Old Doctrines, New Taxes: What Nexus Standards Apply in the World of Gross Receipts Taxes?

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Baker's SALT Corner

Bloomberg BNA regularly spotlights the insights of state and local attorneys at Baker & McKenzie. In this installment of Baker's SALT Corner, Maria P. Eberle, Lindsay M. LaCava and Nicole Ford discuss the increasingly aggressive, and creative, approach states are taking with respect to nexus in the context of gross receipts taxes. In 2016, the authors explain, nexus was arguably expanded with respect to gross receipts tax regimes, with the blessing of the Ohio and Washington supreme courts. The authors conclude that it's unclear if this activity will cause those states with gross receipts tax systems to become even more aggressive or whether it will affect states that impose traditional net income taxes.

Maria P. Eberle Lindsay M. LaCava Nicole Ford

By Maria P. Eberle, Lindsay M. LaCava and Nicole Ford

Maria Eberle and Lindsay LaCava are partners in Baker & McKenzie LLP's New York office and Nicole Ford is an associate in the firm's Dallas, Texas office; all three practice in the area of state and local tax.

In 2017, uncertainty abounds in the world of state tax. Will the U.S. Supreme Court accept any state tax cases? Will Quill survive another year? Will federal tax reform finally happen, and how will the states respond? Notwithstanding this uncertainty, there is one thing that is certain—states are far more diverse (or aggressive) in their approaches to taxation. Gone are the days where states merely imposed traditional sales taxes, business net income taxes, property taxes and personal income taxes to raise revenues. States are now taking a hybrid approach to taxing business activity in the form of gross receipts-based taxes (“GRTs”), which have certain components of a traditional net income tax and certain components of a sales tax. Given the hybrid nature of GRTs, threshold questions arise regarding the appropriate nexus standards (e.g., physical presence or economic nexus). In this article, we will explore recent state court decisions on nexus in the GRT context.

GRTs—used most notably by Ohio (the Commercial Activity Tax or “CAT”), Texas (the Franchise Tax or Margin Tax) and Washington (the Business & Occupation Tax or “B&O Tax”) in place of a net income tax—are generally based on gross receipts rather than corporate net income. However, unlike a sales tax, which is tied to specific transactions, a GRT is generally imposed on the privilege of doing business within a state. Because a GRT is neither a net income tax nor a sales tax, questions arise as to what the relevant nexus standards are or should be. Does a GRT, like a sales tax, require physical presence within the state, or will economic nexus, which many states have adopted in the net income tax context, suffice? Also, what level of nexus is required to impose a GRT—does the state only need to have nexus with the person (e.g., corporate entity), or must there also be nexus with the particular receipts at issue (i.e., “transactional nexus”)? (Although this article focuses on nexus, these hybrid GRTs, which are part sales taxes and part income taxes, raise a number of additional questions, including questions regarding (1) the applicability of Public Law 86-272 (which applies by its terms to “net income” taxes); (2) the deductibility of GRTs paid from other states' net income taxes (which typically only allow deductions for “income” taxes); and (3) whether the tax is required to be apportioned.)

Several years ago, an appellate court in Texas decided that the physical presence standard of Quill v. North Dakota, 504 U.S. 298 (1992), applied to the then-current version of the Franchise Tax and the state has continued to apply that standard to its current GRT-style Franchise Tax. Rylander v. Bandag Licensing Corp., 18 S.W.3d 296 (Tex. App. – Austin 2000, pet. denied). However, since then, Ohio and Washington have adopted statutory economic nexus standards in the context of the CAT and the B&O, respectively ( SeeOhio Rev. Code § 5751.01(I); Wash. Rev. Code §§ 82.04.066, 82.04.067(1)(c)(iii)), and the Ohio Supreme Court has recently upheld the validity of the CAT's economic nexus standard against a constitutional challenge.

In Crutchfield Corp. v. Testa, Slip Opinion No. 2016-Ohio-7760 (Ohio S. Ct. Nov. 17, 2016), the Ohio Supreme Court determined that an out-of-state company maintained “substantial nexus” with Ohio for purposes of the CAT despite lacking physical presence in the state. The court held that Quill's physical presence requirement applies for purposes of use tax collection but “does not extend to business privilege taxes such as the CAT, as long as the privilege tax is imposed with an adequate quantitative standard that ensures the taxpayer's nexus with the state is substantial.” The majority ruled that the $500,000 Ohio sales-receipts threshold was an “adequate quantitative standard.” (A dissenting opinion argued that the physical presence requirement should not be abandoned absent federal legislation.)

