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South Dakota and a number of other states have challenged Quill's physical presence nexus requirement for taxing online sales. In this article, University of Richmond School of Law Assistant Professor Hayes R. Holderness, and Dover Dixon Horne PLLC's Matthew C. Boch, discuss how South Dakota's efforts have created an additional transactional nexus issue.
By Hayes R. Holderness & Matthew C. Boch
Hayes Holderness is an Assistant Professor of Law at the University of Richmond School of Law; Matthew Boch is a member of Dover Dixon Horne PLLC in Little Rock, Arkansas.
Consider, if you will, a clothing retailer based in Ohio that also has a brick-and-mortar storefront in Michigan. Let's call this vendor Homage. Assume Homage makes hundreds of sales a year at its Michigan store to Ohioans en route to their homes in the Buckeye State after vacations up north. One of these Ohioans is a state revenue agent who notices that Homage is not collecting Ohio sales tax on its sales to Ohioans in Michigan and decides to issue a sales tax assessment to Homage for those taxes. Sure, Homage has a physical presence in Ohio, but this misguided effort is doomed to fail, thanks to a bit of constitutional formalism born in the 1940s. Compare McLeod v. J.E. Dilworth Co., 322 U.S. 327 (1944) (forbidding Arkansas from imposing its sales tax on transactions consummated in Tennessee for goods to be used in Arkansas) with Gen. Trading Co. v. State Tax Comm'n of Iowa, 322 U.S. 335 (1944) (permitting Iowa to impose its use tax on transactions consummated in Minnesota for goods to be used in Iowa).
Despite their close and complementary relationship, sales taxes and use taxes diverge on at least one key constitutional front: transactional nexus. Transactional nexus refers to the requirement that a tax be “applied to an activity with a substantial nexus with the taxing State” for the tax to be validly imposed. Quill Corp. v. North Dakota, 504 U.S. 298, 311 (1992) (citing Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977)); see also Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 184 (1995) (analyzing whether a substantial nexus existed between the sale of a bus ticket and the state where the bus travel originated); Goldberg v. Sweet, 488 U.S. 252, 262-63 (1989) (analyzing whether a substantial nexus existed between a telephone call and a state in which the call terminated). As derived from the companion cases of McLeod v. J.E. Dilworth Co. and General Trading Co. v. State Tax Commission of Iowa, Ohio cannot impose its sales tax on sales consummated in Michigan because Ohio lacks transactional nexus with the thing taxed—the sale—even though Ohio can impose its use tax on the subsequent use in the state of the product sold because Ohio has transactional nexus with that use.
Much of the attention in the current debate over states' jurisdiction over remote vendors—those vendors without a physical presence in the taxing state—is focused on the taxing state's nexus with the taxpayer or collector. However, the transactional nexus inquiry may present hurdles to collecting tax on online sales. Replace Homage's Michigan storefront with an online sales processing center through which all Homage's online sales are consummated and the issue becomes clear: if Ohio could not tax the Michigan sales before, why allow it now?
Now replace Ohio with South Dakota, and that state's potential transactional nexus issue comes into focus. In this Article, we explain how, in its efforts to kill Quill, South Dakota created a transactional nexus issue, the impact of that transactional nexus issue on South Dakota's efforts to collect taxes on online sales to its residents, and the effect the transactional nexus issue may have on the South Dakota v. Wayfair, Inc. case currently awaiting a decision on certiorari from the United States Supreme Court.
