With states facing unprecedented financial budget crises, every week we read about their efforts to generate more tax revenue. One popular trend has states looking to tax out-of-state companies by proposing broader nexus thresholds that would subject previously untaxed companies to the state’s tax. States such as California, Colorado, Connecticut, Minnesota, Michigan, New York, North Carolina, Ohio, Rhode Island and Washington have recently adopted broader nexus standards. Without Supreme Court guidance or congressional intervention, the country’s entire nexus landscape seems likely to have a thorough makeover in the near future. However, despite the wave of aggressive efforts to close budget gaps, a surprising opposition movement has surfaced in some locations — raising the possibility that the rising nexus waters could recede.
Nexus is the connection between an entity and state that determines whether that entity is subject to a state’s tax. Nexus thresholds can vary from tax to tax (e.g. income tax, sales and use tax, gross receipts tax, etc.) as well as from state to state.
When the U.S. Supreme Court last spoke on the issue in 1992, it appeared that nexus standards might largely be settled. In Quill Corp. v. North Dakota, 504 US 298 (1992), a case dealing with sales tax collection responsibility for an out-of-state retailer, the Court found that the Commerce Clause requires physical presence that is more than de minimis before a state can impose a tax obligation. However, some state courts began to chip away at this interpretation and attempt to limit the decision to sales tax. The typical state court analysis has focused on the easier Due Process standard, has given little attention to the Commerce Clause standard, and has erroneously relied on the theory of in rem jurisdiction, which was abandoned by the Supreme Court in 1977. The Supreme Court, however, has remained silent, and many states have become more and more emboldened in applying economic nexus concepts to state income tax.
In addition to the growing specter of economic nexus, another recent disturbing nexus trend has seen something called “click-through nexus” or “Amazon nexus” adopted or proposed in several states. Where Amazon nexus did not take hold, some states have enacted enhanced reporting requirements on out-of-state retailers in an effort to “educate” in-state customers on their use tax obligations. In the extreme case, Colorado has attempted to impose penalties on the non-filing of a burdensome informational report.
The economic nexus theory applied to income, gross receipts and business activity taxes arises when an out-of-state entity exploits the economic market in a state. Many states currently apply economic nexus theory, but have not clearly defined what establishes taxability.
Even states’ attempts to define economic nexus have not always been helpful. Initially, Connecticut attempted to define “a substantial economic presence” as:
A purposeful direction of business toward this state, examined in light of the frequency, quantity and systematic nature of a company's economic contacts with this state, without regard to physical presence, and to the extent permitted by the Constitution of the United States. H.B. 6802 (effective January 1, 2010).
2010 has heralded a surge of various adaptations of the Multistate Tax Commission’s (MTC) factor presence nexus standard, which establishes a bright-line threshold for establishing economic nexus. Adopting states include California, Connecticut, Minnesota, Michigan, North Carolina, Ohio and Washington.
The MTC’s Factor Presence Nexus Standard for Business Activity Taxes was introduced on October 17, 2002, and provides that:
Substantial nexus is established if any of the following thresholds is exceeded during the tax period:
(a) a dollar amount of $50,000 of property; or
(b) a dollar amount of $50,000 of payroll; or
(c) a dollar amount of $500,000 of sales; or
(d) 25 percent of total property, total payroll or total sales.
Our emphasis on $500,000 of sales is to highlight the economic nexus controversy of this bright-line nexus standard. Supporters argue that it is better to have a flawed bright-line standard than a hodgepodge of largely undefined economic nexus concepts throughout the states. Ohio was the first state to enact the MTC’s factor presence nexus standard as part of the commercial activity tax in 2005.
On December 28, 2010, the Connecticut Department of Revenue Services issued Information Publication 2010 (29.1), which pronounced that a bright-line threshold for economic nexus is met with $500,000 of Connecticut gross receipts, adding some specificity to its previous general definition.
California, Colorado, Connecticut, Michigan and Washington adopted the MTC’s factor presence nexus standard or a variation thereof effective in 2010 or 2011. Following the MTC’s standard, California, Colorado, Connecticut and Ohio have adopted sales thresholds of $500,000. Michigan and Washington have taken more aggressive positions with lower gross receipts thresholds of $350,000 and $250,000, respectively.
