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Bloomberg BNA regularly spotlights the insights of state and local tax professionals at Grant Thornton. In this installment of Grant Thornton Insights, Patrick Skeehan discusses how states may aggressively interpret economic nexus for purposes of taxing out-of-state retailers in light of the Crutchfield decision.
By Patrick Skeehan
Patrick K. Skeehan is a senior associate in Grant Thornton's state and local tax practice in Philadelphia and provides sales and use tax, income and franchise tax and gross receipts tax assistance to clients. He can be reached at firstname.lastname@example.org.
In late November, the Ohio Supreme Court ruled in Crutchfield Corporation v. Testa that the bright-line presence standard of the Ohio Commercial Activity Tax (CAT) satisfied the substantial nexus requirement under the Commerce Clause of the U.S. Constitution. [ Crutchfield Corporation v. Testa, Ohio Supreme Court, No. 2015-0386, Nov. 17, 2016. The court issued Crutchfield with two other companion cases, Newegg, Inc. v. Testa, Ohio Supreme Court, No. 2015-0483, Nov. 17, 2016, and Mason Companies, Inc. v. Testa, Ohio Supreme Court, No. 2015-0794, Nov. 17, 2016.] In doing so, the court became the first state supreme court to weigh in on the constitutionality of a bright-line presence standard to determine nexus for purposes of a corporate-level tax, further eroding the long-time physical presence standard established in Quill Corp. v. North Dakota. [504 U.S. 298 (1992).] The Crutchfield decision comes at a crucial juncture as states are looking for ways to expand nexus standards and bring out-of-state retailers within their taxing jurisdiction. Most of all, the decision serves as the latest sign that the U.S. Supreme Court may choose to intervene to address the Quill standard and its future role in the Court's Commerce Clause jurisprudence.
Crutchfield Corporation is a Virginia-based online retailer of consumer electronics with no employees or facilities in Ohio. Crutchfield's only connection with Ohio during the tax years at issue was that it sold goods from outside the state to Ohio-based customers using common-carrier delivery services, and that Crutchfield's annual gross receipts to customers in Ohio exceeded $500,000. By reason of its level of gross receipts to Ohio customers, Crutchfield exceeded the state's statutory sales threshold to trigger a bright-line presence and thus substantial nexus with Ohio for purposes of the CAT. [Ohio Rev. Code Ann. §5751.01(I).]
As state taxes go, the CAT is somewhat unique in that it is a gross receipts tax imposed on the “privilege of doing business” in Ohio. [Ohio Rev. Code Ann. §5751.02(A).] “Doing business” is defined as engaging in any activity, whether legal or illegal, that is conducted for or results in gain, profit or income at any time during the calendar year. [ Id.] The CAT is levied on those persons having “substantial nexus” with the state, which is defined to include persons having a bright-line presence in the state. [Ohio Rev. Code Ann. §5751.01(H).] Under the statute, there are a number of ways to trigger bright-line presence in Ohio, including having at least $500,000 of gross receipts in the state during a calendar year. [Ohio Rev. Code Ann. §5751.01(I).] Ohio was the first state to enact a bright-line factor presence nexus standard for an entity-level tax back in 2005. Many states have since followed suit by adopting their own factor presence nexus standards for corporate net income taxes or gross receipts taxes, [In addition to specific sales thresholds, other statutory thresholds based on the level of property and payroll, or on a percentage of total sales, property or payroll also exist] including Alabama [Ala. Code §40-18-31.2 (began in 2015 and current threshold is $500,000 in sales)], California [Cal. Rev. & Tax. Code §23101 (began in 2011 and current threshold is $547,711 in sales)], Colorado [Colo. Code Regs. §39-22-301.1 (began in 2010 and current threshold is $500,000 in sales of services)], Connecticut [Conn. Gen. Stat. §12-216a; Conn. Info. Pub. 2010(29.1), Dec. 28, 2010 (began in 2010 and current threshold is $500,000 in sales)], Michigan [Mich. Comp. Laws §206.621(1) (originally imposed by the Michigan Business Tax, which was in existence from 2008-2011, and maintained by the Michigan Corporation Income Tax that has been in existence since January 1, 2012, with a threshold of $350,000 in sales)], New York [N.Y. Tax Law §209.1(b) (began in 2015 and current threshold is $1 million in sales)], Tennessee [Tenn. Code Ann. §67-4-2004 (began in 2016 and current threshold is $500,000 in sales)] and Washington [Wash. Rev. Code §82.04.067 (began in 2010 and current threshold is $267,000 in gross receipts for purposes of the service, royalty and wholesale classifications of the B&O tax)].
On appeal to the Ohio Supreme Court, Crutchfield argued that imposition of the CAT violated the federal dormant Commerce Clause because it lacked “substantial nexus” with Ohio. Crutchfield asserted that it did not have substantial nexus because it lacked physical presence in the state, a necessary prerequisite to imposing a tax under the dormant Commerce Clause. The Ohio Tax Commissioner countered that the Commerce Clause does not require a physical presence for the CAT and that the $500,000 gross receipts threshold satisfied the substantial nexus requirement. Even if a physical presence were required for a business privilege tax, the Tax Commissioner argued, Crutchfield's computerized connections with Ohio consumers involved the presence of tangible personal property on customer computers located in Ohio, thereby constituting a physical presence in the state.