In 2016, South Dakota legislators accepted Justice Kennedy's invitation from Direct Marketing Association v. Brohl, 135 S. Ct. 1124, 1134-36 (2015) and took aim at Quill and the physical presence rule for sales and use taxes by passing South Dakota Senate Bill 106. That bill added section 10-64-2 to the South Dakota Codified Laws, which in full provides that:
Notwithstanding any other provision of law, any seller selling tangible personal property, products transferred electronically, or services for delivery into South Dakota, who does not have a physical presence in the state, is subject to chapters 10-45 and 10-52, shall remit the sales tax and shall follow all applicable procedures and requirements of law as if the seller had a physical presence in the state, provided the seller meets either of the following criteria in the previous calendar year or the current calendar year:
(1) The seller's gross revenue from the sale of tangible personal property, any product transferred electronically, or services delivered into South Dakota exceeds one hundred thousand dollars; or
(2) The seller sold tangible personal property, any product transferred electronically, or services for delivery into South Dakota in two hundred or more separate transactions.
The new law unapologetically takes aim at the physical presence rule with the clear goal of having the United States Supreme Court overturn the Quill decision, as confirmed by the legislative findings codified at section 10-64-1 of the South Dakota Codified Laws. And on this count, the law has so far been successful, as a petition for certiorari now awaits decision from the high court in the Wayfair case. However, something is missing from section 10-64-2: the statute does not apply to the South Dakota use tax, which is imposed in Chapter 10-46 of the South Dakota Codified Laws. This omission occurred despite the facts that the legislative findings reference the use tax in South Dakota Codified Laws §10-64-1(1)-(3), and (11) and that Quill was a decision about use tax collection obligations.
This omission matters immensely because it raises the specter of transactional nexus: does South Dakota have a substantial nexus with the sales it seeks to tax after extending its jurisdiction to remote vendors? As indicated in the introduction, precedent indicates that the answer is “no” because South Dakota is seeking to impose its sales tax rather than its use tax. Therefore, the transactional nexus issue could prevent South Dakota from taxing out-of-state sales delivered into the state by common carrier regardless of the fate of the physical presence rule, derail the Wayfair case, or alter the legal relationship of sales taxes and use taxes, as will be discussed. But first, we examine why this omission occurred. There may be many reasons, but the strongest appear to be either (1) a belief that section 10-64-2 would be incorporated into the use tax rules or (2) an acceptance of the State Department of Revenue's position, as expressed in South Dakota Administrative Rule 64:06:01:25, that, broadly-speaking, sales made to South Dakota residents for use in the state are subject to sales tax instead of use tax.
On its face, section 10-64-2 fails to apply to use taxes. The statutory language states that “any seller … who does not have a physical presence in the state, is subject to chapters 10-45 and 10-52, [and] shall remit the sales tax … .” Chapter 10-45 contains the state's sales tax, and Chapter 10-52 contains authorizes the state's municipalities to impose local sales and use taxes that conform to the state taxes. Any reference to Chapter 10-46, which contains the state's use tax, is missing.
This omission by the South Dakota legislature seems deliberate. After all, the legislative findings codified along with the economic nexus rule display an awareness of the sales tax/use tax divide. One might argue that section 10-64-2 covers the state's use taxes by reference, though this argument is tenuous. South Dakota Codified Laws section 10-46-39 does provide that “[t]he secretary of revenue and regulation shall enforce and administer this chapter in the same manner and subject to all of the provisions contained in chapter 10-45.” By extension, a seller subject to the sales tax provisions of Chapter 10-45 could be subject to the use tax provisions of Chapter 10-46.
There are a few issues with this argument. First, section 10-64-2 is not part of Chapter 10-45 and thus is not directly incorporated into the enforcement and administration rules for the use tax. Second, the sales tax is imposed directly on retailers, as a function of their gross receipts from the sale of tangible personal property in the state. S.D. Codified Laws §10-45-2. In contrast, the use tax is imposed directly on the user of the property. S.D. Codified Laws §10-46-4. As a result, Chapter 10-46 contains unique provisions addressing retailers' use tax collection obligations, which have no analogue in the sales tax chapter. (See S.D. Codified Laws §§10-46-19, 10-46-23, 10-46-33) These provisions essentially state that only retailers with a business-related physical presence in the state can be required to collect the user's use tax. South Dakota Codified Laws §10-46-23 provides that “a retailer maintaining a place of business in this state” shall collect and remit the use tax. “Retailer maintaining a place of business in the state” is defined by section 10-46-1(12) as “any retailer having or maintaining within this state, directly or by a subsidiary, an office, distribution house, sales house, warehouse, or other place of business, or any agents operating within the state under the authority of the retailer or its subsidiary, irrespective of whether such place of business or agent is located here permanently or temporarily or whether such retailer or subsidiary is admitted to do business within this state pursuant to the laws of the State of South Dakota granting the rights of foreign corporations to do business in this state.” It is this use tax collection obligation that one would have expected South Dakota to broaden in its attempt to kill Quill.