Click-through nexus or Amazon nexus might more properly be referred to as affiliate nexus. The concept applies to sales and use tax and focuses on the relationship between out-of-state internet retailers and their in-state affiliates that, under this theory, help facilitate the sale of goods over the internet. Independent persons, or affiliates, who post a link to an out-of-state business for a share of the revenue generated by the link are sufficient presence to establish nexus for the out-of-state business and require them to collect sales tax.
Enacted in 2008, New York’s revised nexus standards under Tax Law Section 1101 provide that out-of-state online retailers are required to collect sales and use tax on sales to New York customers because of contracts between the retailer and New York residents/affiliates to solicit sales. Amazon and Overstock.com litigated and lost. After the loss, several states quickly introduced Amazon law legislation but pure Amazon laws have only passed in North Carolina and Rhode Island. (South Dakota’s legislature just passed an affiliate nexus bill and an enhanced reporting bill. That state’s affiliate nexus bill, however, requires a substantial ownership connection.)
According to a 2010 Survey of State Tax Departments by BNA, 14 additional states indicated that an Amazon-type arrangement with an in-state affiliate would trigger nexus if the affiliate were paid less than $10,000 during the year. The states are Arizona, D.C., Florida, Iowa, Maryland, Missouri, Nevada, New Mexico, North Dakota, Pennsylvania, South Dakota, Tennessee, Texas and Washington.
As the pioneer of Amazon nexus, New York claims it collected an estimated $70 million for the 2009-10 fiscal year from 30 internet companies. However, Amazon has filed suit, and appeals, against New York challenging the constitutionality of New York’s nexus laws (Amazon.com LLC v. New York State Dept. of Taxation & Fin., 2010 NY Slip Op., Nov. 4, 2010). New York’s apparent success to date has not generally been duplicated in other states as internet companies have retaliated against states that have passed click-through nexus legislation.
As a consequence of the Amazon law, companies across the country cancelled their agreements with New York in-state commissionaires, including Amazon. Similar retaliatory responses were seen in North Carolina, Rhode Island, and even Colorado, which enacted a modified Amazon-type law with an enhanced reporting requirement.
Enhanced Reporting Requirements
Hoping to avoid the type of retaliation Amazon has made against other states, Colorado adopted a variation on Amazon laws that omitted the “affiliates” language. Focused on the revenue related to untaxed transactions, but forgoing the path of taxing out-of-state retailers themselves, some states are instead looking for use tax from in-state customers. Colorado and Oklahoma have attempted to require online retailers to notify customers of their use tax obligations. These requirements range from website or mail notifications to Colorado’s burdensome informational reporting requirement, complete with non-filing penalties. Even if a state can be allowed to impose a reporting obligation on an entity with no nexus and possibly no jurisdiction, the attempt appears likely to breach privacy laws. Subsequently,a federal district court issued a preliminary injunction, on constitutional grounds, preventing the Colorado Department of Revenue from enforcing the sales tax notice and reporting obligations it imposed on out-of-state retailers (see The Direct Marketing Association v. Huber, Jan. 26, 2011). More recently, a bill was introduced in the Colorado Senate to repeal the use tax notification and reporting requirements altogether.
Similarly, Amazon won a declaratory judgment over the North Carolina Department of Revenue for requesting that Amazon produce customer purchase records. The request was deemed to violate the First Amendment and the Video Privacy Protection Act (see Amazon.com LLC v. Lay, Oct. 25, 2010).
More Pushback Against the New Nexus Standards
State propositions for Amazon laws have been unpopular not only with online retailers but with in-state residents as well. In response to Colorado’s proposal of adopting a modified Amazon law, many in-state affiliates protested. At a House Finance Committee hearing in Denver, dozens of Colorado participants in Amazon’s affiliate program opposed the proposition, fearing that Amazon would eliminate the affiliate program as it had in other states, thus devastating their businesses. Despite Colorado’s different approach and removal of the affiliates language, Amazon, along with numerous other businesses, nonetheless did just that and eliminated their Colorado affiliates program. With out-of-state businesses responding as aggressively as Amazon has, it is not surprising that the wave of new state tax legislation has shown signs of receding.
Despite the dire economic straits of so many states and their aggressive push to increase tax revenue, some have backtracked on proposals intended to do just that. Notably, Amazon nexus bills in numerous states have failed to pass (e.g. Connecticut, Maryland, Minnesota, Tennessee and Wisconsin); in other states (California and Hawaii), bills had passed but have been vetoed. Recently, a similar bill was again proposed in California. The Board of Equalization requested Amazon’s opinion of the bill. Not surprisingly, in an open letter, Amazon objected to the bill on constitutional and practical grounds including state revenue implications.
