Due Process Emerges as Primary Argument For Fighting Taxes on Multistate Transactions

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By Rebecca Helmes  

As electronic commerce, such as cloud computing, and transactions involving intangibles continue to proliferate, state tax agencies and taxpayer advocates have yet to resolve how state and local levies should be imposed on many of these transactions, according to prominent accountants and attorneys speaking at New York University's 32nd Institute on State and Local Taxation on Dec. 12 and 13 in New York City.

Perhaps this is one reason why the U.S. Constitution's due process clause seems to be taking center stage in state tax disputes over the past few years. The due process clause requires that there be some minimum connection between a state and the person, property or transaction it seeks to tax. As business transactions continue to move online and involve affiliates based in other locations, or are conducted using out-of-state pass-through entities, geographical borders can appear blurry at times. In some situations, the connection between state and the transaction can seem attenuated.

In recent years, taxpayer advocates have been particularly attuned to U.S. Supreme Court due process jurisprudence regarding a state court's right to impose general jurisdiction over a foreign defendant. Two non-tax related decisions in this area, which some believe have favorable implications for multistate taxpayers, are Goodyear Dunlap Tires Operations S.A. v. Brown, 131 S. Ct. 2846 (2011) and J. McIntyre Machinery LTD v. Nicastro, 131 S. Ct. 2780 (2011).

Upcoming U.S. Supreme Court Decision

A similar ruling is expected in 2014, when the U.S. Supreme Court is expected to issue its opinion in Daimler AG v. Bauman, U.S. No. 11-965. The case addresses the question of whether a state court can exercise general personal jurisdiction over a foreign corporation based solely on the performance of services in the forum state by an indirect corporate subsidiary on behalf of the foreign defendant, and whether the exercise of jurisdiction violates due process.

Lack of Clarity

While multistate taxpayers must generally deal with a lack of clarity on many important issues, the speakers noted that this state of affairs has been exacerbated by inconsistent state court rulings. A recent Maryland court decision regarding income tax nexus drew the ire of a prominent state tax practitioner, who described it as a “crazy position.”

Meanwhile, the states have had mixed success in their battle to impose sales or use tax on Internet transactions. More states enacted click-through nexus statutes in 2013 and New York's Amazon decision still stands. But Illinois struck down its click-through nexus statute and the Marketplace Fairness Act remains stalled in Congress.

Several states have also recently made false starts at expanding their sales tax base to include services. While these measures have generally failed, the fact that more states are considering them could be a sign of things to come, one speaker observed.

Cloud Computing

Cloud computing remains as one of the most debated issues in state taxation. States are being more aggressive in taking the position that cloud-computing sellers are “present” wherever their website is accessed, wherever their software is used, and wherever the benefits of their services are delivered, said Leah Robinson, a partner at McDermott Will & Emery LLP in New York Dec. 13. As a result, Robinson said there has been a renewed interest in whether state taxes on certain cloud-based transactions satisfy due process clause requirements. Some situations beg the question of whether the seller has engaged in continuous and regular contacts with the state, she said.

For income tax purposes, “I think we're seeing a lot of states starting to take a deep dive into due process,” and reaching some favorable decisions for taxpayers, Robinson said, such as in the ConAgra and Scioto cases.

In Griffith v. ConAgra Brands, Inc., 728 S.E.2d 74 (W. Va. 2012), the West Virginia Supreme Court held that assessments against an out-of-state licensor for West Virginia corporate net income and business franchise tax, based on royalties earned from the nationwide leasing of food industry trademarks and trade names, were prohibited by the due process and commerce clauses of the U.S. Constitution. In Scioto Ins. Co. v. Okla. Tax Comn., 279 P.3d 782 (Okla. 2012), the Oklahoma Supreme Court held that payments received by an out-of-state subsidiary from its parent, Wendy's International Inc., under a licensing agreement for use of trademarks and other intellectual property by Wendy's restaurants in Oklahoma did not create sufficient nexus under the due process clause to impose corporate income tax on the subsidiary.

“It's not a fluke, it's not just one state, we're seeing state after state say, 'due process actually has teeth,' and in a lot of situations, those teeth are really reaching taxpayer-favorable results,” Robinson said.

Harley Duncan, managing director of KPMG LLP in Washington, D.C., agreed that due process could play a larger role in cloud computing cases. “In a cloud world, if you're a provider, you can be pretty well self-contained and you can stay in a state, or one or two states, and you're going to reach everybody just by the nature of the technology and providing the service; [here], the question of the due process threshold really becomes much more important,” Duncan said Dec. 13.

Sales Tax Nexus

In the sales tax arena, states had mixed success in laying the legal groundwork for imposing sales or use tax on transactions conducted over the Internet. Four states, Kansas, Maine, Minnesota and Missouri, enacted “click-through” nexus statutes. The laws aim to permit the state to assert sales tax nexus based on a remote vendor's affiliation with an in-state website. Further, the first click-through nexus statute still stands after it was upheld by New York's highest court in Overstock.com Inc. v. New York Dept. of Taxn. and Fin., 987 N.E.2d 621 (N.Y. 2013), and the U.S. Supreme Court denied certiorari (U.S., No. 13-252 and13-259, cert. denied Dec. 2, 2013).