Whereas Chapter 10-46 asks whether the retailer is maintaining a place of business in the state, Chapter 10-45 looks only to whether the retailer makes sales at retail in the state because the tax applies only to gross receipts from in-state sales. Compare S.D. Codified Laws §10-46-23 with S.D. Codified Laws §10-45-2. The physical presence rule may prevent South Dakota from reaching some vendors with in-state sales—perhaps vendors transferring products electronically, for example—but Chapter 10-45 is concerned with determining when a sale is taxable, what the tax is, how a seller must remit the tax that it owes to the state, and how the state must enforce the law when the seller fails to meet its obligation. These rules are certainly relevant in the use tax area—the state must determine when a use is taxable, what the tax is, how a user must pay the tax, and how the state must enforce the law when the tax is not paid—but Chapter 10-46 adds a new wrinkle: the taxpayer must pay the tax to a third-party, the vendor, if the vendor is within the state's jurisdiction. Therefore, Chapter 10-46 provides specific rules for when the vendor must collect and how. Section 10-46-39 is best read in this context as ensuring that the rules for determining and remitting the use tax are equivalent to those applying to the sales tax, but not as affecting use tax collection obligations, which have their own rules.
In sum, the new economic nexus rule of section 10-64-2 provides for when the state has jurisdiction over the taxpayer—the seller in the case of the sales tax. Section 10-64-2, even if it were incorporated into the use tax rules, does not alter when the state has jurisdiction over the tax collector—the physically-present seller in the case of the use tax.
Though the new economic nexus rule is not clearly incorporated into South Dakota's use tax law, South Dakota legislators may not have cared if they believed the sales tax is the only tax at issue in the case of remote vendors.
As noted, South Dakota imposes its sales tax directly on the vendor, as a function of the vendor's gross receipts from sales of certain goods and services in the state. S.D. Codified Laws §§10-45-2, 10-45-4, 10-45-5, 10-45-6, 10-45-7, 10-45-8. The use tax, imposed directly on the user, applies to the use of such goods or services in the state when the sales tax was not imposed at the time of purchase. S.D. Codified Laws §§10-46-2, 10-46-4, 10-46.6, 10-46-6.1. Therefore, when the sales tax applies, the use tax does not. In practical (and judicial) understanding, this split means that sales made in the state are subject to sales tax and sales made outside of the state are subject to use tax. See, e.g., W. Wireless Corp. v. Dep’t of Revenue, 665 N.W.2d 73, 75-76 (S.D. 2003) (“Thus, the Legislature imposes a sales tax on purchases of goods and services within the state and a complementary use tax on goods and services purchased outside the state for use within the state.”); Dep't of Revenue v. Sanborn Tel. Co-op., 455 N.W.2d 223, 225 (S.D. 1990) (“As we said in Sioux Falls Newspapers v. Secretary of Revenue, 423 N.W.2d 806, 810 n. 3 (S.D.1988), the use tax ‘is levied on property used within the state if that property would have been subject to sales tax if purchased within the state.’”). So how then would the South Dakota legislature come to believe that sales by out-of-state vendors to South Dakotans are subject to sales tax instead of use tax?