While the court concluded that the physical presence standard of Quill did not apply in the CAT context, mainly because the CAT is not a sales tax, the court failed to explain this conclusion or meaningfully analyze the CAT to justify its conclusion (e.g., what was it about the CAT that made it more akin to an income tax or less like a sales tax, etc.). Additionally, given the growing number of states that have adopted factor presence nexus standards (even in those states that impose traditional corporate net income taxes) and the U.S. Supreme Court's historic silence (i.e., declining to grant certiorari) on the issue of whether Quill's physical presence requirement applies outside of the sales and use tax context, Crutchfield could have implications beyond the GRT context.

Another interesting GRT nexus case recently emerged in the context of the B&O Tax, Avnet Inc. v. Dep't of Rev., Dkt. No. 92080-0 (Wash. S. Ct. Nov. 23, 2016). In Avnet, physical presence versus economic presence was not at issue as the taxpayer maintained an office and employees in the state (Washington has a factor-presence nexus statute similar to the statute upheld by the Ohio Supreme Court in Crutchfield), but the Washington Supreme Court was asked to analyze whether certain receipts of the taxpayer were sufficiently connected to Washington for purposes of imposing the B&O Tax on those receipts. In Avnet, the taxpayer argued that nexus was lacking with certain of its sales and, therefore, it could not be subject to the B&O Tax on those sales (termed “national sales”). Avnet was headquartered in Arizona and shipped all of its products from distribution centers outside Washington. Avnet's Washington office and its Washington employees were not involved with its national sales. Avnet argued that its Washington activities were sufficiently dissociated from its national sales such that, under relevant U.S. Supreme Court precedent, citing Norton Co. v. Dep't of Rev., 340 U.S. 534 (1951), the national sales at issue did not have substantial nexus with the state and could not be subject to the B&O Tax. In Norton, the U.S. Supreme Court addressed whether the dormant commerce clause prohibited Illinois from imposing its business privilege tax on out-of-state sales that were not facilitated or fulfilled by the taxpayer's Illinois branch. The U.S. Supreme Court held that a taxpayer with a physical presence in the taxing state may not be subject to tax on certain revenue streams if it can show that the particular revenue generating activities at issue are “dissociated from the local business and interstate in nature.” While the Washington Supreme Court recognized the continued validity of Norton and its disassociation analysis, it concluded that to demonstrate disassociation a taxpayer would need to show a “ complete absence of any connection between the local office and the underlying sales to meet its burden.” This standard, while achievable in theory, may prove extremely difficult, if not impossible, to meet in practice.

The Avnet case also raises the question of whether a disassociation analysis is even relevant outside of the sales tax context. Recently, the U.S. Supreme Court has opined in Comptroller of the Treasury v. Wynne, 575 U.S. ___, 135 S. Ct. 1787 (2015), that there is no meaningful distinction between gross receipts-based taxes and traditional income taxes, thereby suggesting that the nexus standards applicable in the income tax context should also apply in the GRT context. A GRT, although measured by “receipts” like a sales tax, is not tied to specific transactions like a sales tax. It seems clear that, with respect to transaction-based taxes, the state must have a direct connection not only to the taxpayer but also to the transaction at issue to impose the tax. See, e.g., Goldberg v. Sweet, 488 U.S. 252 (1989); Oklahoma Tax Comm'n v. Jefferson Lines, 514 U.S. 175 (1995). It is not as clear whether this requirement applies in the GRT context, where the tax is imposed, more generally, on the privilege of engaging in business in the state. Furthermore, the unitary business principle—which exists in the net income/business activity tax context—may be an additional safeguard against taxing revenue streams that do not have a sufficient connection with the state. See e.g., Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), Butler Bros. v. McColgan, 315 U.S. 501 (1942). In other words, where the in-state business is unitary with the out-of-state business, it may seem less offensive to tax the out-of-state business's revenues even if they are dissociated from the in-state business activities. However, the unitary business principle is an apportionment concept—it is not a substitute for nexus. Thus, the question of whether a state has substantial nexus with the particular transaction (or, activity) it seeks to tax could remain a viable concern in both the net income tax and GRT areas.

In sum, 2016 was a year in which nexus was addressed and arguably expanded with respect to GRT regimes, with the blessing of two state high courts. Whether this causes those states that already have GRT systems in place to become even more aggressive, or influences the activities of other states that impose traditional net income taxes remains to be seen.

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