as applied to interstate transactions. No longer can the minimum connections of due process be assumed, but rather, must be proven as part of a complete nexus analysis.
The PACT Act cases demonstrate the need for a more comprehensive standard for due process constraints for Internet sales. What constitutes “purposeful availment of the marketplace” within a state to trigger state jurisdiction to impose tax collection responsibilities? What is the “definite link” or “minimum contacts” that tax administrators and taxpayers alike can look to as a defining threshold for economic presence nexus?” The current sales threshold standards for use tax collection enacted by many states fail to pass constitutional muster on their face because there is no required targeted marketing or purposeful availment of the market resulting in those sales to in-state residents as required under due process. Sales to residents within the state are not enough without targeted exploitation of the market under Quill and Scripto. Sales to state residents, even if resulting from general advertising, do not create the required link to the state without proof of directed marketing by the retailer. Miller Brothers, 347 US at 346-347 (holding that there is “a wide gulf between … active and aggressive operation within a taxing state and the occasional delivery of goods sold at an out-of-state store with no solicitation other than the incidental effects of general advertising.”).
One possible economic nexus standard for the interstate transactions is the jurisdiction standard set forth for electronic commerce by Zippo Mfg., supra. In Zippo, the plaintiff, a Pennsylvania corporation, claimed trademark dilution and infringement by use of the domain name zippo.com, and filed in Pennsylvania federal district court. Zippo Dot Com, Inc. (DotCom), moved to dismiss for lack of personal jurisdiction citing lack of offices, employees or agents in Pennsylvania. DotCom’s advertising for its service to Pennsylvania residents involves posting information about its service on its Web page, which is accessible to Pennsylvania residents via the Internet. Two percent of DotCom's customers were Pennsylvania residents. The court held that the likelihood that personal jurisdiction can be constitutionally exercised is directly proportionate to the nature and quality of commercial activity that an entity directs to a state over the Internet. These subscribers contracted to receive DotCom's service by visiting its Web site and filling out the application. Additionally, DotCom entered into agreements with seven Internet access providers in Pennsylvania to permit their subscribers to access DotCom's news service. Two of these providers are located in the Western District of Pennsylvania.
The court held that DotCom purposefully availed itself of doing business in Pennsylvania when it “repeatedly and consciously chose to process Pennsylvania residents' applications and to assign them passwords,” knowing that the contacts would result in business relationships with Pennsylvania customers.“ Id. at 1126. The Zippo court held that intentionality was of primary importance:
When a defendant makes a conscious choice to conduct business with the residents of a forum state, ‘it has clear notice that it is subject to suit there.’. . . If [the defendant] had not wanted to be amenable to jurisdiction in Pennsylvania, . . . it could have chosen not to sell its services to Pennsylvania residents. [Id. ]
In Zippo, the court developed a “sliding scale” approach to the due process analysis of the contacts necessary for state jurisdiction over commercial activity on the Internet:
At one end of the spectrum are situations where a defendant clearly does business over the Internet. If the defendant enters into contracts with residents of a foreign jurisdiction that involve the knowing and repeated transmission of computer files over the Internet, personal jurisdiction is proper. At the opposite end are situations where a defendant has simply posted information on an Internet Web site which is accessible to users in foreign jurisdictions. A passive Web site that does little more than make information available to those who are interested in it is not grounds for the exercise of personal jurisdiction. The middle ground is occupied by interactive Web sites where a user can exchange information with the host computer. In these cases, the exercise of jurisdiction is determined by examining the level of interactivity and commercial nature of the exchange of information that occurs on the website. [Id. at 1124] (citations omitted).
Thus, selling products over the Internet and knowingly conducting business through the Internet in a state is a sufficient contact to satisfy due process concerns.
More recent cases have continued to apply this due process standard to Internet jurisdictional disputes. In Intercarrier Commc'ns LLC v. WhatsApp Inc., E.D.Va. No. 3:12-cv-00776-JAG-DGN (2013), the court held that an option to share location in a mobile messaging device application purchased and used over the Internet does not create due process jurisdiction over the app creator in the location of the mobile device. The court held that there was no purposeful availment of the marketplace in the forum state where the application user unilaterally downloads or uses its software within that forum. Thus, a sale created by the purchaser's unilateral action without targeted advertising into the purchaser's state does not create the requisite minimum contacts. More recently, in Simpson Performance Prods., Inc. v. Wagoner, W.D.N.C. No.5-15-cv-00026-RLV-DSC (5/8/2015), the court applied the Zippo sliding scale test. Two out-of-state purchases of defective counterfeit products sent to the purported manufacturer's servicing facility for repair did not support personal jurisdiction over the counterfeit seller in the manufacturer's home state. Two individuals purchased race car head and neck restraints via eBay from Messrs. Wagoner and Randall that were labeled as Simpson Performance Products but were counterfeits. The two individuals sent the restraints to Simpson's North Carolina facility. Simpson subsequently purchased counterfeit restraints from the defendants directly.
The court applied the Zippo sliding scale test for jurisdiction and held that the defendant's website was passive and did not offer the counterfeit items for sale. The court held that Simpson could not create jurisdiction via its own purchases alone, and purchases by nonresident third parties were too attenuated for the stream-of-commerce standard.
Due process nexus has developed from an amorphous general principle to a requirement for directed or targeted marketing within a state that results in state sales. The due process nexus standard cannot be assumed to have been met by a certain level of sales to in-state residents; rather, due process nexus standards must be separately met by an out-of-state retailer for use tax collection responsibility to be imposed. As taxpayers and tax administrators work to determine when directed solicitation occurs in an electronic sales environment, the sliding scale of Internet website interactivity may provide much needed guidance and a standard for measuring directed, marketed and purposeful availment of a market in the taxing state.
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