The answer may lie in a South Dakota Department of Revenue regulation and state Supreme Court case addressing that regulation. South Dakota Administrative Rule 64:06:01:25 provides that:
Sales tax must be paid even though the property sold is transported directly to the buyer from a point outside this state if the seller is engaged in the business of selling tangible personal property in this state and if possession of the property is transferred to a buyer residing or located in this state.
The purchase or contract may either precede or follow the interstate shipment. Sales tax applies to the transaction whether the shipment is made free on board (f.o.b.), point of origin or f.o.b. destination and no matter how the goods are transported.
Sales tax applies regardless of whether the sales are made through solicitation, direct mail, or through catalogs.
An unstrained reading of this regulation is that the South Dakota sales tax applies to any sale of a product to a South Dakota resident, regardless of where the sale occurs or how the product is delivered to the resident, just so long as the seller is engaged in the business of selling tangible personal property in the state. The South Dakota Supreme Court, referencing the regulation, confirmed as much in a 1994 decision:
In determining whether a taxable event occurred in South Dakota for sales tax purposes, the question is: where was the sale consummated by delivery? … If the out-of-state retailer does not deliver the merchandise into the state, title passes to the buyer before the merchandise enters the state and the seller is not liable for sales tax. Conversely, if the out-of-state retailer delivers the merchandise into the state, title passes when the retailer completes delivery in the state and the seller is liable for sales tax.
State v. Dorhout, 513 N.W.2d 390, 393 (S.D. 1994) (emphasis added, citations omitted).
Under this approach to the sales tax, South Dakota's economic nexus rule appears to fix the state's remote vendor problems. All of the remote vendor's sales to South Dakota residents would be subject to the sales tax, if only the state could overcome Quill’s physical presence rule preventing the state from exercising jurisdiction over the remote vendor. Section 10-64-2 disregards that physical presence rule, extending the state's sales tax jurisdiction to many remote vendors. The problem is that the regulation may fail to meet the constitutional requirements for transactional nexus—the connection required between the state and the activity taxed, as opposed to the connection required between the state and the taxpayer. Therefore, by attacking the physical presence rule only in the context of sales taxes and seeking to tax all of current remote vendors' sales to South Dakota residents, South Dakota has also put the issue of transactional nexus on the table.
In Quill, the United States Supreme Court confirmed the established understanding regarding transactional nexus: that the Commerce Clause requires a connection between the taxing state and the activity taxed. “[W]e will sustain a tax against a Commerce Clause challenge so long as the ‘tax  is applied to an activity with a substantial nexus with the taxing State … .” Quill Corp. v. North Dakota, 504 U.S. 298, 311 (1992) (citing Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977)); see also Oklahoma Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 184 (1995) (analyzing whether a substantial nexus existed between the sale of a bus ticket and the state where the bus travel originated); Goldberg v. Sweet, 488 U.S. 252, 262-63 (1989) (analyzing whether a substantial nexus existed between a telephone call and a state in which the call terminated). As with many constitutional issues, the standard for finding that transactional nexus can be vague, but the Court has provided some guidance in the case of sales taxes. Though the Court has found that a telephone call terminating in a state has such a nexus with the state if the call is also charged to a service address in that state or billed or paid in that state, Goldberg, 488 U.S. at 263, the Court has also found that the delivery of products to a state by common carrier does not create such nexus, National Bellas Hess, Inc. v. Dep’t of Revenue of Illinois, 386 U.S. 753, 754-55 (1967); cf.McLeod v. J.E. Dilworth Co., 322 U.S. 327, 330 (1944) (“We would have to destroy both business and legal notions to deny that under these circumstances the sale—the transfer of ownership—was made in Tennessee. For Arkansas to impose a tax on such transaction would be to project its powers beyond its boundaries and to tax an interstate transaction.”). The Quill Court confirmed these bounds of the transactional nexus requirement. Quill, 504 U.S. at 311.