The court sided with the Ohio Tax Commissioner. In rejecting Crutchfield's arguments, the court found it significant that the CAT's statutory language does not require certain in-state activities or a physical presence for nexus to apply. The court rejected Crutchfield's argument that a “local incident” is required for a state to impose a tax, noting that this argument relied on cases preceding Complete Auto Transit v. Brady, first establishing the substantial nexus requirement. [430 U.S. 274 (1977). Complete Auto established that a state tax meets Commerce Clause scrutiny if it passes a four-part test: 1) it is applied to an activity with a substantial nexus with the taxing state; 2) it is fairly apportioned, 3) it does not discriminate against interstate commerce; and 4) it is fairly related to the services provided by the state. Id.]
Next, the court addressed the question of whether Quill’s physical presence requirement applies to business privilege taxes such as the CAT. Echoing previous state court decisions finding that Quill applies specifically to sales and use taxes, the court determined that Quill’s holding is not binding on taxes measured on income. Rather, the court reasoned that the CAT's $500,000 sales-receipts threshold satisfied Complete Auto’s substantial nexus requirement because it provided an “adequate qualitative standard.” In doing so, the court made the distinction that while physical presence is a sufficient condition for imposing a business privilege tax, it is not a necessary condition. Finally, the court concluded that the burden imposed by the CAT on interstate commerce was not “clearly excessive” in relation to the benefits of evenhandedly taxing the sales receipts of both in-state and out-of-state sellers.
At first glance, the influence of the Crutchfield decision appears limited given the fact that it concerns the application of bright-line nexus to a gross receipts tax rather than a corporate net income tax, which exists in most states. Its true impact, however, could be more far-reaching. Ohio is not the only state that imposes a non-income based tax, and it is gaining company. Similar to Ohio, Washington imposes a business and occupancy (B&O) tax on the privilege of engaging in business activities, measured by gross receipts. [Wash. Rev. Code § 82.04.220.] Texas imposes a “franchise tax” on each entity doing business in Texas, measured by taxable margin. [Tex. Tax Code Ann. §171.001.] As the latest state to enact a gross receipts tax, Nevada in 2015 enacted a controversial commerce tax, a tax on businesses with annual Nevada-sourced gross revenue exceeding $4 million. [Nev. Rev. Stat. §363C.200.] Potentially emboldened by Crutchfield, gross receipts tax states such as Washington may cite the decision as further support for the proposition that their tax applies to out-of-state retailers without a physical presence. Indeed, this issue is not new to Washington: one of the state's appeals tribunals found that a service business without a physical presence in the state was subject to B&O tax because its Washington-sourced gross receipts exceeded the state's threshold. [Wash. Dept. of Revenue, Det. No. 14-0342, Apr. 30, 2015.]
States with corporate net income taxes may take the Crutchfield decision as a sign of encouragement to move to a gross receipts tax regime for more stable sources of revenue. With a gross receipts tax, these states can minimize revenue fluctuations and reduce budget deficits by tapping into more reliable income sources from out-of-state taxpayers such as online retailers. The looming question is whether states that impose corporate net income taxes will rely on the holding of the Crutchfield case to support the constitutionality of a factor presence nexus statute for corporate income tax purposes. Although high courts in other states have previously ruled that physical presence is not necessary to impose an entity-level net income tax (and are doing so with increasing speed) [ See Geoffrey, Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993); Tax Commissioner v. MBNA America Bank, N.A., 640 S.E.2d 226 (W. Va. 2006); Capital One Auto Fin. Inc. v. Dept. of Revenue, Oregon Tax Court, TC 5197 (Dec. 23, 2016).], the Crutchfield decision represents the first time a state's highest court has addressed the constitutionality of a bright-line presence standard.
As the case is likely to be appealed to the U.S. Supreme Court, Crutchfield becomes a prime candidate for review for two reasons. First, the Ohio Supreme Court's endorsement of the CAT's $500,000 sales-receipts threshold as an “adequate qualitative standard” ensuring substantial nexus presents some potentially troubling results. Two dissenting justices gave an example of an out-of-state retailer that would be subject to the CAT if it made sales to just one Ohio resident who spent more than $500,000 on its products. [ Crutchfield v. Testa, Ohio Supreme Court, No. 2015-0386 (Kennedy, J., dissenting).] Without any other connections to the state, such a business would be dragged “into Ohio's taxing scheme based on one act of interstate commerce.” [ Id.] The dissent concluded that this was clearly an undue burden on interstate commerce that Quill and other cases were designed to prevent. Such fact patterns are ripe for further examination as states continue to implement factor presence standards with varying dollar thresholds that may be questioned as arbitrary. In light of Crutchfield, questions remain on the boundaries of an adequate qualitative standard for purposes of satisfying substantial nexus.