The concept of click-through nexus illustrates the idea of how the old rules apply to what's going on in today's economy, said Laura A. Kulwicki, of counsel at Vorys, Sater, Seymour and Pease LLP in Akron, Ohio Dec. 12. She pointed to Scripto v. Carson, 362 U.S. 207 (1960), which she said stands for the proposition that a physical presence is created in a state if a person or business has a living human being in a state doing something for them. In that case, the court held that Florida did not violate the commerce clause or the due process when it imposed sales tax on a Georgia company that solicited business in Florida through Florida-based independent contractors.

One result of U.S. Supreme Court's denial of cert. in Overstock.com is that the New York high court's ruling on the case stands and the state statute at issue establishes nexus--even though the people working on behalf of the sellers are not really soliciting sales, which is required under Scripto, Kulwicki said.

But state attempts to tax online transactions suffered some setbacks as well. The Illinois Supreme Court held that the state's click-through nexus law was preempted by the federal Internet Tax Freedom Act (ITFA), in Performance Marketing Association v. Hamer, No. 114496 (Ill. Oct. 18, 2013). The statute was found to violate the ITFA because it treats some forms of advertising differently from others, said Jeffrey A. Friedman, partner at Sutherland Asbill & Brennan LLP in Washington, D.C. Dec. 12. For example, click-through links give rise to nexus, but “regular” Internet advertising does not.

The Illinois law deserved to fail because it was not well drafted, added Richard Pomp, professor of law at the University of Connecticut Dec. 12. The provisions (35 ILCS 105/2(1.1) and 110/2(1.1)) specifically defined as retailers or servicemen maintaining a place of business in Illinois, and consequently subjected to tax, those who agreed to refer potential customers to a retailer's products or services via their Internet website in exchange for consideration. The way retailers and servicemen were defined acted as an irrebuttable presumption of taxability. In contrast, New York's statute (N.Y. Tax Law § 1101(b)(8)(vi)) imposes a rebuttable presumption of business solicitation on persons who use independent contractors or other representatives to refer potential customers to their products via the Internet or other means.

The enactment of federal legislation addressing the states' ability to impose tax on remote retailers would likely clarify some issues. But even in the event the Marketplace Fairness Act (S. 743) (MFA) were enacted, legal questions would likely persist, Friedman and Pomp agreed. Taxpayers affected by the MFA would probably assert due process violations, Friedman said. “We should all sleep easy, we'll all have plenty to do if the MFA passes,” Pomp added.

False Starts on Taxing Services

Several states attempted to expand their sales tax base by imposing tax on additional types of services during their legislative sessions in 2013, but these efforts were largely unsuccessful or not as far-reaching as proponents wanted, said Susan K. Haffield, a partner at PricewaterhouseCoopers LLP in Minneapolis Dec. 12. Ohio's sales tax expansion was outright rejected, North Carolina limited some of their base expansion, and Minnesota imposed tax on repair services for businesses and passed a warehousing tax.

However, the effective date on the warehousing tax was delayed so the legislature can study it more during the 2014 session, Haffield said. “To see this many states actually consider it to us could be an indication that more and more services might become subject to tax,” Haffield said.

Unpredictable Income Tax Nexus Rulings

Tax practitioners have also had to cope with inconsistent rulings on important issues, Friedman and Pomp said. They singled out an appellate ruling in Maryland Comp. of the Treas. v. Gore Enter. Holdings Inc., 60 A.3d 107 (Md. Ct. Spec. App. 2013), cert. granted, Case No. 36 (Md. May 17, 2013) as being especially egregious. The court held that two out-of-state subsidiaries holding their parent company's patents and financial assets are unitary with the patent and have sufficient nexus for their income to be subject to tax by Maryland. Maryland's highest court, the Court of Appeals, has accepted the case for review. It used to be that Alabama would get made fun of for its inconsistency, said Friedman. “Everyone is now making fun of Maryland for taking these crazy positions,” Friedman said. “We're all quite concerned about what this Maryland high court is going to do.” Friedman and Pomp said they think the court is mixing up apportionment and nexus principles, and Pomp predicted that the high court will just affirm the lower court's decision. “That's what you do when you're confused,” Pomp said.

State rulings have also been inconsistent in cases involving income tax nexus for an out-of-state owner of a pass-through entity. No nexus was found in Vogt v. Alabama Dept. of Rev., Admin. Law Div., No. INC 11-660 (Jan. 3, 2013) said Bruce Ely, partner at Bradley Arant Boult Cummings LLP in Birmingham, Ala. Dec. 12. In that case, a Minnesota doctor owned an interest in an Alabama LLC, and the state revenue department determined that the doctor, rather than the LLC, owed income tax on the distributed share of the LLC. On appeal, the judge found that the state could have assessed income tax against the LLC, but the mere ownership of the LLC interest did not provide minimum contacts for the state to exercise jurisdiction over the nonresident owner.

In contrast, in the Pennsylvania case, Marshall, Jr. v. Commonwealth, 41 A.3d 67 (Pa. Commw. Ct. Jan. 3, 2012) (on appeal), an intermediate appellate court found that an out-of-state passive investor's ownership interest in Pennsylvania real estate through a Connecticut-based limited partnership was enough to establish nexus with the state, and therefore Pennsylvania could impose income tax on the investor's share of the partnership's discharge of indebtedness income. It did not violate the investor's due process rights because he purposefully availed himself of the forum when he chose to invest in the real estate company.


To contact the reporter on this story: Rebecca Helmes in Washington at rhelmes@bna.com

To contact the editor responsible for this story: Karen Irby at kirby@bna.com

Copyright 2013, The Bureau of National Affairs, Inc.

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