Given that the South Dakota sales tax cannot be applied past constitutional limits, (as the state readily accepts, see S.D. Codified Laws §10-45-9) Rule 64:06:01:25 must be read contrary to the understanding that it extends the sales tax to all sales to South Dakota residents by vendors under the state's jurisdiction. Rather, at best, the rule may cover the sale of services that terminate in the state and are billed in the state—similar to the telephone calls at issue in Goldberg—and the delivery of goods by the vendor itself, but the rule cannot cover the delivery of goods through common carriers—the primary type of sales at issue in Wayfair. (South Dakota Supreme Court's decision in State v. Dorhout can be narrowly read to apply only to deliveries of sold goods into South Dakota by the vendor itself. Indeed, the Dorhout Court cites to McLeod v. J.E. Dilworth Co. for the proposition that “Tennessee vendors [were] not liable for Arkansas sales tax because ‘we are here concerned with sales made by Tennessee vendors that are consummated in Tennessee for the delivery of goods in Arkansas.’” See State v. Dorhout, 513 N.W.2d 390, 393 (S.D. 1994). While the McLeod Court did not explicitly provide that the goods sold in Tennessee were shipped to Arkansas by common carrier, it did provide that “[t]itle passes upon delivery to the carrier in Memphis,” indicating that the vendor was not personally delivering the goods. McLeod, 322 U.S. at 328. The Dorhout decision may have been focused only on the rule for vendor deliveries—as it appears, though is not totally clear, from the Dorhout opinion that the vendor was making personal deliveries—taking McLeod as settling the rule for common carrier deliveries.)
Indeed, by limiting the scope of the new economic nexus rule to sales taxes, South Dakota has put up an additional hurdle in the way of the victory it desires. The state may find that even if it wins on the physical presence issue, it will remain unable to tax the proceeds from sales of products delivered into the state by common carrier, and additional legislation will be necessary. Alternatively, the United States Supreme Court will have to be called on not only to abolish the physical presence rule but also to redefine the limits of transactional nexus as relate to sales taxes.
What's more, transactional nexus issues do not exist to the same degree with use taxes. At the same time that the United States Supreme Court decided in McLeod v. J.E. Dilworth Co. that Arkansas had no authority to impose a sales tax on sales of property made in Tennessee, it found in General Trading Co. v. State Tax Commission of Iowa, 322 U.S. 335 (1944), that Iowa could impose a use tax on the use of property sold in Minnesota, and that the state could oblige the Minnesota seller to collect the tax where the seller had salesmen soliciting orders in Iowa.
The Court implicitly confirmed this understanding years later in National Geographic Society v. California Equalization Board, 430 U.S. 551 (1977), when it found that an out-of-state vendor with certain activities in California could be required to collect use taxes on products sold in a line of business unrelated to its California activities. The use of the taxable product in the state was enough to establish the transactional nexus for the use tax. The National Geographic Society holding makes South Dakota's failure to extend the economic nexus rule of section 10-64-2 to the use tax even more puzzling, as the holding indicates that once a state has nexus with the remote vendor for any reason, it can require the vendor to collect use taxes on products the vendor sold into the state.
In focusing its efforts on convincing the United States Supreme Court to abandon the physical presence rule, South Dakota appears to have overlooked the importance of the transactional nexus rule. We see several ways that transactional nexus could impact the Wayfair challenge to Quill that is currently awaiting a certiorari decision from the Court:
(1) Transactional nexus could support denying certiorari;
(2) The Court could grant certiorari, address transactional nexus and revisit or update the McLeod / General Trading transactional nexus principles;
(3) The Court could grant certiorari, address the physical presence rule, and note the need for South Dakota to also extend its economic nexus statute to the use tax before it can require tax collection; or
(4) The Court could address the physical presence nexus rule and ignore transactional nexus, implicitly suggesting that the transactional nexus distinction between sales and use taxes is of little or no importance.
To the first potential outcome, and the one most devastating to South Dakota and the Kill Quill movement, the omission of a use tax collection obligation could persuade the United States Supreme Court not to grant certiorari in Wayfair. Quill was a decision about use tax collection obligations, not sales taxes (although the decision did include sales taxes in its discussion, Quill, 504 U.S. at 317, and the Court may view the South Dakota law as not meeting Justice Kennedy's invitation to challenge Quill.