Second, Crutchfield is yet another way for the high court to review Quill’s contentious physical presence rule. Currently the Quill case is under assault from states such as Alabama, South Dakota and Tennessee, which have adopted sales and use tax bright-line nexus standards for remote sellers. [ See Ala. Admin. Code r. 810-6-2-.90.03; South Dakota S.B. 106, Laws 2016; Tenn. Comp. R. & Regs. 1320-05-02-.129.] The other issue remains whether Quill’s physical presence standard applies to non-income taxes such as gross receipts taxes. Absent intervention from Congress, only the U.S. Supreme Court would be able to resolve that question once and for all. The dissenting justices in Crutchfield felt strongly enough about Quill’s physical presence standard to the extent that they believed it also applies beyond sales and use taxes. [The dissenting opinion found no evidence that “gross receipts taxes are meaningfully different from use taxes for substantial nexus purposes.” Crutchfield, No. 2015-0386 (Kennedy, J., dissenting).]
Many state tax practitioners would welcome the U.S. Supreme Court's consideration of a number of important state tax issues, including retroactive state tax legislation [Two certiorari petitions have been filed with the U.S. Supreme Court on the issue of retroactivity. See Gillette Commercial Operations N.A. & Subsidiaries v. Michigan Department of Treasury, 880 N.W.2d 230 (Mich. 2016); and Dot Foods, Inc. v. Washington Department of Revenue, 372 P.2d 747 (Wash. 2016).], anti- Quill sales and use tax laws and regulations [Litigation challenging Alabama's regulation requiring out-of-state sellers to collect and remit sales tax in the absence of a physical presence was filed in the Alabama Tax Tribunal in 2016. Newegg, Inc. v. Alabama Department of Revenue, Alabama Tax Tribunal, No. S. 16-613, filed June 8, 2016. South Dakota filed a declaratory judgment action asserting that its remote seller sales and use tax legislation was valid. South Dakota v. Wayfair, Inc., No. 32CIV16-000092 (S.D. 6th Cir. Ct.), filed Apr. 28, 2016. Meanwhile, remote retailers filed suit challenging the facial constitutionality of the South Dakota legislation. American Cataloging Mailers Ass'n v. Gerlach, No. 32CIV16-000096 (S.D. 6th Cir. Ct.), filed Apr. 29, 2016.], and remote retailer notice requirements. [In December 2016, the U.S. Supreme Court denied certiorari in Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016), which upheld the constitutionality of Colorado's notice and reporting requirements imposed on out-of-state retailers that do not collect sales tax in the state.] The confirmation of a new justice to fill the current vacancy in the Court resulting from the death of Justice Antonin Scalia may have an effect on how the Court ultimately proceeds on decisions relying on bright-line nexus concepts like Crutchfield, including a potential re-evaluation of Quill itself. While speculating about how a potential future U.S. Supreme Court justice may rule on specific issues may be difficult, the recent nomination of Judge Neil Gorsuch to the Court does provide a window of opportunity to consider how the nominee might address these issues if confirmed.
Judge Gorsuch has publicly acknowledged that he applies a strict interpretation of the U.S. Constitution. [The Denver Post, Transcript: Neil Gorsuch's Full Remarks After Accepting the U.S. Supreme Court Nomination (Jan. 31, 2017).] This acknowledgment may imply a view that the concept of the dormant Commerce Clause is incompatible with the structure of the Constitution, because the clause cannot be found in the text of the Constitution itself. Recent opinions penned by Judge Gorsuch align with this view, and reveal his skepticism of the U.S. Supreme Court's dormant Commerce Clause jurisprudence. For example, as a judge on the Tenth Circuit Court of Appeals, Gorsuch penned a concurrence in Direct Marketing Association v. Brohl, which upheld the constitutionality of Colorado's notice and reporting requirements imposed on out-of-state retailers that do not collect sales tax in the state. [ Direct Marketing, 814 F.3d at 1147 (Gorsuch, J., concurring).] In his concurrence, Gorsuch agreed with U.S. Supreme Court Justice Anthony Kennedy that the judicial system should find an appropriate case by which to re-examine Quill and its physical presence standard. Gorsuch referred to the Quill rule as an “analytical oddity” that gives a competitive advantage to mail order and Internet vendors merely because of the way they are organized. [ Id. at 1150.] Believing that Quill may have an “expiration date” attached to it due to eroding reliance interests, Gorsuch wrote that the decision “seems deliberately designed to … wash away with the tides of time.” [ Id. at 1151.] Based on Gorsuch's overall view strictly interpreting the U.S. Constitution and his opinion in Direct Marketing, if confirmed, he may support a consideration and potential overhaul of the Quill physical presence standard.
In the short term, Crutchfield is a case that that will encourage other states to aggressively interpret economic nexus. Beyond that, it provides the U.S. Supreme Court yet another opportunity to make a definitive statement on Quill. It is anyone's guess as to whether the U.S. Supreme Court will take up the Crutchfield case to resolve the constitutionality of the bright-line presence standard, but the future composition of the Court may make that possibility all the more likely.
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