As a seeming counter to the proposed Amazon bill, the California Senate introduced legislation that, for sales and use tax purposes, amends the definition of “retailer engaged in business in this state” to include any retailer that has substantial nexus with California pursuant to the Commerce Clause of the U.S. Constitution and any retailer capable of bearing use tax collection duties under federal law.
On February 9, 2011, the Illinois General Assembly introduced SB 1783, which provides that a website link is not sufficient to qualify a retailer as maintaining a place of business in Illinois. This bill was in direct contrast to one passed by the General Assembly not one month earlier that contained Amazon nexus provisions.
Illinois’s backtracking on Amazon nexus is significant considering that its financial circumstances are among the most dire in the nation at the moment. Illinois carries a $13 billion deficit (roughly 34 percent of its $35 billion general fund budget), a $6 billion debt consisting of unpaid bills to public universities, schools, social service agencies, druggists and vendors, plus a state employee pension fund that is estimated to be $80 billion to $90 billion underfunded. Having increased income tax rates 66 percent (to five percent from three percent), it is interesting that Illinois would pull the plug on strategies it hoped would help plug the gap. Presumably, Illinois wants to retain and attract businesses.
Looking at how Amazon nexus has fared in the states that have enacted such legislation, it is not surprising that many states are vetoing or reconsidering their slew of proposed methods to generate additional tax revenue. States with newly enacted Amazon nexus, such as Rhode Island, have apparently not generated any additional revenue because large numbers of internet retailers like Amazon eliminated the in-state affiliate programs as a result. The internet retailers’ responses not only eliminated the tax that would likely have been generated with the new nexus standard, but also reduced the taxable income of in-state affiliates that relied on the affiliate program for revenue.
In Texas, which does not have an Amazon law, Comptroller Susan Combs audited Amazon and determined that it owes $269 million in uncollected sales and use tax for five back years. The comptroller asserts that Amazon’s Irving warehouse and its 120 employees was enough physical presence to require collection. Amazon — and Governor Rick Perry, who is worried about job losses — argue that the warehouse is not a storefront and is not the type of physical presence required. In response to the assessment, now pending in the State Office of Administrative Hearings, Amazon recently announced it will close its Irving warehouse, leaving 120 workers unemployed, and abandon future plans for expanding operations in Texas. The prospect of losing over a thousand potential jobs and tens of millions of investment dollars has put the governor at an impasse with the comptroller.
On February 16, 2011, House Resolution 95 was introduced in the U.S. House of Representatives, opposing any congressional action to grant states sales tax collection authority over out-of-state small businesses engaged in electronic commerce. HR 95 proclaims, “Whereas at a time when national unemployment numbers are high and businesses across the Nation are struggling to keep their doors open, Federal policy should promote pro-growth and pro-business policies instead of enacting legislation that extracts additional taxes from the Nation’s Internet-enabled businesses.” This resolution is an apparent stab at not only Amazon nexus laws, but also the streamlined sales tax initiative, whose ultimate goal is to have Congress enact legislation allowing states to require retailers to collect sales/use taxes on all taxable sales regardless of nexus.
Alvarez & Marsal Taxand Says:
Some states are desperately trying to increase tax revenue by increasing rates or expanding the reach of their taxing systems. Other states are trying to cannibalize the business communities outside their borders by displaying more reasonable and moderate tax policies — in other words, by looking attractive and asking for a date. Indiana’s overt attempts to woo Chicagoland businesses over the state line are a prime example. Indeed, the voices of moderation assert their states should be more desirable business locations. When it comes to nexus, the moderate voices could use a little help from the Supreme Court.
Some proposals earmarked as bringing in millions of dollars in tax revenue from out-of-state companies have also brought unpleasant in-state ramifications. As states roll out waves of tax proposals in hopes of washing away the red ink from their budgets, perhaps a change in the pendulum’s direction will help balance not only state budgets but also the interests invested in the state’s current crisis and its future growth. Nevertheless, taxpayers remain wary of becoming ensnared by an expanding nexus trap.
Managing Director, San Francisco
George Yu, Senior Associate, contributed to this article
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