A second potential scenario is that the Court grant certiorari and issue a ruling on the merits in Wayfair, in which it could address the standards for transactional nexus and, more broadly, the equivalence of sales taxes and use taxes under the law. Despite many moves away from formalism in the state and local tax jurisprudence and broader constitutional jurisprudence, see, e.g., Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the formalistic distinction of sales and use taxes underpinning the McLeod and General Trading decisions still remains in the law. See Hayes R. Holderness, Questioning Quill, 37 Va. Tax Rev. ___ (forthcoming 2018) (analyzing the legal distinctions between sales taxes and use taxes). The same transaction (the out-of-state sale of a product for use in the taxing state) that creates jurisdiction for one type of tax—use taxes—fails to create jurisdiction for the other—sales taxes. If both taxes are intended to be on consumption and to complement one another, as sales and use taxes are commonly understood to do, see, e.g., Multistate Tax Compact, art. II, cl. 8. (defining “use tax” as “a nonrecurring tax, other than a sales tax, ...which is complementary to a sales tax.”), then this split may no longer be needed. In ruling on South Dakota's economic nexus statute as written, the Court could explicitly address whether there is a transactional nexus issue with imposing sales tax on gross receipts from out-of-state sales shipped into the state, either reaffirming or changing the fundamental principles of transactional nexus. Indeed, conceivably the Court could strike South Dakota's law based on transactional nexus principles without reaching the physical presence nexus rule; if the Court believes that South Dakota has overstepped the bounds of transactional nexus rules by extending its jurisdiction over out-of-state sales transactions, then the Court could merely say that the state does not have the authority to impose sales tax on a vendor's gross receipts when the vendor is located outside of the state and only ships goods into the state by common carrier.
Third, the Court could rule on the merits of the physical presence rule but note the transactional nexus issue requiring correction. Practically speaking, if South Dakota's economic nexus rule prevailed, South Dakota would have sales tax jurisdiction over remote sellers but not sales tax jurisdiction over their remote sales. Though this result would be frustrating, the state could fix the issue by amending section 10-64-2 to apply to use taxes as well. This would leave the existing sales tax and use tax transactional nexus legal framework in place, while adding confidence in its continued relevance and validity.
Lastly, the Court could rule on the merits of the physical presence rule while ignoring transactional nexus completely. In recent years we have seen a trend toward state courts conflating transactional nexus with physical presence taxpayer nexus, essentially using a finding of physical presence nexus to determine that any transactional nexus requirement is satisfied. See, e.g., Fla. Dep't of Revenue v. Am. Bus. USA Corp., 191 So. 3d 906, 913-14 (Fla. 2016), cert. denied, 137 S. Ct. 1067 (2017); Travelscape, LLC v. S.C. Dep't of Revenue, 705 S.E.2d 28, 36-37 (S.C. 2011). Presumably that trend would accelerate.
In considering these scenarios, one also should bear in mind that South Dakota can easily fix the transactional nexus problem by extending the economic nexus statute to also apply to the use tax collection obligation. The next session of the South Dakota Legislature begins in January of 2018. Query the impact of passage of such a bill on pending litigation. Perhaps the change would moot potential transactional nexus arguments.
In conclusion, South Dakota appears to have unintentionally and unnecessarily created a transactional nexus question in its efforts to overturn Quill. The transactional nexus problem could support arguments to deny certiorari for Wayfair as the wrong vehicle to revisit Quill, which was a use tax collection case. If certiorari is granted, though, the transactional nexus problem would be an opportunity for the Court to revisit and refresh its relatively dated transactional nexus jurisprudence. Amidst billions of state tax dollars hanging in the balance, South Dakota's transactional nexus gap presents a new wrinkle to states' e-fairness efforts.
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